Treaty Platforms: Traps For The Unwary

TAX TREATY PLATFORMS

Traps for the Unwary

Presented By:

Festus Akunobera, Esq.
LL.M., International Tax (NYU); LL.B., 1st Class (MUK); Dip LP (LDC)
Attorney & Counselor at Law (New York, USA); Advocate (Uganda)

CEO, East African School of Taxation
Partner, Akunobera & Akena, Tax & Legal Consultants
Tel. +256 (782) 405-913
Email: akunobera@taxation.east.co.ug

March 24, 2010 Centre for Continuing Education, East African School of Taxation

TABLE OF CONTENTS

I. BACKGROUND

II. TREATY SHOPPING

III. ANTI-TREATY SHOPPING MEASURES

2

I. Background
Reasons for Concluding Tax Treaties

1. To Promote Exchanges of Goods and Services and the Movement of Capital and
Persons, by Eliminating International Double Taxation (See Para. 7 of the OECD
Commentary to Article 1 of the OECD Model Convention).

Illustration 1(a):
Tata, an Indian multinational corporation, is engaged in manufacturing in Uganda. Tata derives
income from its manufacturing operations in Uganda.

• India imposes income tax on its residents‟ worldwide income. Uganda imposes tax on income
derived by foreign corporations from sources in Uganda.

• If there were no tax treaty between India and Uganda, Tata would incur Ugandan tax on
income derived from its manufacturing operations in Uganda (i.e., Ugandan sourced-based
tax) and incur Indian residence-based tax on income derived from its operations in Uganda.

4

I. Background
Reasons for Concluding Tax Treaties (cont’d)

Illustration 1(b):

Tata, an Indian multinational corporation, is engaged in manufacturing in Uganda. Automobiles
manufactured in Uganda are sold in South Africa.

• Assume that income derived from goods manufactured in Uganda is treated as derived from
sources in Uganda. Assume also that income derived from sales of goods in South Africa is
treated as derived from sources in South Africa.

• Tata is at risk of incurring Ugandan source-based tax, South African source based tax and
Indian residence-based tax.

• Would a treaty between Uganda and South Africa alleviate the double taxation problem as
between South Africa and Uganda? – No. treaty benefits are available only to residents of
contracting states, and in our illustration, Tata is resident in neither Uganda nor South Africa.

5

I. Background

There are two principal means adopted under tax treaties to alleviate the double taxation problem:

• The foreign tax credit method. If a resident of a contracting state (“State R”) incurs tax on
income derived from sources in the other contracting state (“State S”), State R must, subject
to limitations, permit its resident to reduce State R tax liability by the amount of State S
income tax incurred on that income.

• The exemption method. If a resident of State R derives income from State S sources, State R
is, subject to limitations, required to exempt that income from State R tax.

Note: Most countries unilaterally grant an exemption or foreign tax credit under domestic law.
A unilateral credit or exemption may not be sufficient where both State R and State S consider
income to be derived from domestic sources. A tax treaty alleviates this problem through
what is called „re-sourcing‟ (i.e., if State S imposes tax in accordance with the terms of the tax
treaty, State R is required to treat the income as foreign source, notwithstanding the provisions
of State R‟s domestic law).

6

I. Background

2. Prevention of Tax Avoidance and Evasion (See Para. 7 of the OECD Commentary to Article
1 of the OECD Model Convention).

• Most tax treaties contain provisions for co-operation between tax administrations of
contracting states through mutual assistance and exchange of information in the collection of
taxes.

• Tax administrations may also exchange other sensitive information related to tax
administration and compliance improvement, for example risk analysis techniques or tax
avoidance or evasion schemes.

7

I. Background
Uganda’s Tax Treaty Network
• Currently, Uganda has 9 tax treaties in force: Denmark (2001), India (2004), Italy (2005),
Mauritius (2004), Netherlands (2006), Norway (2001), South Africa (2001), United Kingdom
(1993) and Zambia (1968).
• The Uganda – Belgium DTT was signed in 2007 but it is not yet in force. The tripartite
Income Tax Agreement between Uganda, Kenya and Tanzania was signed in 1997 but it is not
yet in force.

Status of a Tax Treaty under Domestic Tax Law
• S. 88(1) of the Act provides that an international agreement entered into between the
Government of Uganda and the government of a foreign country or foreign countries shall
effect as if the agreement was contained in the Act.
• S. 88(6) of the Act defines „international agreement‟ as –
– An agreement with a foreign government for the relief of international double taxation
and the prevention of fiscal evasion; or
– An agreement with a foreign government providing for reciprocal administrative
assistance in the enforcement of tax liabilities.
• Note: The definition of international agreement is exhaustive. Therefore, an agreement of the
kind not defined in S. 88(6) is not an international agreement within the meaning of the Act
(e.g., a technical assistance is not an international agreement for income tax purposes).
8

I. Background
Status of a Tax Treaty under Domestic Tax Law (cont’d)
• An international agreement takes precedence over the provisions of the Act in the event of
conflict. However, the tax avoidance provisions of the Act (i.e., S. 90 – transactions between
associates and S. 91 - tax avoidance schemes) take precedence over the tax treaty (S. 88(2) of
the Act).

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II. Treaty Shopping
Meaning of Treaty Shopping

• Treaty shopping typically arises where a person (whether or not a resident of a Contracting
State) acts through a legal entity created in a contracting state essentially to obtain treaty
benefits that would not be available directly.

• Treaty shopping is commonly accomplished through what are known as „conduit‟ entities or
special purpose vehicles.

• The conduit company takes advantage of the treaty provisions under its own name in State S;
economically, however, the treaty benefit goes to persons not entitled to use that treaty.

• The conduit company is usually able to enjoy reduced withholding tax rates or exemption
from capital gains tax in the source country.

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II. Treaty Shopping
Meaning of Treaty Shopping (cont’d)
Direct Conduit Structure
In the illustration below, instead of a United States person investing directly in a Ugandan
company and incurring 15% withholding tax, the United States person invests through a Mauritius
GBC structure. As such, the United States person is able to take advantage of the Uganda –
Mauritius tax treaty, which provides for a 10% rate of withholding tax. Foreign-source interest
received by the GBC is exempt from tax in Mauritius.

United States
Person

0% Dividend and United States
Interest Withholding Tax

15% Dividend and
SPV (e.g., GBC1)
10% Dividend and Mauritius

Limited Company
Uganda

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II. Treaty Shopping
Stepping stone conduits
The stepping stone conduit is an advanced conduit structure. In this case, payments received in
State B are subject to tax in State A. However, State A tax is reduced by excessive interest,
commission and other deductions that flow as income to a State C conduit, where they enjoy a
special exemption regime.

State C Conduit

Payments exempt in State C
under a special tax regime Loans, mgt
contracts, etc
State C

Deductible Payments e.g., Non-treaty Protected
commissions, interest, etc. State A Company
Payments
that erode State A‟s tax base

State A

Treaty-protected
payments
Limited Company
State B 13

II. Treaty Shopping

• Treaty shopping includes a situation where an individual who has both his permanent home
and all his economic interests in State A, including a substantial shareholding in a State A
company, and who, essentially in order to sell the shares and escape taxation in State A on the
capital gains from the alienation (by virtue of paragraph 5 of Article 13), transfers his
permanent home to State B, where such gains are subject to little or no tax.

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II. Treaty Shopping
Why Treaty Shopping is Undesirable

• Treaty benefits negotiated between two or more states are extended to persons resident in a
non-treaty (“third”) state in a way unintended by the contracting states. On the other hand, as
there is no tax treaty between a third state and the contracting states, residents of the
contracting states would not receive treaty-protected tax treatment with respect to income
derived from the third state. Thus, the principle of reciprocity is breached.

• Income may be exempted from taxation altogether or be subject to inadequate taxation in a
way unintended by the contracting parties. This is especially true if the ultimate beneficial
owner of the income is a resident of a country that follows the exemption system. “Double
non-taxation” is inconsistent with the underlying assumption when negotiating treaties that
income protected from source-country income tax will be taxed in the taxpayer‟s country of
residence or at least falls under the normal tax regime of that state.

• The state of residence of the ultimate income beneficial owner has little incentive to enter into
a treaty with the state of source, because residents of the state of residence can directly access
treaty benefits from the state of source without the need for the state of residence to provide
reciprocal benefits.

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III. ANTI-TREATY SHOPPING MEASURES

III. Anti- Treaty Shopping: Statutory Measures
‘Ownership’ Test under S. 88(5) of the Income Tax Act
 A treaty benefit (i.e., exemption from, or reduction of, Ugandan tax) is not available to any
person who, for the purposes of the agreement, is a resident of the other country state where
50% or more of the underlying ownership of that person is held by an individual or
individuals who are not residents of that other contracting state for purposes of the agreement.
Analysis Framework under S. 88(5)

Is ≥50% of the underlying
ownership of a State R enterprise
held by an individual or individuals?
No
Yes
Do the individuals that hold ≥50%
Yes of the underlying ownership of a
State R enterprise reside in State R
for purposes of the International
Agreement?
No

Eligible for Benefits Not Eligible for
Benefits

• S. 88(5) uses the phrase „underlying ownership‟ as opposed to the term „ownership‟. The
phrase „underlying ownership‟ permits an inquiry into the ultimate owners of the enterprise,
not merely its immediate owners. 17

III. Anti- Treaty Shopping: Statutory Measures
General Anti-Avoidance Provisions
• S. 88(2) cross-references Ss. 90 and 91 of the Act, as a backstop against treaty-based tax
avoidance schemes. S. 90 is a transfer pricing provision, while S. 91 is a general anti-
avoidance provision.
• S. 91 permits the commissioner to recast/ recharacterise a transaction or an element of a
transaction where –
‾ It was entered into as part of a tax avoidance scheme;
‾ It does not have substantial economic effect; or
‾ The form of the transaction does not reflect the substance
• S. 91(2) defines „tax avoidance scheme‟ to include a transaction, one of the main purposes of
which is the avoidance or reduction of liability to tax.

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III. Anti- Treaty Shopping: Treaty-based Measures
Conduit Company Cases
 A report of the OECD Committee on Fiscal Affairs, entitled “Double Taxation Conventions
and the Use of Conduit Companies”, recommends a number of approaches to counter the
treaty shopping problem.

1. “Look-through” Approach
• Under the look-through approach, a company that is a resident of State R would be denied
treaty benefits with respect to items of income and gains if it is owned or controlled directly
or through one or more companies wherever resident, by persons who are not residents of
State R.

• The look-through approach would ensure that the ultimate beneficiaries of treaty relief are
residents of State R, not residents of third states.

• This approach is too broad. It does not distinguish between abusive transactions and bona fide
business transactions.

19

Conduit Company Cases (cont’d)
2. The “Subject-to-tax” Approach
• Under the subject-to-tax approach, a company that is a resident of State R would be granted
treaty benefits in State S only if the income in question is subject to tax in State R under the
ordinary rules of its tax law. This approach does not offer adequate protection against
advanced tax-avoidance strategies such as „stepping-stone strategies‟.

3. The “Channel” Approach
• The OECD Committee on Fiscal Affairs has recommended a provision similar to the Ugandan
ownership/base erosion test, drafted in the following terms:
“Where income arising in State S is received by a company that is a resident of State R, and
one or more persons who are not residents of State R
a) have directly or indirectly, …a substantial interest in such company, in the form of a
participation or otherwise, or
b) exercise directly or indirectly, alone or together, the management or control of such
company
any provision of this Convention conferring an exemption from, or a reduction of, tax shall
not apply if more than 50% of such income is used to satisfy claims by such persons
(including interest, royalties, development, advertising, initial travel expenses, and
depreciation of any kind of business assets including those in immaterial goods and process”.
20

• To ensure that bona fide business transactions are not subject to the proposed anti-treaty
shopping provision, the OECD Committee on Fiscal Affairs has proposed the following
exceptions:

– Where the treaty benefit claimant establishes that its conduct of business and the
acquisition or maintenance of its shareholding or other property, are motivated by sound
business reasons and do not have as primary purpose the obtaining of benefits under the
convention.
– Conduct of substantial business operations in State R and the income with respect to
which treaty benefits are claimed is connected with such operations.
– The tax actually imposed by State R is greater than the reduction of tax claimed in State
S.
– A company resident in State R that has the principal class of its shares registered on
approved stock exchange in a contracting state, or if such company is wholly-owned
directly or through one or more companies, each of which is a resident of a contracting
state, and the principal class of whose shares is so registered.
– Residents of third states have income tax conventions in force with State S and such
conventions provide relief from taxation not less than the relief from taxation under the
convention in question.
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4. The “Exclusion” Approach
• Certain types of companies enjoying tax privileges in State R facilitate conduit arrangements
and raise the issue of harmful tax practices (e.g., the Mauritian GBC1). The OECD
Committee on Fiscal Affairs recommends three alternative ways to tackle the problem of tax
privileged companies –

– Deny the tax benefits to such companies by excluding them from the scope of the tax
convention;
– Insert a safeguarding clause which would apply to the income received or paid by such
companies. Under this approach, tax privileged companies would remain entitled to
treaty benefits but only certain types of income, such as dividends, interest, capital gains
or director‟s fees, are excluded; or
– Deny treaty benefits to a foreign-held company that enjoys a preferential tax regime in
State R, where similarly situated company held by residents of State R would not enjoy
preferential tax treatment in State R.

22

5. Beneficial Ownership Requirement
• The OECD Model Tax Convention and all the tax treaties Uganda has concluded contain a
beneficial ownership requirement in Articles 10, 11 and 12 (these provisions are based on the
OECD Model Tax Convention). Under this requirement, a state is not obligated to give up its
taxing rights over dividends, interests or royalties merely because the income was immediately
received by a resident State R.

• The term “beneficial owner” is not used in a narrow technical sense, rather, it should be
understood in its context and in light of the object and purpose of the convention, including
avoiding double taxation and the prevention of fiscal evasion and avoidance.

• In practice, beneficial ownership is determined with the assistance of domestic “anti-abuse”
provisions such as business purpose doctrine, the step-transaction and substance-over-form
doctrines and conduit principles. Although each case is limited to a particular set of facts,
there are a number of common factors which are generally considered by the courts in the
commonwealth as part of a beneficial ownership analysis:
- Title/Possession – whether a taxpayer possesses legal title or has physical possession
of the underlying asset.
- Capitalization – whether the entity holding the asset is adequately capitalized.
- Economic Risk – whether a taxpayer is exposed to the economic risks associated with
a particular asset.
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5. Beneficial Ownership Requirement (cont’d)

- Profits – whether a taxpayer is entitled to the profits or income related to a particular
asset.
- Liability – whether a taxpayer assumes the liabilities associated with a particular asset
(e.g., payment of taxes).
- Dominion and Control – whether a taxpayer has the power to make decisions related
to the asset, such as the decision to dispose of the asset.
- Agency Relationship – whether the nature of the relationship between the taxpayer
and the party in possession (legal or physical) of a particular asset created an agency
relationship.
 Treaty benefits will be denied if State S successfully asserts that the conduit company
established in a treaty jurisdiction lacks beneficial ownership of the income that is sought to
be protected by the relevant treaty provisions.

24

Indofood International Finance Ltd v JPMorgan Chase Bank,
N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal.

Facts

PT Indofood SM ("the Parent Guarantor") , a company incorporated Parent
in the Republic of Indonesia, carried on substantial business in the Guarantor
production and distribution of food. It wished to raise capital by issue
Interest subject to Indonesia
of loan notes on the international market. If it had done so itself, it DTA WHT of 10%
would have been obliged under Indonesian law to deduct 20% as loan
withholding tax on interest payable to the noteholders. The rate of
withholding tax could be reduced to 10% if the issue of the loan notes
was made by a wholly owned subsidiary incorporated in Mauritius SPV
and the capital so raised was lent on to the Parent Guarantor on terms “Issuer”
which complied with the conditions specified in the Indonesia -
Interest not
Mauritius tax treaty. Accordingly, the Parent Guarantor procured the Mauritius
subject to tax
incorporation in Mauritius of the claimant Indofood International loan
Finance Limited ("the Issuer").

The Issuer raised US$280m loan notes and lent the capital so raised
to the Parent Guarantor on the same terms. The issue, servicing and Noteholders
redemption of the loan notes and the loan to the Parent Guarantor
were regulated, inter alia, by a Trust Deed under which JPMorgan
Chase ("the Trustee") was appointed trustee for the noteholders.

25


N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal Parent
(Civil Division) Guarantor
Interest subject to
Facts (cont’d) DTA WHT of 10% Indonesia

Under terms of the notes, if there was a change in Indonesian law
whereby the obligation to withhold tax from interest payable to the
Issuer exceeded the rate of 10% for which the Mauritian DTA SPV
provided, and "such obligation cannot be avoided by the Issuer NewCo
taking reasonable measures available to it", the Issuer might, with Onward payment of
interest paid by Netherlands
the approval of the Trustee, redeem the notes. Parent Guarantor
Assignment of
In 2004, Indonesia issued a notice to terminate the Mauritius DTA Issuer Rights
effective January 1, 2005, the effect of which would be that the
Parent Guarantor would be obligated to withhold at the rate of SPV
20%. Accordingly, the Issuer gave notice to the Trustee of its “Issuer”
intention to redeem the loan notes. The Trustee refused approval of
Interest not
the redemption on the grounds that the Issuer had reasonable subject to tax
Mauritius
measures available to reduce the increased liability for withholding
loan
tax (i.e., that the Issuer assign the benefit of the loan agreement
between the Issuer and Parent Guarantor to a company
incorporated in Netherlands ("NewCo"), which, the Trustee argued,
would have reduced the rate of withholding tax to 10% under the Noteholders
Indonesia - Netherlands treaty).
26


N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal Parent
(Civil Division) Guarantor
Interest subject to
Issue DTA WHT of 10% Indonesia

Whether the interposition of NewCo between the Parent Guarantor
and the Issuer could reduce the rate of withholding tax in respect of
interest payable by the Parent Guarantor under the loan agreement SPV
to 10% or less - which depended, inter alia, on whether NewCo NewCo
could be the beneficial owner of the interest payable by the Parent Onward payment of
interest paid by Netherlands
Guarantor. Parent Guarantor
Assignment of
Holding / Observations on Beneficial Ownership Issuer Rights

A conduit can normally not be regarded as the beneficial owner if, SPV
though the formal owner of certain assets, it has very narrow “Issuer”
powers which render it a mere fiduciary or an administrator acting
Interest not
on account of the interested parties (most likely the shareholders of subject to tax
Mauritius
the conduit company).
loan

One way to test beneficial ownership is to ask: what would happen
if the recipient went bankrupt before paying over the income to the
intended, ultimate recipient? Noteholders

27

N.A., London Branch [2006] EWCA Civ. 158, Court of Appeal
(Civil Division) Parent
Guarantor
Observations on Beneficial Ownership (cont’d) Interest subject to
If the ultimate recipient could claim the funds as its own, then the DTA WHT of 10% Indonesia
funds are properly regarded as already belonging to the ultimate
recipient. If, however, the ultimate recipient would simply be one
of the creditors of the actual recipient, then the funds properly
SPV
belong to the actual recipient.
NewCo
Onward payment of
The meaning to be given to the phrase 'beneficial owner' is plainly interest paid by Netherlands
not to be limited by so technical and legal an approach. Regard is Parent Guarantor
to be had to the substance of the matter. In accordance with the Assignment of
legal structure, Parent Guarantor is obligated to pay interest two Issuer Rights
business days before the due date to the credit of an account
nominated for the purpose of the Issuer and the Issuer is obliged to SPV
pay the interest due in one business day before the due date to the “Issuer”
account specified by the Principal Paying Agent. In both Interest not
Mauritius
commercial and practical terms, the Issuer is, and NewCo would subject to tax
be, bound [by the Note Conditions] to pay on to the Principal loan
Paying Agent that which it receives from the Parent Guarantor. In
practical terms, the Issuer or NewCo lacked the 'full privilege‟
needed to qualify as the beneficial owner, rather the position of the
Issuer and NewCo equates to that of an 'administrator of the Noteholders
income„.
28

6. Place of Effective Management of Subsidiary Companies
• Claims to treaty benefits by subsidiary companies established in tax havens or benefiting from
harmful preferential regimes may be refused where the facts and circumstances suggest that the
place of effective management of a subsidiary does not lie in its alleged state of residence, but
rather lies in the state of residence of the parent company.

• The place of effective management is the place where key management and commercial
decisions that are necessary for the conduct of the entity's business as a whole are in substance
made. All relevant facts and circumstances must be examined to determine the place of
effective management. An entity may have more than one place of management, but it can have
only one place of effective management at any one time.

• Careful consideration of the facts and circumstances may also show that a subsidiary was
managed and controlled in the state of residence of the parent company in such a way that the
subsidiary had a permanent establishment (e.g., by having a place of management) in that state
to which all or a substantial part of its profits were properly attributable.

29

Note
 Some of the recommended OECD approaches are too generalized (e.g., the exclusion
approach). Leonard Beighton, a former Deputy Chairman of the U.K. Board of Internal
Revenue, is quoted as having noted that the U.K. does not favor general anti-treaty shopping
provisions for the reason that they are likely to hit the wrong targets and create uncertainty;
that the significant degree of discretion they give to officials is undesirable; that they are
likely to be costly and difficult to operate; and that in practice such widely targeted provisions
may not prevent abuse (See “Treaty Shopping: Imitation is Flattering” - [2000] BTR 133).

 Most of the anti-treaty shopping approaches recommended by the OECD Committee on
Fiscal Affairs have not been officially incorporated into the model tax convention.

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III. Anti- Treaty Shopping Measures – Recommended Readings

1. Report of the OECD on Fiscal Affairs – “Double Taxation Conventions and the Use of
Conduit Companies” (2005).
2. Commentary of the OECD Committee on Fiscal Affairs to Articles 1, 10-12 of the OECD
Model Tax Convention (July 17, 2008).
3. Craig Elliffe: “The Interpretation and Meaning of „Beneficial‟ Owner in New Zealand” –
B.T.R. 2009, 3, 276-305
4. Rose Fraser & J.D.B. Oliver: “Treaty Shopping and Beneficial Ownership: Indofood
International Finance Limited v JP Morgan Chase NA London Branch” – B.T.R. 2006, 4, 422-
429.

31

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