On 6 January 2017, the Organisation for Economic Co-operation and Development (OECD) released a Public Discussion Draft (the Discussion Draft) for comment that includes three draft examples with respect to treaty entitlement of non-collective investment vehicle (non-CIV) funds when the principal purposes test (PPT), one of the minimum standards to protect against treaty shopping, is applied. Although no final agreement has yet been reached on the inclusion of the examples, the Discussion Draft notes that they are being released for public comment to determine whether they are useful in clarifying the application of the PPT rule to common transactions involving non-CIV funds. Comments on the examples are requested by 3 February 2017.
In October 2015, the OECD released its final report (the Final Report) with recommendations to address treaty abuse in connection with Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances) of the Action Plan on Base Erosion and Profit Shifting (BEPS). Among other model provisions, the Final Report included the PPT rule, under which treaty benefits generally would be denied when it is reasonable to conclude, based on all relevant facts and circumstances, that obtaining treaty benefits was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the tax treaty.
The Final Report did not contain any model provisions or related Commentary on the treaty entitlement of non-CIV funds but noted that further work would be needed in this area. Following this, in March 2016, the OECD released a public consultation document (the Consultation Document) seeking input on the treaty entitlement of non-CIVs. The Discussion Draft notes the importance of undertaking this work before the recommendations under Action 6 would be included in the Multilateral Instrument (MLI) under Action 15, designed to implement tax treaty related measures according to the BEPS recommendations.
The Consultation Document included a number of specific questions related to how the new treaty provisions could affect the treaty entitlement of non-CIV funds. In addition to requesting some more general comments, the Consultation Document specifically sought feedback with respect to four particular issues, including the PPT rule and examples of its application.
On 24 November 2016, the OECD released the text of the MLI under Action 15 with the expectation of quickly introducing the treaty related BEPS measures into a significant number of the bilateral tax treaties that are in existence today. The MLI is open for signature as of 31 December 2016 and a signing ceremony is foreseen for June 2017. Given the entry into force provisions, it is probable that the MLI will introduce the new treaty provisions into a significant number of treaties from 2019. Among the tax treaty related BEPS measures covered by the MLI are the PPT rule and a simplified limitation on benefits (LOB) test. Introduction of a PPT rule alone or the simplified LOB test in combination with a PPT rule will allow countries to meet their obligations relating to the minimum protection they agreed to install against treaty abuse. Countries are currently preparing lists of treaties to be covered by the MLI and are considering which options to apply. Given these developments, introduction of the PPT into existing bilateral treaties is expected as of 2018, with broad introduction being anticipated in 2019.
The Discussion Draft
The Discussion Draft provides an update on the work relating to the interaction between the treaty provisions of the Final Report, in particular the minimum standard on treaty abuse, and the treaty entitlement of non-CIV funds, including the conclusions reached at the May 2016 meeting of Working Party 1 of the OECD Committee on Fiscal Affairs (WP1). The Discussion Draft states that the derivative benefits provision included in the simplified LOB rule, which does not include (i) any limit on the number of equivalent beneficiaries, (ii) any base-erosion test or (iii) any requirement related to intermediate owners, means that few non-CIV funds would fail to qualify for treaty benefits under that rule. The Discussion Draft does however, indicate that the practical application of the simplified LOB raises a number compliance and administrative issues related to the determination of treaty entitlement of investors and suggests that there could be future work done to consider this issue and find solutions for non-CIV funds.
With respect to the PPT, which is subjective in nature, WP1 determined that examples related to the application of the PPT rule to non-CIV funds could be added to the OECD Model Commentary to illustrate the application of the PPT rule to common types of arrangements or transactions entered into by non-CIVs that do not raise concerns related to treaty shopping or inappropriate granting of treaty benefits. Specifically, the three draft examples relate to: (1) a regional investment platform, (2) a securitization company, and (3) an immovable property non-CIV fund, and may be found in Appendix 1 to this Tax Alert.
With the finalization of the MLI, and the first MLI signing ceremony likely to take place in June 2017, it is expected that a significant number of tax treaties could be modified to incorporate a minimum level of protection against treaty shopping, which includes the option of implementing a PPT rule. Given the subjective nature of the PPT rule, the inclusion of examples in the OECD Model Commentary to clarify the application of the PPT rule in the context of non-CIV funds would be helpful and it would therefore be beneficial if agreement could be reached at WP1 with respect to the inclusion of some useful examples in the OECD Model Commentary. Stakeholders should carefully consider the examples to determine whether the factual circumstances posited accurately reflect typical non-CIV fund operations and consider commenting as appropriate. It is expected that WP1 would discuss comments received at their February meeting, possibly resulting in revisions to the OECD Model Commentary, the next release of which (along with the OECD Model Treaty) is tentatively scheduled for mid-2017.
1. Regional investment platform example
Example [XX]: RCo, a company resident of State R, is a wholly-owned subsidiary of Fund, an institutional investor that is a resident of State T and that was established and is subject to regulation in State T. RCo operates exclusively to generate an investment return as the regional investment platform for Fund through the acquisition and management of a diversified portfolio of private market investments located in countries in a regional grouping that includes State R. The decision to establish the regional investment platform in State R was mainly driven by the availability of directors with knowledge of regional business practices and regulations, the existence of a skilled multilingual workforce, State R’s membership of a regional grouping and use of the regional grouping’s common currency, and the extensive tax convention network of State R, including its tax convention with State S, which provides for low withholding tax rates. RCo employs an experienced local management team to review investment recommendations from Fund, approve and monitor investments, carry on treasury functions, maintain RCo’s books and records, and ensure compliance with regulatory requirements in States where it invests. The board of directors of RCo is appointed by Fund and is composed of a majority of State R resident directors with expertise in investment management, as well as members of Fund’s global management team. RCo pays tax and files tax returns in State R.
RCo is now contemplating an investment in SCo, a company resident of State S. The investment in SCo would constitute only part of RCo’s overall investment portfolio, which includes investments in a number of countries in addition to State S which are also members of the same regional grouping. Under the tax convention between State R and State S, the withholding tax rate on dividends is reduced from 30 per cent to 5 per cent. Under the tax convention between State S and State T, the withholding tax rate on dividends is 10 per cent.
In making its decision whether or not to invest in SCo, RCo considers the existence of a benefit under the State R-State S tax convention with respect to dividends, but this alone would not be sufficient to trigger the application of paragraph 7. The intent of tax treaties is to provide benefits to encourage cross-border investment and, therefore, to determine whether or not paragraph 7 applies to an investment, it is necessary to consider the context in which the investment was made, including the reasons for establishing RCo in State R and the investment functions and other activities carried out in State R. In this example, in the absence of other facts or circumstances showing that RCo’s investment is part of an arrangement or relates to another transaction undertaken for a principal purpose of obtaining the benefit of the Convention, it would not be reasonable to deny the benefit of the State R-State S tax convention to RCo.
2. Securitisation company example
Example [XX]: RCo, a securitisation company resident of State R, was established by a bank which sold to RCo a portfolio of loans and other receivables owed by debtors located in a number of jurisdictions. RCo is fully debt-funded. RCo has issued a single share which is held on trust and has no economic value. RCo’s debt finance was raised through the issuance of notes that are widely-held by third-party investors. The notes are listed on a recognised stock exchange, which allows for their trading on the secondary market, and are held through a clearing system. To comply with regulatory requirements, the bank also retained a small percentage of the listed, widely-held debt securities issued by RCo. RCo currently holds 60 per cent of its portfolio in receivables of small and medium sized enterprises resident in State S, in respect of which RCo receives regular interest payments. The bank is a resident of a State T which has a tax treaty with State S that provides benefits equivalent to those provided under the State R-State S tax treaty. Under the tax treaty between State R and State S, the withholding tax rate on interest is reduced from 30 per cent to 10 per cent.
In establishing RCo, the bank took into account a large number of issues, including State R’s robust securitisation framework, its securitisation and other relevant legislation, the availability of skilled and experienced personnel and support services in State R and the existence of tax benefits provided under State R’s extensive tax convention network. Investors’ decisions to invest in RCo are not driven by any particular investment made by RCo and RCo’s investment strategy is not driven by the tax position of the investors. RCo is taxed in State R on income earned and is entitled to a full deduction for interest payments made to investors.
In making its decision to sell receivables owed by enterprises resident in State S, the bank and RCo considered the existence of a benefit under the State R-State S tax convention with respect to interest, but this alone would not be sufficient to trigger the application of paragraph 7. The intent of tax treaties is to provide benefits to encourage cross-border investment and, therefore, to determine whether or not paragraph 7 applies to an investment, it is necessary to consider the context in which the investment was made. In this example, in the absence of other facts or circumstances showing that RCo’s investment is part of an arrangement or relates to another transaction undertaken for a principal purpose of obtaining the benefit of the Convention, it would not be reasonable to deny the benefit of the State R-State S tax convention to RCo.
3. Immovable property non-CIV fund example
Example [XX]: Real Estate Fund, a State C partnership treated as fiscally transparent under the domestic tax law of State C, is established to invest in a portfolio of real estate investments in a specific geographic area. Real Estate Fund is managed by a regulated fund manager and is marketed to institutional investors, such as pension schemes and sovereign wealth funds, on the basis of the fund’s investment mandate. A range of investors resident in different jurisdictions commit funds to Real Estate Fund. The investment strategy of Real Estate Fund, which is set out in the marketing materials for the fund, is not driven by the tax positions of the investors, but is based on investing in certain real estate assets, maximising their value and realising appreciation through the disposal of the investments. Real Estate Fund’s investments are made through a holding company, RCo, established in State R. RCo holds and manages all of Real Estate Fund’s immovable property assets and provides debt and/or equity financing to the underlying investments. RCo is established for a number of commercial and legal reasons, such as to protect Real Estate Fund from the liabilities of and potential claims against the fund’s immovable property assets, and to facilitate debt financing (including from third-party lenders) and the making, management and disposal of investments. It is also established for the purposes of administering the claims for relief of withholding tax under any applicable tax treaty. This is an important function of RCo as it is administratively simpler for one company to get treaty relief rather than have each institutional investor process its own claim for relief, especially if the treaty relief to which each investor would be entitled as regards a specific item of income is a small amount. After a review of possible locations, Real Estate Fund decided to establish RCo in State R. This decision was mainly driven by the political stability of State R, its regulatory and legal systems, lender and investor familiarity, access to appropriately qualified personnel and the extensive tax convention network of State R, including its treaties with other States within the specific geographic area targeted for investment. RCo, however, does not obtain treaty benefits that are better than the benefits to which its investors would have been entitled if they had made the same investments directly in these States and had obtained treaty benefits under the treaties concluded by their States of residence.
In this example, whilst the decision to locate RCo in State R is taken in light of the existence of benefits under the tax conventions between State R and the States within the specific geographic area targeted for investment, it is clear that RCo’s immovable property investments are made for commercial purposes consistent with the investment mandate of the fund. Also RCo does not derive any treaty benefits that are better than those to which its investors would be entitled and each State where RCo’s immovable property investments are made is allowed to tax the income derived directly from such investments. In the absence of other facts or circumstances showing that RCo’s investments are part of an arrangement, or relate to another transaction undertaken for a principal purpose of obtaining the benefit of the Convention, it would not be reasonable to deny the benefit of the tax treaties between RCo and the States in which RCo’s immovable property investments are located.
EYG no. 00112-171Gbl