Base erosion and profit shifting – treaty shopping

The concept of base erosion and profit shifting (“BEPS”) has been much discussed at various international forums including the G20 Finance Ministers and Central Bank Governors meeting in July 2013 in Moscow as well as the G20 Heads of State meeting in September 2013.

From a South African perspective, the Davis Tax Committee has been set up, inter alia, in order to address the issue of BEPS in a South African context.

An issue considered by the OECD as part of its BEPS reports is that of “treaty shopping”.

According to the OECD, “treaty shopping” is an abuse or an improper use of a tax treaty, being contrary to the objectives of the treaty. “Treaty shopping” occurs where taxpayers who are not residents of contracting states seek to obtain the benefits of a tax treaty by placing a company or another type of legal entity in one of the countries to serve as a conduit for income earned in the other country, (Indonesian Director General of Taxes quoted in Indofood International Finance Ltd v JP Morgan Chase Bank N.A., London Branch [2006] EWCA Giv 158 (Court of Appeal) at para 18).

The UN Commentary on article 1 of the UN Model Convention states: “A guiding principle is that the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions.” (ITC “Improper Use of Tax Treaties, Tax Avoidance and Tax Evasion” May 2013, p6)

Silke on International Tax argues that subject to the potential application of specific anti-avoidance provisions, there seems to be no warrant for claiming that the mere presence of a tax avoidance purpose (even if it is a sole purpose) turns a given factual matrix into unacceptable ‘treaty shopping’. A typical would-be ‘treaty shopper’ then only has a single real hurdle to clear, namely to qualify in principle for benefits in terms of a particular treaty. Once this threshold has been negotiated, all that usually remains is for the relevant provisions of the treaty to be invoked, (Silke on International Tax at § 46.42).

In a South African context, treaty shopping could apply in the context of, for example, a parent company with a South African subsidiary where the parent company has advanced interest-bearing loan funding to its subsidiary. However, due to the introduction of the new interest withholding tax, the parent company now looks to route its loan funding to its South African subsidiary through a company in an intermediate jurisdiction which has a more favourable double tax agreement (“DTA”) with South Africa. Such DTA would then not allow South Africa to impose its interest withholding tax on interest paid by the South African subsidiary to the company in the intermediate jurisdiction.

There are certain tax sparing clauses in various DTA’s, for example, the DTA with Brazil in respect of government bonds.

Article 11(1) of the DTA between South Africa and Brazil provides that interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.

However, Articles 11(4)(a) and (b) provide that notwithstanding the provisions of paragraphs 1 and 2:

“(a)       interest arising in a Contracting State and derived and beneficially owned by the Government of the other Contracting State, a political subdivision thereof, the Central Bank or any agency (including a financial institution) wholly owned by that Government or a political subdivision thereof shall be exempt from tax in the first-mentioned State;

(b)        subject to the provisions of subparagraph (a), interest from securities, bonds or debentures issued by the government of a Contracting State, a political subdivision thereof or any agency (including a financial institution) wholly owned by that government or a political subdivision thereof, shall be taxable only in that State”.

Article 11(4)(b) read with Article 11(4)(a) of the DTA therefore applies, inter alia, to provide exclusive taxing rights to Brazil in respect of interest derived from bonds issued by the Brazilian government and derived and beneficially owned by South African residents other than the South African government, South African Reserve Bank or other governmental agencies set out in Article 11(4)(a) of the DTA.

In addition the DTA between South Africa and Zambia provides taxing rights to Zambia in respect of interest paid on certain debt instruments advanced by South African residents. South Africa may not tax such interest.

Principle issues with treaty shopping?

The question arises whether and to what extent South Africa should care about treaty shopping. As set out in the example above, if a parent company chooses to invest into South Africa through an intermediate jurisdiction with a more beneficial DTA, is such parent company not simply structuring its investment in a tax efficient manner, as permitted in terms of South African case law?

In the view of the writer this should be considered by the South African tax authorities at the time of entering into DTA’s with other jurisdictions. For example South Africa entered into a DTA with Mauritius in the knowledge that, for example, interest payable by a South African entity to a Mauritian entity would be taxed at an effective rate of approximately 3% in Mauritius.

South Africa has also entered into DTA’s with various European jurisdictions which jurisdictions have provisions effectively mitigating the quantum of tax paid in those jurisdictions. For example, an investor may set up a foreign company and invest in equity in that foreign company in the form of, for example, redeemable preference shares. The foreign company may then advance a loan to the South African entity. As a matter of the foreign jurisdiction’s tax law, a deduction will be granted for the dividends payable in respect of the redeemable preference shares leaving the foreign company taxable only on its spread/margin. In this regard there is significant competition for tax revenues on a world-wide basis. Jurisdictions are incentivised to enter into as many DTAs as possible and then also to offer tax incentives, inter alia, to attract multi-nationals into their jurisdictions.

South Africa is one of such jurisdictions. For example South Africa has recently introduced a “headquarter company” regime in terms of which foreign investors may invest through South Africa into, inter alia, Africa. As part of marketing this initiative South Africa has made mention of its many DTAs with African jurisdictions. In particular South Africa competes directly with Mauritius in respect of attracting foreign investment into Africa.

It is therefore not in South Africa’s interest and would also provoke justified criticism if South Africa attacked foreign investors for investing in South Africa via an intermediate jurisdiction with a favourable DTA when South Africa is doing precisely the same in terms of its headquarter company regime. In particular, in terms of this regime South Africa is encouraging foreign investors who wish to invest in, inter alia, various African jurisdictions to invest in these jurisdictions via South Africa and thereby take advantage of South Africa’s DTAs with such African states. This will have the effect of reducing the amount of tax paid by such foreign investors in the African jurisdictions and will increase the amount of tax revenue generated by the South African fisc.

This issue goes to the heart of the BEPS debate. Where profits are “shifted” from one jurisdiction to another, it is typically only the jurisdiction from which they are shifted that raises a concern. Most member states of the OECD and other jurisdictions which are taking part in the BEPS process have tax incentives which encourage profit shifting into their own jurisdictions. However they are then aggrieved when the same techniques are used to “shift profit” away from such jurisdictions and thereby erode their tax base.

Put simply, with the global economic downturn, all jurisdictions are looking to increase their tax revenues. Turning back to South Africa, it seems that South African tax law already provides several defences against treaty shopping. Three important defences in this regard are the concepts of “beneficial ownership” and “effective management” as well as the use of South Africa’s domestic anti tax-avoidance rules.

Take the above example of the parent company looking to route its loan funding to its South African subsidiary through a company in an intermediate jurisdiction with a favourable DTA with South Africa. If the company set up in the intermediate jurisdiction does not qualify as the “beneficial owner” of the interest received from the South African subsidiary then the terms of the relevant DTA will simply not be applicable. South Africa can therefore attest whether such company qualifies as the beneficial owner of the interest.

A further issue is whether the company in the intermediate jurisdiction is “effectively managed” in that jurisdiction. If it is simply a “post box company” with no substance then it is very likely that it will not be “effectively managed” in that intermediate jurisdiction and South Africa can then simply ignore the provisions of the relevant DTA and impose its interest withholding tax on the payments made to that company.

South Africa also has anti tax-avoidance provisions.  In terms of these rules if the “sole or main purpose” of a taxpayer was to obtain a “tax benefit” and certain abnormal features exist in respect of such arrangement, the anti tax-avoidance rules can be applied to disregard the transaction entered into by the parties. A “tax benefit” will apply if a party side-steps an anticipated tax liability.

In the context of the definition of a “tax benefit” in terms of section 1 of the Income Tax Act No. 58 of 1962 (‘the Act’), based on case law (Hicklin v SIR 41 SATC 179 and Smith v Commissioner for Inland Revenue 26 SATC 1) the liability for the payment of any tax, levy or duty that a taxpayer must seek to avoid, postpone or reduce is not an accrued or existing liability, but an anticipated liability. It was held that to avoid liability in this sense is “to get out of the way of, escape or prevent an anticipated liability”.

If there is a “tax benefit”, the second requirement for the application of the anti tax-avoidance provisions is that the “sole or main purpose” is to obtain such tax benefit. Therefore, provided the taxpayer does not comply with this requirement, the arrangement will not constitute an impermissible tax avoidance arrangement, i.e., the provisions of section 80A of the Act will not apply.

It is provided in section 80G that:

an avoidance arrangement is presumed to have been entered into or carried out for the sole or main purpose of obtaining a tax benefit unless and until that party proves that, reasonably considered in light of the relevant facts and circumstances, obtaining a tax benefit was not the sole or main purpose of the avoidance arrangement; and

the purpose of a step in or part of an avoidance arrangement may be different from a purpose attributable to the avoidance arrangement as a whole.

In terms of the example set out above, if the South African subsidiary repays its existing loan funding to the parent company and the parent company routes such loan funding through an intermediate jurisdiction this has the effect of the parent company side-stepping an anticipated tax liability in respect of interest withholding tax. A tax benefit will therefore arise for the parent company. In order to avoid the application of South Africa’s anti tax-avoidance provisions, such parent company then bears the onus of proving that its “sole or main purpose” was not to achieve such tax benefit.