Landmark Tax Avoidance Treaty Could Change International System
June 13, 2017
Last Wednesday representatives from 76 countries and jurisdictions came together in Paris to sign the Multilateral Instrument (MLI) treaty. This OECD initiative is a relatively unknown part of the BEPS project but is a key component for implementing the remainder of the BEPS recommendations. The MLI streamlines the process of creating tax treaties among multiple countries, a process which could last a decade, by setting default rules which apply to all treaties unless explicitly over-written. Additionally, the MLI introduces binding arbitration when tax disputes arise among signatory countries. The United States and Estonia were the only members of the OECD that did not sign the MLI treaty, but many of the signatory countries have chosen to abstain from many of the treaty’s provisions. As such, it remains uncertain whether the MLI will achieve the goals of the BEPS project.
The MLI treaty includes:
- Rules for entity transparency
- Procedures for resolving hybrid mismatches among countries
- Appropriate methods for eliminating double taxation
- Procedures for denying treaty benefits to individuals who treaty shop
- Limitations on the tax base for dividend and capital gains
- Rules for permanent establishment
- A process for conflict resolution through mandatory binding arbitration
The MLI was Action 15 of the BEPS initial report released in September, 2014 and refined in the October 2015 final report. Last November an ad hoc group concluded negotiations and produced a model treaty for the MLI. As of December 31, 2016, the convention was open to all countries and jurisdictions, and support for the treaty gained momentum this spring. This culminated in 68 countries agreeing to the MLI in a signing ceremony on June 7, 2017.
The MLI sets default rules and common definitions for all bilateral tax treaties. This allows new tax treaties to be written with contingency rules and definitions of terms already defined. This is important because treaties require precise language to avoid unintended consequences or abuse of treaty benefits. With a set of rules to underpin tax treaties, the process of constructing and ratifying a tax treaty can be simplified and expedited.
However, not all the articles in the MLI are required. Article 28 of the treaty lists all the provisions which are mandatory; the remainder were up to the discretion of the country. Many countries chose to reject certain articles. For example, India rejected seven of the 39 articles.
The United States participated in the negotiations but has chosen to refrain from signing the MLI treaty. Tax professionals cite that many of the anti-treaty-shopping rules in the MLI have already been implemented by the U.S. Treasury, but there was considerable uncertainty around many other articles in the treaty.
The mandatory binding arbitration is one of the most controversial articles. Of the 68 countries that signed the MLI treaty, only 26 countries opted for the binding arbitration. As such, one of the key provisions of the MLI may not have the critical mass needed to ensure arbitration decisions will be enforced.
With so many countries deciding to opt out over many of the MLI’s articles, it is uncertain whether the MLI can deliver the promised benefits of a streamlined tax-treaties process. It remains to be seen whether the OECD’s efforts will have a real impact on the international tax system.
Overview of the MLI rules
The MLI sets rules for dealing with hybrid mismatches. Hybrid mismatches are situations where one country considers the taxable income from one source, e.g., income from a corporation, while another country considers the same income as from another source, e.g., income from a partnership. As such, the income may never be taxed because each country is expecting the other country to tax the income due to different definitions of income. The MLI sets rules to resolve this problem by requiring tax authorities to agree upon the definition of the income. Moreover, if there is no consensus, then the taxpayer is required to pay the taxes on the same income in both countries.
The MLI also establishes acceptable methods for eliminating double taxation. Income tax in one country can be deducted from the tax base, exempted from income, or become a tax credit in the amount of the tax paid in the other country. Signers of the treaty cannot opt out of this provision.
The MLI sets grounds for denying a treaty’s benefits to an individual or business. The MLI treaty includes model language for adding a purpose to a tax treaty. If the purpose of the tax treaty is not met by the action of an individual or business, then the tax authority of a country can deny the individual or business the benefits of the treaty. It also defines a process for denying benefits.
The MLI lays out common definitions for terms such as permanent establishment and agency. The MLI strengthens the test for permanent establishment by assigning permanent establishment to any “habitual” activity conducted by a business in a country. Agents who do not garner at least 50 percent of the profit from a transaction are not considered independent. The MLI requires split contracts to be summed over the entire year as part of the permanent establishment test. Moreover, it restricts treaties from exempting or redefining permanent establishment.
The MLI also restricts permanent establishment when a third-party country is involved. Assume a business is a resident of country A, has a permanent establishment in country B, and has sales from country B to country C in which the business does not have permanent establishment. Country C can claim the income from sales if the difference between the taxes paid on the income in country B is less than 60 percent of the taxes it would have paid if the income was attributed to country A, where the business is a resident. This provision is intended to reduce income shifting to low tax countries.
To enforce these rules the MLI establishes procedures for resolving conflict that may arise, particularly when third parties are involved. An individual or business has three years to dispute a tax claim. The tax dispute can be logged in either of the countries under that tax treaty or in the country in which the individual or business is a resident.
The countries have two years to resolve the dispute among themselves. If the dispute is not resolved, then the two tax authorities are required to undergo arbitration. Arbitration consists of a council of three tax experts: one from each country and a chair from an unrelated country. The council’s decision is final and binding according to the MLI treaty.