Principal Purpose Test Needs Time

The views and opinions expressed in this article are those of the authors only.

Chul Hun Lee*
Vol. 39 Associate Editor

Article 7 of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”) requires the signatories to adopt measures to meet the minimum standard to prevent treaty abuse. The baseline approach of Article 7 is the Principal Purpose Test (“PPT”), which denies tax treaty benefits if one of the principal purposes of a transaction was to obtain such benefit under the tax treaty.[1] Furthermore, Article 7 is not an elective provision; all signatories must implement the measures provided for in the Article.[2] However, this is not as onerous as it may sound. Although the PPT is the only test that can satisfy the minimum standard on its own, it is not the only approach permissible under the MLI. Instead, the signatories are permitted to either supplement the PPT with a simplified Limitations on Benefits rule (“LOB”), or to adopt a detailed LOB in lieu of the PPT.[3] Given these options, is the PPT a better option than the LOB, or is it an IED as Mr. Richard Reinhold[4] suggested? Perhaps the most significant characteristic of the PPT – and also its point of criticism – is its subjective nature.[5] The essence of the PPT is determining the purpose underlying the transaction at issue, with “regard to all relevant facts and circumstances.”[6] As a general matter, proving the intent and purpose is difficult, if not impossible, even when deducing such intent from the circumstances surrounding the transaction.[7] Furthermore, neither Article 7 nor the BEPS Action 6 Report provides much guidance as to how this inquiry should be conducted.[8] The problem caused by the inherent subjectivity of the test is further exacerbated by the fact that the PPT as currently articulated in the MLI is arguably too loose. In order to deny the treaty benefits, the competent authority only needs to find that it is “reasonable to conclude” that “one of the principal purposes” was to obtain the treaty benefit.[9] As such, the competent authorities of the Contracting States are left with much discretion in interpreting the requirements of the PPT.[10] This lack of guidance as to the interpretation of the PPT raises questions as to the wisdom of such a standard. The scenario that can be imagined is the abuse of the anti-abuse provision. By adopting a test that is subject to the discretionary interpretation of the competent authority, a Contracting State can appear to adhere to the minimum standard while in effect not imposing any substantial limitations on treaty abuse. In other words, the PPT could be manipulated to legitimize the actions of certain States in a tax competition environment.[11] Conversely, assuming that all Contracting States have some interest in protecting their tax base,[12] one can also imagine the test being deployed stringently to deny treaty relief as a means of preserving a State’s own authority to tax such person.[13] Given the reciprocal nature of treaties, such blatant abuses of the PPT may only be a theoretical concern. These two hypothetical concerns nevertheless point to the underlying issue that such a flexible standard can lead to the potential problem of divergent interpretation between the Contracting States. Even if the PPT does not lead to tax competition, the problem of coordination still exists. It is unimaginable for two Contracting States to enter into a bilateral treaty with each having a different understanding as to what constitutes an improper purpose. Thus, when States sign the MLI and amend their treaties to adopt the PPT, they must go beyond simply adopting the model provision to affirmatively reaching a mutual understanding of the standard. Such a consequence would defeat the purpose of the MLI, which was to “implement agreed changes in a synchronised and efficient manner . . . without the need to bilaterally renegotiate each such agreement.”[14] At the same time, it is plausible that the MLI was designed to defer such determination until a conflict between the Contracting States arose.[15] Does this mean that a mechanical LOB would be a better option? Although it may appear to be easy to understand and objective as it is based on several determinable criteria,[16] a mechanical LOB rule as incorporated in the treaties is complex and requires a substantial resource in its application.[17] Furthermore, mechanical LOB provisions tend to be highly treaty-specific, leading to heightened complexity and differences across treaties.[18] The subjective nature of the PPT inquiry may, furthermore, also yield benefits. Unlike rigid mechanical LOB rules, PPT inquiry will be flexible enough to capture newly formulated treaty abuse mechanisms. Moreover, under the subjective PPT test, taxpayers will not be able to manipulate their business organization to obtain treaty benefit, which remains a possibility under a mechanical LOB rule.[19] Given the problems that the subjectivity inherent in PPT can cause, one must question whether such a standard should be the baseline approach. Although the wide net cast by the PPT is a commendable initiative to capture all possible treaty abuses, it is clear that the language of the MLI on its face itself defers too much to the whims of the competent authorities. The answer, then, is whether there are, or will be, any meaningful limitations to applying the PPT. It is worth noting that many countries also deploy domestic General Anti-Abuse Rule (“GAAR”) similar to the PPT to prevent base erosion,[20] and have developed domestic judicial precedents designed to prevent treaty abuse.[21] As these measures have the same objective of preventing treaty abuse, they could be the starting point from which a more concrete framework for PPT could emerge.[22] If such common understanding of the PPT emerges to provide substantive guidelines, it is less likely that the PPT would be considered an IED, and more a guided missile against treaty abuse.

* Chul Hun Lee is a J.D. Candidate, December 2018, at the University of Michigan Law School, and Vol. 39 Associate Editor for the Michigan Journal of International Law. [1] Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting art. 7, para. 1, June 7, 2017, [hereinafter MLI]. [2] See id. (“a benefit . . . shall not be granted”). [3] Org. for Econ. Co-Operation & Dev. [OECD], Explanatory Statement to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, at 22 (2016); see also MLI, supra note 1, at art. 7, para. 16 (allowing signatories that adopt simplified LOB to opt out of Article 7 if the other Contracting State chooses not to apply simplified LOB). [4] Richard L. Reinhold is Senior Counsel in Willkie Farr & Gallagher LLP and Adjunct Professor of Law at the New York University School of Law. [5] See S. Exec. Rep. No. 106-8, at 5 (1999) (“The new main purpose tests in the proposed treaty are subjective, vague, and add uncertainty to the treaty”). [6] MLI, supra note 1, at art. 7, para. 1. [7] Michael Lang, BEPS Action 6: Introducing an Antiabuse Rule in Tax Treaties, 74 Tax Notes Int’l 655, 658 (2014). [8] See MLI, supra note 1, at art. 7; OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 – 2015 Final Report (2015), [hereinafter BEPS Action 6 Report]. [9] MLI, supra note 1, at art. 7. [10] See Reuven S. Avi-Yonah & Haiyan Xu, Evaluating BEPS: A Reconsideration of the Benefits Principle and Proposal for UN Oversight, 6 Harv. Bus. L. Rev. 185, 221 (2016); Reinout Kok, The Principal Purpose Test in Tax Treaties Under BEPS 6, 44 INTERTAX 406, 408 (2016). [11] See generally John Douglas Wilson, Theories of Tax Competition, 52 Nat’l Tax J. 269; OECD, Harmful Tax Competition: An Emerging Global Issue (1998), [12] Hugh J. Ault & Brian J. Arnold, Protecting the Tax Base of Developing Countries: An Overview, in United Nations Handbook on Selected Issues in Protecting the Tax Base of Developing Countries (Alexander Trepelkov et al. eds., 2015). [13] Whether the PPT can be abused by the competent authorities in this way may depend on the scope of the treaty benefits that will be denied, which is another interpretative issue regarding Article 7. See Amanda Kazacos, BEPS Action 6: The Principle Purpose Test Revisited – Part 1, Int’l Tax Rep. (Nov. 9, 2016),–part-i–1.htm. [14] MLI, supra note 1, Preamble. [15] See id., at art. 16 (providing improved Mutual Agreement Procedure), art. 19 (providing for elective arbitration clause). [16] See Anna A. Kornikova, Comment, Solving the Problem of Tax-Treaty Shopping Through the Use of Limitation on Benefits Provisions, 8 Rich. J. Global L. & Bus. 249, 280-81 (2008). [17] See, e.g., Convention Between the United States of America and the Republic of Poland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, Pol.-U.S., Feb. 13, 2013, S. Treaty Doc. No. 113-5 (2013); Protocol Amending the Income Tax Convention Between the United States and Canada, Can.-U.S., Sept. 21, 2007, [18] Avi-Yonah & Xu, supra note 9, at 220. [19] See BEPS Action 6 Report, supra note 7, at 55-56. [20] Christophe Waerzeggers & Cory Hillier, Introducing a General Anti-Avoidance Rule, 1 Tax Law IMF Technical Note 8 (2016), [21] See Simone M. Haug, The United States Policy of Stringent Anti-Treaty-Shopping Provisions: A Comparative Analysis, 29 Vand. J. Transnat’l L. 191, 250-55, 265-69 (1996). [22] See Kok, supra note 9, at 409-12 (applying Dutch judicial interpretation and tax literature to understand the phrase “object and purpose”).