Is the Principal Purpose Test an “Atomic Bomb” and should it be used against Treaty Abuse?

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

Eran Levy*

A summary and opinion on the session “Article 7 and Prevention of Treaty Abuse” by Mr. Richard Reinhold[1] and Prof. Reuven Avi-Yonah[2] as commentator (the “Session”), which took place at the “Perspective on the Multilateral Instrument” conference at the University of Michigan Law School on October 13, 2017. Background There is considerable debate on which type of anti-abuse rules should be used in the OECD Multilateral Instrument (the “MLI”).[3] The two types of anti-abuse rules which were discussed in the Session were (1) the “Limitation of Benefits” (“LOB”) provisions, which are used by the United States in its bilateral tax treaties,[4] and the Simplified LOB, currently offered in the MLI, and (2) the “Principal Purpose Test” (“PPT”), which is the default anti-abuse rule offered in the MLI. Generally, LOB tests limit the availability of treaty benefits to entities that meet certain conditions based on legal nature, general activities, and ownership. These conditions seek to ensure that there is a sufficient link between the entity and its state of residence.[5] For example, according to the Simplified LOB provisions offered in the MLI, generally speaking, if at least fifty percent of a corporation’s shares are owned by residents of the corporation’s country of residency for at least half the days of a twelve-month period, a corporation will be entitled to the favorable tax regime of the tax treaties of its country of residence.[6] The idea is that LOB provisions do not rely on a determination of purpose or intention but instead set forth a series of objective, rule-based tests.[7] The PPT, on the other hand, applies a different test: the PPT states that a benefit under a tax treaty shall not be granted in respect of an item of income or capital if it is reasonable to conclude, in light of all relevant facts and circumstances, that obtaining said benefit was one of the principal purposes of any arrangement or transaction that resulted in that benefit, unless it can be established that granting that benefit under these circumstances would accord with the object and purpose of the relevant provisions of the tax treaty.[8] This determination – of whether the principal purpose of an arrangement or transaction was to obtain treaty benefits – should be made using an objective analysis of the aims and objects of all persons involved.[9] For the anti-abuse rule to be activated under the PPT, obtaining the tax benefits under the treaty does not have to be the sole or dominant purpose; rather, it is sufficient that at least one of the principal purposes of an arrangement or transaction was to obtain the benefit.[10] The MLI allows countries to choose between three options of anti-abuse rules: (1) a PPT only; (2) a PPT and either the Simplified or Detailed LOB; or (3) the Detailed LOB supplemented by a mechanism that would deal with conduit arrangements not already dealt with in tax treaties. Since the PPT is the only approach that can satisfy the minimum standard of the MLI on its own, it is presented as the default option.[11] The presentation of the PPT as the default option may be considered as semantic matter, since each country which signs on to the MLI is free to choose between options (1), (2) or (3) above. However, from political point of view, it may be useful for countries to adopt the PPT as the minimum standard without any further actions.   The Session Before addressing the legal debate between Reinhold and Avi-Yonah, I will briefly describe the Prévost case,[12] which was presented by Reinhold during the Session and which illustrates how the use of either the LOB or PPT could lead to different results: Volvo Bussar A.B (“Volvo”) and Henlys Group PLC (“Henlys”) intended to jointly acquire all the shares in Prévost Car Inc. (“Prévost”), which was incorporated in Canada, using a holding company (“Holdco”). Both Volvo and Henlys preferred to incorporate Holdco in their residency countries, Sweden and the UK, respectively. As a compromise, and after considering several options, Volvo and Henlys chose to form Holdco in the Netherlands, based on business considerations[13] and tax considerations,[14] which according to a statement by Volvo’s representative, were not overriding. When Prévost made dividend distributions to Holdco (the “Dividends”), the Canadian Revenue Agency argued that Holdco was not entitled to the favorable tax rates pursuant to the Canada-Netherlands Treaty since the “Beneficial Owner” of the Dividends was not Holdco but rather Volvo and Henlys. The question, raised by Reinhold, was: What would be the result of the case under the LOB and under the PPT, respectively? First, the LOB provisions, as they appear in the Canada-Netherlands Treaty, were applied by both the Tax Court of Canada and then the Canadian Federal Court of Appeal, both of which held that Holdco is the beneficial owner of the dividends distributed by Prévost. Thus, the courts held that the favorable tax rate under the Canada-Netherlands Treaty applied. Applying the PPT, Reinhold concluded that on the facts of the Prévost case, it is most likely that Holdco would not be entitled to the tax treaty’s favorable rates, since Volvo’s representative declared upfront that tax was a consideration in the decision to form Holdco in the Netherlands. Prof. Pasquale Pistone[15] commented during the Session that the PPT would probably have led to a different result as compared with the LOB test, but he mentioned that the same issue would arise under the “Essential Purpose” test that is currently applied by EU courts. The central question, then, is which type of anti-abuse rules is better? According to Reinhold, the PPT is overbroad and exposes even companies with real economic and business substance to application of the anti-abuse provisions, because they operate in low tax rate jurisdictions (e.g., a company that decides to establish R&D activities in an Irish subsidiary employs hundreds of employees and derives inter-group dividends, interest, and royalties in such a subsidiary). Additionally, Reinhold shared his concerns about the overbreadth of the PPT causing negative effects of uncertain tax consequences for taxpayers. Nonetheless, Reinhold believes that the Simplified LOB test on its own, an option which is not actually offered in the MLI,[16] is not perfect either, mainly because it does not address issues of base erosion. Reinhold concluded by suggesting that instead of the PPT, the MLI should use the Simplified LOB provisions, with anti-conduit restrictions and additions for the prevention of base erosion, because this will result in more certainty for taxpayers, which is a positive outcome in his opinion. Avi-Yonah, as a commentator for the Session, presented a different approach by stating that PPT should be used – and not any kind of LOB. In his opinion, the PPT is not overbroad due to the exception which states that even if tax is a principal purpose of a transaction, the transaction will not be considered as an abuse of the treaty if granting the benefit would be in accordance with the object and purpose of the treaty (the “Object and Purpose Exception”). Reinhold did not agree with Avi-Yonah’s argument, since even under the Object and Purpose Exception, the relevant tax authority still has broad discretion to interpret the facts at hand and could easily find that the Object and Purpose Exception shall not apply because granting the treaty benefits under the specific facts does not accord with the object and purpose of the treaty. Avi-Yonah posed an interesting question: Should the object and purpose of a treaty be determined by analyzing the original treaty negotiations between the countries or the signing of the MLI? Avi-Yonah thinks that the second option is the correct one and that, therefore, taxpayers could have stronger arguments in favor of their claims to apply the Object and Purpose Exception. With regards to the U.S. LOB rules, Avi-Yonah believes that they have a few substantial problems. First, the U.S. LOB rules include an unjustified exception for publicly-traded corporations. Second, the LOB rules in the actual treaties to which the United States is a party are much more complicated than the rules in the U.S. Model Income Tax Convention, and they usually include loopholes which enable taxpayers to abuse them.   Opinion I disagree with Reinhold because his approach is substantially driven by the importance of providing certainty to taxpayers regarding the tax results of their international activities and the need to limit the tax authorities’ power to use anti-abuse arguments. As I see it, on the other side of the balance is the importance of providing flexible legal tools to tax authorities for dealing with creative, abusive tax planning, which often uses loopholes in mechanical rules like the LOB. In my view, both sides of such balance should bear equal weight when considering the right type of anti-abuse rules to use. Additionally, uncertainty of tax results is an inherent part of tax laws all around the world, not only at the international level but also in domestic transactions and business activities. Whereas I agree that it is better to minimize such uncertainties wherever possible, I do not think that minimizing them should be one of the main considerations in choosing the right anti-abuse rule. Moreover, how severe is the uncertainty for taxpayers under the PPT? Since the PPT was adopted by all 71 countries currently signed on to the MLI (among them most of the world’s strongest economies with the exception of the United States), it has arguably become the new global standard for anti-abuse and, as a result of this widespread global consensus, a part of international law. Hence, in addition to the OECD guidelines for applying the PPT,[17] in years to come, case law from around the world will begin to shed light on how the PPT is applied by different courts. This might serve to reduce taxpayer uncertainty. Furthermore, even if one accepts the challenges of uncertainty, how do such challenges compare with the problem of treaty abuse? The implications of treaty abuse are immediate and direct, in the manner of treaty benefits granted to taxpayers in inappropriate circumstances. However, the implications of uncertainty for taxpayers are indirect: Whereas uncertainty may increase disputes between taxpayers and tax authorities, taxpayers with meritorious arguments will be disadvantaged mostly as a result of the legal expenses surrounding such disputes and not by tax itself, since tax authorities will avoid litigating such cases or because courts will most likely rule in favor of the taxpayer. In my opinion, preventing the direct and immediate consequences of treaty abuse in exchange for the potential risk of a period of increased disputes and taxpayer uncertainty is worthwhile. Last, another risk which derives from the uncertainty is the risk of economic inefficiency, where taxpayers may avoid carrying out good transactions because of uncertain tax results. In my view, such risk is insignificant because once the PPT becomes the standard global anti-abuse rule, taxpayers will purportedly “suffer” from such uncertainty in most of the jurisdictions in which they consider carrying out their activities. In other words, taxpayers will not have many alternatives to carry out their international activities without such alleged uncertainty. Therefore, the PPT’s uncertainty, if it exists at all, would be, simply put, the “new certainty” in taxpayers’ calculations of the worthwhileness of possible international transactions or activities.

* Eran Levy is an International Taxation LLM candidate at the University of Michigan Law School. Eran graduated the combined program of Law (LLB) and Accountancy from Tel Aviv University in 2013 (magna cum laude, Accounting). Eran is a lawyer and Certified Public Accountant (Israel) and worked in the International Tax department of Shekel & Co. (Israel) as well as in the Corporate Tax department of KPMG Israel. Eran also served as a teaching assistant in taxation at Tel Aviv University. [1] Richard L. Reinhold is Senior Counsel in Willkie Farr & Gallagher LLP and Adjunct Professor of Law at the New York University School of Law. [2] Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law and director of the International Tax LLM Program at the University of Michigan Law School. [3] Anti-abuse rules are basically rules which intend to prevent granting of treaty benefits in inappropriate circumstances, e.g., treaty shopping. [4] See U.S. Dep’t of Treasury, United States Model Income Tax Convention art. 22 (2016). [5] Org. for Econ. Co-Operation & Dev. [OECD], Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 2015 Final Report, at 9 (2015), [hereinafter OECD BEPS Action 6].   [6] Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, art. 9(e), June 7, 2017, [hereinafter Multilateral Convention]. [7] U.S. Dep’t of Treasury, United States Model Technical Explanation Accompanying the United States Model Income Tax Convention of November 15, 2006 63 (2015). [8] Multilateral Convention, supra note 6, at art. 7(1). [9] OECD BEPS Action 6, supra note 5, at 57-58. [10] Id. at 58. [11] See OECD, Explanatory Statement to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, at 22, 89 (2016). [12] Prévost Car Inc. v. The Queen, 2008 D.T.C. 3080 (Can. Tax Ct.). [13] For example, a preference to form Holdco in Europe and in a jurisdiction which is not too expensive and where business could be conducted in English. [14] Under certain conditions, the withholding tax rate on dividend distributions is five percent. Convention Between Canada and the Kingdom of the Netherlands for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, Can.-Neth., art. 10, May 27, 1986, [15] The Academic Chairman of the International Bureau of Fiscal Documentation, Jean Monnet ad personam Chair in European Tax Law and Policy at WU Vienna University of Economics and Business (Austria) and Associate Professor of Tax Law at the University of Salerno (Italy). [16] The Simplified LOB can be implemented by country only in conjunction with the PPT. [17] OECD BEPS Action 6, supra note 5, at 54.