Typically, the treaty-shopping is countered under the Act by General Anti-Avoidance Rules or Specific
Anti-Avoidance Rules. However, under the tax treaties, the same has been countered by anti-treaty-shopping provisions like limitation of benefit (LOB) clause and/or beneficial ownership provisions. Generally, the LOB clause restricts availing of the treaty benefits by a conduit entity or an entity which has been formed for the purposes of treaty-shopping. It also restricts entities who attempt to claim double non-taxation; for example, LOB clause under India-Singapore tax treaty. In other words, LOB clause limits the benefits of tax treaties to legitimate residents of the other country. Basically, LOB clause is designed to test the substance of the claimant to the tax treaty. Accordingly, it prevents treaty-shopping and tax avoidance. The LOB clause in the treaty consists of various tests which need to be fulfilled in order to avail the treaty benefit; for example, main purpose of transaction, bona-fide business activity, qualified person test, stock exchange test, threshold for expenditure test, etc.
The LOB concept in tax treaties was introduced by the US while it was non-existent in OECD as well as UN Model Conventions. The US Model Tax Convention (of 1996 and 2006) has detailed LOB provisions in Article 22 of the Convention. In September 1989, India entered into a tax treaty with the US which incorporated the LOB clause for the first time in Indian treaties consisting of various objective tests.
In January 2003, the report of the working group in India on non-resident taxation recommended that in future negotiations, provisions relating to anti-abuse/LOB may be incorporated in the tax treaties. In last decade, India has entered into several tax treaties and most of them include the LOB clause; for example, Singapore, the UK, Poland, Malaysia, Switzerland, Luxembourg, Saudi Arabia, UAE, etc.
LOB clauses are worded differently from treaty to treaty and are often quite complex. The treaties of some countries, such as the UK, focus on subjective purpose for a particular transaction, denying benefits where the transactions were entered into, in order to obtain undue benefits under the treaty. Other countries, such as the US, focus on the objective tests to be complied with by the party seeking treaty benefits.
The protocol to the India-Singapore tax treaty provides for stringent conditions for a non-resident to qualify for capital gains tax exemption so as to ensure that a conduit entity does not avail such benefits.
A few Indian tax treaties have a specific provision that the anti-abuse provisions in the domestic law may override the tax treaties; for example, Luxembourg and Saudi Arabia. Whereas India-Namibia tax treaty provides novel and unique LOB clause wherein contracting state can tax income which is not chargeable to tax in other contracting state being foreign source income.
The LOB clause in some of the tax treaties states that benefit of the tax treaty shall not be available to a resident of contracting state, or with respect to any transaction undertaken by such a resident, if the main purpose or one of the main purposes of the creation or existence of such a resident or of the transaction undertaken by him was to obtain benefits under the tax treaty; for example, the UK, UAE, Mexico, Kuwait, etc.
Recently, India has proposed to amend its tax treaty with Spain where a unique LOB clause has been proposed. According to this clause, domestic rules and procedures regarding abuse of law will be applicable. Further tax treaty benefits will not apply to non-beneficial owners. It is also provided that the tax treaty does not prevent both the states from applying their domestic controlled foreign company (CFC) rules. Lastly, benefits derived from the tax treaty will not apply, if the main purpose or one of the main purposes of the creation, existence, set up, registry or presence of the resident, or the transaction made by him, is to obtain treaty benefits that would not otherwise be available. Accordingly, the GAAR provisions which will come into effect from April 1, 2015, will override India-Spain tax treaty. Similarly, CFC provisions proposed in the Direct Taxes Code, whenever it comes in effect, will have an overriding effect over this tax treaty.
It is interesting to note that the Supreme Court, in the case of Azadi Bachao Andolan, while dealing with the applicability of India-Mauritius tax treaty, observed that in the absence of LOB clause in the India-Mauritius tax treaty, in comparison to the India-US tax treaty which has an LOB clause, the Mauritius tax treaty benefit can be availed by a resident as long as tax residency certificate was obtained. Further, the Supreme Court in the case of Vodafone International Holdings BV observed that LOB clause has to be expressly provided for in the tax treaty. Such a clause cannot be read into the tax treaty by interpretation.
The Supreme Court in the aforesaid decisions supports the view that taking advantage of a beneficial treaty by incorporating a company in a tax haven should not be considered as illegal or taking advantage of a double non-taxation situation, if the same does not contravene any provisions of the tax treaty and the concept of LOB should not be implied within a tax treaty, unless express provisions exist to that extent.
Recent trends suggest that emphasis on fulfilment of substance requirements has gained momentum. Apart from the tax residency certificate, various factors or conditions such as location of effective decision making, citus of key management, ability to execute the transactions, etc, are becoming necessary to prove substance. This emerging trend may expand the concept of LOB in the forthcoming tax treaties.
With contributions from Mrugen Trivedi, technical director, tax, KPMG in India
Shah is co-head, tax, KPMG in India. Views are personal