Now that the multilateral instrument (MLI)1 coordinated by the Organisation for Economic Cooperation and Development (OECD) has been signed by over seventy jurisdictions,2 the new international tax agreement has moved to the implementation phase, with open issues and challenges ahead.
The practical outgrowth of the OECD’s project to address base erosion and profit-shifting (BEPS), this novel convention provides signatories with a streamlined process for implementing treaty-related measures from the BEPS action plan. Under a new choose-your-own-adventure approach, signatories agree to minimum standards but retain the flexibility to opt in or out of a series of provisions that modify the application of their bilateral tax treaties. Significantly, the changes implemented through the MLI go beyond mere tweaks. At a broad level, the MLI modifies a number of the substantive provisions in tax treaties and makes consequential changes to the express object and purpose of such treaties.
The OECD has historically focused on developing “soft law” instruments such as model agreements and agreed-upon guidelines (including in particular the OECD Model Tax Convention and the transfer pricing guidelines), which have served as models for the implementation and, in certain cases, the interpretation of domestic laws and bilateral agreements. In contrast, the MLI is a binding international legal instrument that represents a novel approach to implementing global consensus. Although the core concept of a multilateral instrument is not new, these instruments historically have constituted self-contained separate agreements, rather than acted as a clearinghouse for amending multiple existing treaties. The MLI, therefore, charts a new course that differs from both model agreements and other multilateral treaties. Upon ratification by signatories, it will serve as an independent and interdependent binding legal instrument that must be read alongside existing bilateral agreements.3
Upon ratification by signatories, the MLI could affect more than 1,100 existing bilateral treaties.4 Although the United States notably has not signed the instrument, U.S. multinationals operating between jurisdictions that have signed the MLI will not be immune to the dramatic shift in the international treaty landscape that the MLI represents. The MLI’s novel structure, in conjunction with its modification of long-understood standards and its injection of greater subjectivity into those standards, is likely to trigger unique issues, interpretive challenges, and, in some cases, traps for the unwary. This article identifies some of the issues and practical challenges the MLI raises and recommends ways to reduce uncertainty, anticipate pitfalls, and prepare for impact.
How Does the MLI Preamble Alter Covered Tax Agreements?
The MLI changes the object and purpose of bilateral tax treaties, modifying their interpretation and application at a fundamental level. As part of the minimum standard described in Action 6 of the Final BEPS Reports,5 signatories to the MLI must include in their tax treaties an express statement that the intent of tax treaties is to “eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance” (emphasis added).6 There are parallel paths to achieving this objective:
- Opting in to Article 6(1) of the MLI: Signatories lacking adequate preamble language in existing agreements must agree to Article 6(1) of the MLI, which provides specific treaty preamble language that signatories can use to supplement or supersede existing language.
- Keep existing adequate preamble language: Signatories can opt out of the MLI-prescribed language only if their tax treaties already contain adequate preamble language that covers the intent to “eliminate double taxation without creating opportunities for non-taxation or reduced taxation.”
- Reliance on the MLI Preamble: All signatories to the MLI remain subject to language in the MLI’s own preamble that is, in fact, more expansive than the option language contained in Article 6(1). As a result, the relevance of opting in or opting out of Article 6(1) is unclear.
Why does this matter to taxpayers? First, this convergence of MLI preamble language with the options offered to signatories to implement the minimum standard is a reminder to taxpayers that the MLI is itself a tax convention, the preamble of which applies to all signatories as a substantive overlay to the convention and provides context for its interpretation.7 The Action 6 Final Report and the Explanatory Statement accompanying the MLI both underscore this intent.
Second, the MLI preamble itself goes beyond articulating the agreed-upon minimum standard regarding the purpose and object of treaties, adding the following condition that all signatories must agree to: “Recognising the importance of ensuring that profits are taxed where substantive economic activities generating the profits are carried out and where value is created.”
While the goal of aligning profits with value creation has been an oft-mentioned driver for BEPS recommendations in commentary and discussion drafts, its inclusion in the MLI preamble represents the first time it has been given legal interpretive significance. Under the rules of the Vienna Convention, “[a] treaty shall be interpreted in good faith . . . in the light of its object and purpose,” which includes its preamble.8
This new MLI preamble language, therefore, will present interpretative challenges. For example, how do you define “substantive economic activities”? What factors go into determining where value is created? Taxpayers turning to the BEPS discussion drafts and consultations for guidance will find divergent views on these topics. The absence of consensus on the meaning of the preamble language, as well as the subjective nature of some of the operative provisions of the MLI, opens the door to divergent interpretations that could increase the risk of controversy and create uncertainty about the availability of treaty benefits.
How Far Does the New MLI Preamble Language Reach?
While it is clear that the MLI preamble provides context for the provisions of the MLI that are selected by signatories, it is not clear whether the “purpose” and “context” reflected in the MLI preamble also serves as a new backdrop for interpreting all provisions of every covered tax agreement listed by signatories. As described above, the MLI is designed to be applied alongside existing tax treaties. In that regard, if any two signatories to the MLI both choose to list the tax treaty between them as a covered agreement, does that mean that such tax treaty should now be interpreted in light of this additional preamble language, even if there are otherwise no matching elections between the signatories?
In this regard, it is important to note that no specific mechanism is provided for the resolution of disputes about the interpretation or implementation of the MLI itself, other than convening a conference of the parties. This is in contrast to disputes about the interpretation or implementation of provisions of a tax treaty that are modified by specific provisions of the MLI (including questions about how the MLI has modified a specific tax treaty), which are subject to resolution by mutual agreement under the treaty.9 It is unclear into which category a dispute over the application or relevance of the MLI preamble would fall. As a practical matter, therefore, taxpayers should consider that such disputes may not be eligible for mutual agreement procedures (MAP) relief in general or arbitration in particular.
How Will the MLI’s Anti-Treaty-Shopping Provisions Affect Existing Structures?
As part of the minimum standard, signatories to the MLI must adopt one of three basic approaches to dealing with treaty shopping: a principal purpose test (PPT), a PPT combined with either a simplified or detailed limitation on benefits (LOB) provision, or a detailed LOB provision in concert with a mechanism to address conduit arrangements. The third option is not offered through the MLI due to the significant bilateral customization required for a detailed LOB, and thus can be adopted only in bilateral treaty negotiations. Because jurisdictions will be subject to peer review with respect to the adoption of the minimum standards, and bilateral treaty negotiations take significant time, all MLI signatories to date have indicated that they will adopt a PPT, with or without a simplified LOB provision, with a few expressing an intent to negotiate a detailed LOB in the future.
The PPT can be used by a treaty partner to deny treaty benefits if it is determined that one of the principal purposes of an arrangement or transaction is to obtain treaty benefits in a manner that is not in accordance with the object and purpose of the relevant provision. The limited guidance on how the new PPT standard will be applied in practice leaves open several interpretive issues relating to the scope of the provision and the interaction with the relevant preamble, the effective date of the PPT, and the interaction of the PPT and LOB provisions.
The MLI changes the object and purpose of bilateral tax treaties, modifying their interpretation and application at a fundamental level.
Scope and Interaction With Preamble Language
In addition to minimum standard preamble language discussed earlier, the MLI also permits countries to adopt optional preamble language reflecting an objective “to further develop their economic relationship and to enhance their co-operation in tax matters.” Interestingly, however, this optional language has been adopted by only forty-five of the seventy-plus signatories.10 It is unclear why a jurisdiction would choose not to include this language, but given that the preamble helps define the object and purpose of tax treaties, there is a risk that countries that have not adopted this optional preamble language may be more inclined to take an aggressive approach to using the PPT to deny treaty benefits.
A second set of interpretive issues arises as a result of the option for MLI signatories to retain existing “comprehensive” PPT provisions, even those that differ from the MLI’s new provisions. Because PPT provisions historically have not been drafted as broadly as the new MLI provisions, it is uncertain whether many of them could satisfy the minimum standard under the MLI. Retaining such legacy PPT provisions raises questions of interpretation, particularly in light of the Commentary and other guidance accompanying the new rules that focus as much on the object and purpose of tax treaties as on the specific language of the new PPT.
Effective Date Issues
Taxpayers accustomed to prospective application of new rules should be aware that the new PPT provisions could apply to future payment streams in existing structures and potentially even apply to payments or to taxable years before the effective date of the MLI.11 The MLI does not grandfather any existing structures. Thus, the PPT could apply to deny benefits to a payment or taxable year after the effective date of the MLI if the operating structure’s original purpose—set years ago—does not pass muster under the MLI. Even more surprising, some of the MLI’s recommended modifications to the Commentary on the OECD Model Treaty suggest that the revised PPT language merely confirms existing principles; this raises the possibility that such principles, which had never before been outlined in such detail, could apply to prior years as well.12 Finally, taxpayers must consider whether the ongoing maintenance of a structure that currently provides substantial tax advantages could be construed as violating the PPT without regard to whether the original purpose for establishing the structure years ago may have passed scrutiny under the PPT. As a practical matter, in such situations it may be hard to produce adequate documentation to substantiate claims regarding the structure’s origin.
The PE provisions are not part of the minimum standard adopted by the MLI signatories; thus, each signatory must choose whether to opt in to individual provisions.
Interaction of PPT and LOB
The Commentary to the LOB and PPT reflects an attempt to balance competing policies. On the one hand, it is stated that neither test is intended to restrict the application of the other, and that passing one rule therefore does not mean that benefits cannot be denied by the other. On the other hand, it is stated that the PPT must be read in the context of the rest of the treaty, including the LOB, to determine the object and purpose of the relevant provisions. For example, an entity that passes the LOB because it is publicly traded should not be denied benefits solely because some owners of its publicly traded shares are third-country residents, but could be denied benefits if the publicly traded company entered into a conduit financing transaction.
The intricate interplay between the PPT and the LOB leaves room for confusion regarding the ambit of each provision. Thus, there are grounds to conclude that the provisions target different types of abuse, with the LOB addressing treaty abuse resulting from the legal nature, ownership in, and general activities of residents and the PPT being more properly targeted at transactions that constitute improper use of a treaty.13 Some parts of the Commentary about the application of the PPT, however, take into account both types of considerations. Indeed, the fact that the PPT by itself is considered sufficient to meet the minimum standard suggests that it must apply to both types of abuses in some circumstances. In light of this ambiguity about the purpose of each provision, taxpayers need to consider that the PPT, by itself, could be used to challenge structures based on the ownership of the entities involved.
How Far Do the MLI’s Expanded Dependent Agent PE Provisions Reach?
The OECD’s BEPS project generated a number of proposals designed to address concerns about the artificial avoidance of permanent establishments (PEs). These proposed revisions to Article 5 of the OECD Model Treaty make the analysis more subjective and extend each jurisdiction’s reach in defining a PE. The PE provisions are not part of the minimum standard adopted by the MLI signatories; thus, each signatory must choose whether to opt in to individual provisions.
Existing OECD model-based treaties provide that a person acting on behalf of a nonresident enterprise creates a PE in a source country only if the person habitually concludes contracts in the name of the principal in that source country.14 This bright-line standard is relatively straightforward in its application, though some questions have arisen in the past relating to the interpretation of “habitually,” as well as what it means to conclude contracts “in the name of” a principal. In contrast, Article 12(1) of the MLI provides that a source country may find the existence of a PE whenever a person acting on behalf of a nonresident enterprise “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise” and these contracts are for the transfer of or use of property of the enterprise, or for the provision of services by the enterprise.15 This new standard is both more expansive and more subjective than the traditional standard, potentially affecting the status of a broad array of existing structures.
Because optional MLI provisions such as this one take effect only if both parties to the treaty elect to apply them, taxpayers may take some solace in the fact that currently fewer than half of the MLI signatories have adopted the expanded dependent agent PE provision.16 Nevertheless, it is important to recognize that there remains some exposure due to the potential interaction of the PPT and domestic rules with the PE provisions.
In particular, a jurisdiction favoring the broader dependent agent PE standard offered in the MLI might be inclined to invoke the PPT to turn off treaty protection with respect to a nonresident operating in its jurisdiction if it can successfully assert under domestic law that the nonresident’s activities create a PE.17 In such circumstances, taxpayers may have limited access to MAP to resolve disagreements about the existence of a PE. Some countries (e.g., the Netherlands) have informally suggested that preserving competent authority review of the expanded PE standard through the MAP process is one of the primary reasons they opted to sign on to the enhanced PE standard in the MLI.
It is important to recognize that there remains some exposure due to the potential interaction of the PPT and domestic rules with the PE provisions.
Must All Activities in a Foreign Jurisdiction Be “Preparatory and Auxiliary” to Avoid PE Status?
Article 5(4) of the 2014 OECD model treaty lists certain activities that, even if conducted through a fixed place of business as defined in paragraph 1, or by a dependent agent as defined in paragraph 5, would not create a PE. The MLI provides signatories with two potential avenues for amending Article 5(4) to clarify the application of the specific activity exemptions.
The nature of these specific activity exemptions was the subject of debate prior to the launch of the BEPS initiative. Subparagraphs (a) through (d) lay out a nonexclusive list of activities, subparagraph (e) refers to “any other activity of a preparatory and auxiliary character,” and subparagraph (f) references any combination of activities described in (a) through (d), as long as the overall activity resulting from the combination is of a preparatory and auxiliary character. One view holds that the exemptions are pure safe harbors; the other view would overlay each exempted activity (or combination of activities) with the additional requirement that it be preparatory and auxiliary to the taxpayer’s business. These views were explained in OECD discussion drafts in 2011 and 2012, but both documents ultimately concluded that neither the language of the OECD Model Treaty nor its historical development supported the view that there was an overlay to the exemptions. Nonetheless, the two views live on in the MLI’s two available elections for activity exemptions:18
- Option A takes the more restrictive view, modifying tax treaties so that the Article 5(4) specific activity exemptions apply only where the activity is of a “preparatory or auxiliary” character.
- Option B would make a slight change to the current version of Article 5(4) of the OECD Model Treaty, to reinforce the interpretation that the specific activity exemptions are intended to be safe harbors or per se exceptions.
Signatories can elect either Option A or B or can decline to adopt either, presumably because they favor retaining the original version of Article 5(4). The choice to adopt Option B, or to decline both options, raises some interpretive challenges. Option B confirms the signatory’s intent to reject the “preparatory and auxiliary” overlay to the specific activity exemptions. But if Option B was intended to remove doubt, what is the significance of opting out of any option versus electing Option B? Interestingly, to date, only seven jurisdictions have chosen Option B. In the absence of such an election, there is a risk that jurisdictions favoring Option A could use a signatory’s failure to choose Option B as a basis to argue that even the original language in Article 5(4) should have a preparatory and auxiliary overlay in order for any exemption to apply. Similarly, a jurisdiction that elects to adopt Option B may have to combat assertions that there is a negative inference with respect to the interpretation of the specific activity exemptions, both in treaties that have not been modified by Option B (because the other party has not adopted the same option) and in years prior to the effective date of the MLI in treaties to which Option B does apply.
Because of these ambiguities and interpretive challenges, multinationals should review any structures that rely on the specific activity exemptions for PE protection, assess vulnerability to a preparatory and auxiliary assessment, and consider measures to mitigate exposure.
Potential Impact of the New “Antifragmentation” Rule in the Case of Dependent Agent PEs
Additional interpretive questions arise in the application of a new antifragmentation rule that operates to nullify the specific activity exemptions if the same enterprise, or a closely related enterprise, carries on complementary functions that are part of the same cohesive business operation in the same state, and either (i) one of the places of activity is a PE for one of the enterprises or (ii) the overall activity of the combined business is not preparatory or auxiliary in character.19 To date, forty signatories have adopted this antifragmentation rule.20
While the antifragmentation rule by its terms refers to a fixed place of business PE, closer analysis suggests the rule also could potentially be invoked with respect to dependent agent PEs. Article 5(5) of the OECD Model Treaty provides that a dependent agent will not create a PE for a nonresident if the agent’s activities “are limited to those mentioned in paragraph 4 that, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.” This cross-reference to paragraph 4 opens up the possibility that the new rule could circumscribe the exemption for dependent agents. If adopted, the antifragmentation rule would potentially limit the application of paragraph 4 to a dependent agent PE to the extent that there are other fixed places of business in the same jurisdiction (even if those fixed places of business do not by themselves rise to the level of a PE).
What is less clear is whether jurisdictions could employ the same type of logic to apply the antifragmentation rule to aggregate the activities of multiple dependent agents of closely related enterprises in situations where those agents would not independently create a PE for those enterprises. In particular, could the antifragmentation rule apply by analogy based on activities of other dependent agents even where no fixed places of business exist? Because there is no definitive guidance on this point, taxpayers need to consider that the antifragmentation rule adds to the arsenal of potential devices that aggressive jurisdictions could employ to identify PEs.
With its multifaceted approach to implementing treaty-based BEPS recommendations, the MLI puts taxpayers in uncharted waters. Added to the challenge of managing different permutations of interlocking provisions is the challenge of interpreting new anti-abuse standards that have been both expanded and imbued with greater subjectivity. Multinational corporations that rely on tax treaties should take heed of the MLI preamble’s focus on substantive economic activities and value creation. They should also consider the potential overlay of the MLI preamble to the existing network of treaties, including the possibility that MAP relief and arbitration may not be available for interpretative disputes. In addition, taxpayers would be wise to reevaluate potential PEs in light of possible new challenges based on the PPT or the new antifragmentation rule. By taking into account these open issues, taxpayers will be better equipped to assess their exposure in this new era of treaty law.
Manal Corwin is national leader of the international tax practice of KPMG LLP (U.S.) and principal in charge of international tax policy in the firm’s Washington national tax practice. Jesse Eggert is a principal and Monica Zubler is a director, both in the international tax group of KPMG’s Washington national tax practice.
Editor’s note: These comments represent the views of the authors only and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax advisor.
- OECD, Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (November 24, 2016) [hereinafter MLI], www.oecd.org/tax/treaties/multilateral-convention-to-implement-tax-treaty-related-measures-to-prevent-BEPS.pdf.
- See Press Release, OECD, Ground-breaking Multilateral BEPS Convention Signed at OECD Will Close Loopholes in Thousands of Tax Treaties Worldwide (July 6, 2017), available at www.oecd.org/tax/ground-breaking-multilateral-beps-convention-will-close-tax-treaty-loopholes.htm (accessed October 3, 2017).
- See OECD, Explanatory Statement to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting ¶ 13 [hereinafter MLI Explanatory Statement].
- OECD, Frequently Asked Questions on the Multilateral Instrument (MLI) (2017), available at www.oecd.org/tax/treaties/MLI-frequently-asked-questions.pdf (accessed October 3, 2017).
- OECD/G20 Base Erosion and Profit Shifting Project, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6: 2015 Final Report ¶ 72 [hereinafter Action 6 Final Report].
- See MLI, Article 6(1) and (2).
- Vienna Convention on the Law of Treaties, art. 31(1) and (2) [hereinafter Vienna Convention].
- See MLI, Article 32(1); see also MLI Explanatory Statement ¶ 315.
- See OECD, Signatories and Parties to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting: Status as of 22 September 2017 [hereinafter Signatories and Parties MLI Position], available at www.oecd.org/tax/treaties/beps-mli-signatories-and-parties.pdf (accessed October 3, 2017).
- See MLI, Article 35(1).
- See OECD Model Tax Convention on Income and on Capital 2014, Commentary on Article 1, ¶ 9.5. See also Draft Contents of the 2017 Update to the OECD Model Tax Convention, at 38-42 and 233.
- See, e.g., Draft Contents of the 2017 Update to the OECD Model Tax Convention, at 234; Action 6 Final Report ¶ 20.
- See, e.g., OECD Model Tax Convention, Article 5(5).
- See MLI, Article 12(1).
- See Signatories and Parties MLI Position. To date, thirty-one jurisdictions have elected to adopt the expanded PE definition in Article 12.
- In most jurisdictions, tax treaties serve only to limit taxing rights and cannot be used to create taxing rights that do not already exist under domestic law. Accordingly, most signatories to the MLI that elect to apply expanded concepts of PE will have to make corresponding changes to domestic law or already have in place domestic laws that are broad enough to accommodate the expanded notion of PE.
- See OECD Model Tax Convention: Revised Proposals Concerning the Interpretation and Application of Article 5 (Permanent Establishment), at 24-26 (October 19, 2012), available at www.oecd.org/ctp/treaties/PermanentEstablishment.pdf (accessed October 3, 2017).
- MLI, Article 13(4).
- See Signatories and Parties MLI Position.