Treaty Shopping - International Taxation - Income Tax

Treaty Shopping The international Tax Glossary defines treaty shopping as a situation where a person who is not entitled to benefits of a tax treaty makes use-in the widest sense of the word of an individual or of a legal person, in order to obtain those treaty benefits that are not available directly. The UN Ad Hoc Group of Experts defined the term abuse of tax treaties as the use of tax treaties by persons the treaties were not designed to benefit, in order to derive benefits that the treaty were not designed to give them. It is defined as the routing of income arising in one country to a person in another country through an intermediary country to obtain an unintended tax advantage of tax treaties. E.g. a person resident of India acts through a legal entity created in another state essentially to obtain treaty benefits which India has with that states say Mauritius, which would otherwise not be available directly. There are a variety of treaty shopping structures. Some of them are: Direct Conduits A direct conduit works as shown in the diagram below. Parent Company in State Y expects to derive dividends, interest or royalties sourced in another state (State Z). So it sets up entity in a third state (State C) that will receive dividends, interest, and royalties in a more tax beneficial way than if income were paid directly from State Z to Y. The tax advantage results from fact that tax treaty between Z and C provides for more advantageous withholding tax rate in State Z if paid to State C Resident than if paid to State Y resident. Stepping stone conduit A stepping stone conduit works as follows: Residents of State Y establish company resident in State C where it is fully subject to tax on income derived from Z. However, it pays high interest, royalties, service fees, commissions other expenses to a second related foreign company (base company) set up in a fourth state (State B) and controlled by shareholders of the conduit company. These payments are deductible in State C and are either not taxed or very advantageously taxed in State B because the company enjoys a preferential tax regime there. Other structures There are other treaty shopping techniques in practice; examples are triangular structures where a low or nil taxed branch of a company in a treaty country receives income from a third country. Another approach is to use hybrid entities that are characterized differently in the two Contracting States. Individuals can also treaty shop by transferring tax residence to another treaty country, i.e., emigration - also a form of treaty shopping. For instance, a resident of USA owning an important shareholding in Indian company may emigrate to Belgium in view of later sale of shares because under Article 18 of Belgium-France tax treaty the right to tax the capital gain is conferred to Belgium but Belgium does not levy capital gains tax on individuals (except speculation). There are four main categories of anti-treaty shopping measures currently in use: Neutral measures by combining domestic and tax treaty provisions. Example: non-domiciled residents in U.K. may be entitled to treaty benefits on foreign income only when remitted. Specific measures that deny benefits to entities which are not subject to tax in their state of residence. Purpose-based measures that deny certain treaty benefits set up only for claiming such benefits. Example is no tax refunds are given under Netherlands treaty with the U.K. in such cases. Comprehensive measures imposed under domestic legislation or treaties. For example, Article 22, U.S. Model Treaty on Limitation on Benefits, 1996; Swiss Abuse Doctrine, 1962 Treaty shopping, when it is beneficial may be tacitly approved and when disadvantageous may be disapproved. For example, some of them have revoked tax treaties in cases of circular situations when the income is sourced in the same country where the shareholder is resident, but the income passes through a company resident in another country for tax reasons, i.e., round tripping . This has been considered abusive by India, Brazil, Indonesia, etc.