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Limitation of Benefit (LoB) Clause – Anti-Treaty Shopping Measures - International Taxation - Income TaxExtract Limitation of Benefit (LoB) Clause Anti-Treaty Shopping Measures In general, the LoB clause is for preventing the use of most favourable treaty. This clause can also be said as Specific Anti-Avoidance (SAAR) measure against treaty shopping which limits the use of treaties by the resident by planning restrictions. In these provisions, conditions are specified which limit the use of the treaty benefits between the residents of either of the contracting states. The residents of third countries are not allowed to use the bilateral convention between two states. This provision is found in the US Model convention which has been included by OECD in its commentary recently. The most significant advantage of these provisions is that they provide more certainty in the application of tax treaties. The term Limitation on benefit is generally never defined under International tax treaties. In fact, at times, the concerned Article may not also be titled as Limitation on benefit , though in essence, the said Article may outline various provisions for limiting treaty benefits. The IBFD international Tax Glossary defines the term LOB as under: Provision which may be included in a tax treaty to prevent treaty shopping, e.g. through the use of a conduit company. Such provisions may limit benefit to companies which have a certain minimum level of local ownership ( look through approach), deny benefits to companies which benefit from a privileged tax regime ( exclusion approach ) or which are not subject to tax in respect of the income in question ( subject-to-tax approach ), or which pay on more than a certain proportion of the income in tax-deductible form ( channel approach or base erosion rule ) .. From Indian perspective let s take an example of Article 24 of DTAA between India and USA. The same reads as under: ARTICLE 24 LIMITATION ON BENEFITS A person (other than an individual) which is a resident of a Contracting State and derives income from the other Contracting State shall be entitled under this Convention to relief from taxation in that other Contracting State only if : more than 50 per cent of the beneficial interest in such person (or in the case of a company, more than 50 per cent of the number of shares of each class of the company's shares) is owned, directly or indirectly, by one or more individual residents of one of the Contracting States, one of the Contracting States or its political sub-divisions or local authorities, or other individuals subject to tax in either Contracting State on their worldwide incomes, or citizens of the United States ; and the income of such person is not used in substantial part, directly or indirectly, to meet liabilities (including liabilities for interest or royalties) to persons who are not resident of one of the Contracting States, one of the Contracting States or its political sub-divisions or local authorities, or citizens of the United States. The provisions of paragraph 1 shall not apply if the income derived from the other Contracting State is derived in connection with, or is incidental to, the active conduct by such person of a trade or business in the first-mentioned State (other than the business of making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company). The provisions of paragraph 1 shall not apply if the person deriving the income is a company which is a resident of a Contracting State in whose principal class of shares there is substantial and regular trading on a recognized stock exchange. For purposes of the preceding sentence, the term recognized stock exchange means : in the case of United States, the NASDAQ System owned by the National Association of Securities Dealers, Inc. and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Act of 1934 ; in the case of India, any stock exchange which is recognized by the Central Government under the Securities Contracts Regulation Act, 1956 ; and any other stock exchange agreed upon by the competent authorities of the Contracting States. A person that is not entitled to the benefits of this Convention pursuant to the provisions of the preceding paragraphs of this Article may, nevertheless, be granted the benefits of the Convention if the competent authority of the State in which the income in question arises so determines. As seen from the LOB clause supra, it will apply only to non-individuals. Unlike corporates, firms etc. an individual cannot indulge in treaty shopping. To meet the conditions of Article 24, an entity is required to satisfy various test e.g. Ownership test Article 24(1)(a), Base erosion test Article 24(1)(b), Active business connection test- Article 24(2), Recognized stock exchange test Article 24(3), Competent authority test- Article 24(4). Ownership test requires that more than 50% of the beneficial interest/50% of the number of shares of each class of shares is owned directly or indirectly by individuals, who are residents in India or USA, Government of India or USA or its political sub-divisions or local authorities, other individual subject to tax in India or USA on their worldwide income or Citizens of USA. Base erosion test requires that the income of the particular entity should not be used in substantial party, directly or indirectly, to meet liabilities (including liabilities for interest or royalties) of persons who are not qualified entities. Active business connection test requires that income earned by an entity is in connection with or is incidental to the active conduct in trade or business in the home country. There is no need to evaluate the active business connection test if an entity fulfils both ownership test and base erosion test. Recognized stock exchange test requires that there is a regular trading of principal class of shares of an entity in a recognized stock exchange of home country. If one or both of test prescribed under Article 24(1) are not satisfied and also the active business test is not satisfied, an entity would still get tax treaty benefit between India-USA, if it fulfils recognized stock exchange test. If the conditions under Article 24 of the tax treaty are not satisfied by an entity, then the source country has the right to deny tax treaty benefit. Importance of LOB Clause in tax treaty with India The decision of Supreme Court of India in the case of Azadi Bacho Andolan (supra) held that there was no inherent anti-abuse rule in Indian tax treaties and hence it required a specific Limitation on Benefit clause in the treaty itself for the denial of treaty rights. Treaty shopping is not illegal. The Court further observed as under: Overall, countries need to take, and to take, a holistic view. The developing countries allow treaty shopping to encourage capital and technology inflows, which developed countries are keen to provide to them. The loss of tax revenues could be insignificant compared to the other non-tax benefits to their economy. Many of them do not appear to be too concerned unless the revenue losses are significant compared to other tax and non-tax benefits from the treaty, or the treaty shopping leads to other tax abuses. Whether it should continue, and, if so, for how long, is a matter which is best left to the discretion of the executive as it dependent upon several economic and political considerations . After the Supreme Court decision, India has included LOB clause in some of its tax treaties. In each case, the LOB provision is based on its national treaty policy and influenced by non-fiscal factors. LOB clause has been inserted, for specific purpose, by India, in the modified treaties of Singapore UAE.
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