2016 financial services taxation conference …€¦ · · 2016-02-242016 financial services...

© Richard Vann 2016

Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2016 FINANCIAL

SERVICES TAXATION

CONFERENCE

Financial Services in a Post-BEPS World

Written by:

Richard Vann

Challis Professor

Sydney Law School

Consultant,

Greenwoods &

Herbert Smith

Freehills

Presented by:

Richard Vann

17–19 February 2016

Surfers Paradise Marriott Resort & Spa, Gold Coast

Richard Vann Financial Services in a Post-BEPS World

© Richard Vann 2016 2

CONTENTS

1 Overview ......................................................................................................................................... 3

2 BEPS Policy and the Corporate Tax ............................................................................................ 4

3 Hybrid Entities and Tax Treaties .................................................................................................. 8

3.1 BEPS treaty provisions ............................................................................................................. 8

3.2 Relationship to OECD Partnership Report and other treaty provisions .................................... 9

3.3 What does fiscally transparent mean? .................................................................................... 11

3.4 Other problems with fiscally transparent entities .................................................................... 14

3.4.1 Special conditions for treaty relief .................................................................................... 14

3.4.2 Procedure ........................................................................................................................ 15

4 Tax Treaty Abuse ......................................................................................................................... 17

4.1 Action 6 Report ....................................................................................................................... 17

4.2 Application of LOB and PPT Tests ......................................................................................... 18

4.3 PE and special regime abuse rules ........................................................................................ 20

5 Permanent Establishment ........................................................................................................... 22

5.1 BEPS on Permanent Establishment ....................................................................................... 22

5.1.1 Time thresholds ............................................................................................................... 23

5.1.2 Preparatory and Auxiliary Activities ................................................................................. 23

5.1.3 Agency PEs ..................................................................................................................... 24

5.2 At Sixes and Sevens: The Australian MAAL........................................................................... 26

5.2.1 Off on a frolic? ................................................................................................................. 26

5.2.2 Operation of MAAL .......................................................................................................... 27

Richard Vann Session C: Financial Services in a Post-BEPS World


1 Overview

This paper will examine (some aspects of) the future state of the financial services industry in a post-

BEPS world. The G20/OECD base erosion and profit shifting (BEPS) project as is well known was

driven very much by the digital disruption to the tax system, not to mention the economy, caused by

new technology and ways of doing business. To date that disruption has not shown up so much in the

financial services industry in Australia as in other areas.

When the BEPS Final Reports were released on 5 October 2015, the new Australian Treasurer was

very quick to adopt more or less all of it and indicate that Australia was already well on its way to

implementation, or to put it another way, there was not much in the way of further implementation

required of Australia.1 Since then the government has been actively proceeding with implementation

of those BEPS measures not already in place (hybrids mentioned in the next paragraph, the bill on

country-by-country reporting, the new thoroughly-BEPSed treaty with Germany) and BEPS inspired

measures (such as the multinational anti-avoidance law).

Although the BEPS project has reached the conclusion of its development phase and is now in the

implementation phase, there is still much substantive work to be done in a number of areas, including

some which is of most interest to the finance industry. For example, the BEPS Report on Action 22 on

hybrids requires extensive work on domestic law implementation for which consultation is currently in

progress by the Board of Taxation.3 That Report leaves up in the air much that is of concern to

financial institutions, including deductible-frankable hybrids, transition and grandfathering, and

regulatory capital hybrids. It is not possible to predict where all this will lead both in Australia and

internationally at the moment but there are signs that countries are likely to struggle with domestic law

implementation of this particular Action, compared to the treaty aspect of hybrids which is much easier

to implement, though currently unclear on exactly what the treaty provision means.

Rather than simply catalogue what the G20/OECD decided and what has happened in Australia this

paper will be selective, looking at substantive issues (rather than transparency covered elsewhere

during the conference and procedural issues) where outcomes are fairly clear at the OECD level and

implementation very likely, but problems already apparent. It covers the treaty measures on hybrid

entities, abuse and permanent establishment, as well as comparing and contrasting the MAAL with

the BEPS outcomes and discussing the broad policy issue of what BEPS means for the corporate

income tax. The last issue is directly relevant to the tax reform debate in Australia and is taken up first.

Transfer pricing is not covered as it is also dealt with in another paper.

1 Treasurer, OECD report supports Australian Government action on multinational tax avoidance (6 October 2015), especially

the table at the end. 2 OECD/G20 Base Erosion and Profit Shifting Project, Neutralising the Effects of Hybrid Mismatch Arrangements ACTION 2:

2015 Final Report (2015). 3 Board of Taxation, Implementation of the OECD Anti-Hybrid Rules Consultation Paper (2015).



2 BEPS Policy and the Corporate Tax

There has been a tax policy paradox surrounding the corporate tax in Australia: in the domestic tax

reform debate the corporate tax has been derided as one of the most inefficient taxes in Australia,

inhibiting growth and being largely borne by labour, not shareholders. In the international tax debate

surrounding BEPS the corporate tax has been seen as an essential tax and the means of taxing

foreign capital as well as ensuring the fairness of the tax system. The cry in the tax reform debate is

cut the corporate tax and replace it with other more efficient taxes; the cry in the international tax

debate is bolster the corporate tax and ensure it operates as intended. One of the unnoticed

achievements of the BEPS work has been to illuminate part of this policy paradox.

The illumination on this issue comes mainly from the Action 1 Report on the digital economy4 though

there is some similar analysis in the other report dealing directly with policy, Action 11 on measuring

BEPS.5 As with many often-proclaimed economic truths about taxation, the apparently contradictory

views of the corporate tax depend on the assumptions underlying the economic models. The Treasury

study in relation to tax reform which ranks the corporate tax as inefficient6 is based on perfect

markets: perfectly competitive markets without economic rents, perfectly capital mobility etc. It also

assumes that the supply of foreign capital is perfectly elastic, the supply of domestic capital is

perfectly inelastic, the elasticity of domestic labour demand with respect to capital stock relatively high

because capital and labour are modelled as gross complements – the rise in price of capital relative to

the wage reduces both capital and labour. These assumptions more or less inevitably lead to the

conclusions about the inefficiency of the tax and its incidence on labour.

The Digital Economy Report recognises that there are economic rents involved in the digital economy

which vary over time, ie not perfectly competitive markets. This is enough to change the outcome of

economic models significantly. The conclusions are (see Annex E Economic incidence of the options

to address the broader direct tax challenges):

• In the case of a perfectly competitive market for digital goods and services, the incidence of

the corporate income tax increase is likely to be borne by labour in the affected foreign

suppliers’ production country and consumers in market countries, depending on the

importance of the affected suppliers in the particular market and the availability of

replacement suppliers with similar cost structures and the availability of alternative goods and

services.

• If the market is imperfectly competitive, the corporate income tax increase is likely to be

borne principally by the equity owners of the affected foreign suppliers.

4 OECD/G20 Base Erosion and Profit Shifting Project, Addressing the Tax Challenges of the Digital Economy ACTION 1: 2015

Final Report (2015). 5 OECD/G20 Base Erosion and Profit Shifting Project, Measuring and Monitoring BEPS ACTION 11: 2015 Final Report (2015).

6 Treasury, UNDERSTANDING THE ECONOMY-WIDE EFFICIENCY AND INCIDENCE OF MAJOR AUSTRALIAN TAXES

(2015) Treasury Working Paper 2015-1.



Always be wary of economists with strong tax messages and ask them about the underlying

assumptions!7 The Action 11 report recognises taxing economic rents as one of the justifications for

the corporate tax (see pp 112-116, 182).

Another aspect of the Action 11 report highlights the two main policies underlying substantive BEPS

proposals. The one that is quoted very commonly (and often taken to describe the BEPS project

overall) is as follows:8

No or low taxation is not per se a cause of concern, but it becomes so when it is associated

with practices that artificially segregate taxable income from the activities that generate it.

This sentence appears in a paragraph which identifies (not very clearly) not one but two policy drivers

as follows:

BEPS relates chiefly to instances where the interaction of different tax rules leads to double

non-taxation or less than single taxation. It also relates to arrangements that achieve no or

low taxation by shifting profits away from the jurisdictions where the activities creating those

profits take place. No or low taxation is not per se a cause of concern, but it becomes so

when it is associated with practices that artificially segregate taxable income from the

activities that generate it. In other words what creates tax policy concerns is that, due to gaps

in the interaction of different tax systems, and in some cases because of the application of

bilateral tax treaties, income from cross-border activities may go untaxed anywhere, or be

only unduly lowly taxed.

To paraphrase, one policy target is exploiting gaps and differences in tax systems’ rules to produce

low or no taxation and the other is separating the location of income from the location of value adding

activity to produce low or no taxation; if neither target is present then the fact that a country has low or

no corporate taxation is not a cause for concern. The policy division of the BEPS substantive work

partly reflects and partly hides this division with Actions 2-5 grouped under the rubric “Establishing

international coherence of corporate income taxation” (intended to cover the first policy) and Actions

6-10 under “Restoring the full effects and benefits of international standards” (intended to reflect the

second policy). The match is not complete, however. Only Action 2 on hybrids and possibly Action 3

on CFC regimes reflects the first policy directly.9 Action 4 on interest deductions and even more

Action 5 on harmful tax practices (so far as Action 5 is about patent boxes and the like as opposed to

transparency of rulings) more easily fit into the second policy concerning separation of income from

value adding activities.10

7 The government has just released more recent modelling which is said to show that the GST-income tax switch will produce

little or no efficiency gains and be very unfair with a great impact on those on lowest incomes even after compensation, ABC,

Tax reform: Treasury modelling presents taxing dilemma for Government, see http://www.abc.net.au/news/2016-02-

12/treasury-modelling-presents-taxing-dilemma-government/7161640 and http://www.abc.net.au/news/2015-12-09/eight-

options-for-tax-reform-explained/7013380. It will be interesting to know what the assumptions in this modelling are. 8 OECD, Action Plan on Base Erosion and Profit Shifting (2013) p 10.

9 OECD/G20 Base Erosion and Profit Shifting Project, Designing Effective Controlled Foreign Company Rules ACTION 3: 2015

Final Report (2015). 10

OECD/G20 Base Erosion and Profit Shifting Project, Limiting Base Erosion Involving Interest Deductions and Other Financial

Payments ACTION 4: 2015 Final Report (2015), OECD/G20 Base Erosion and Profit Shifting Project, Countering Harmful Tax

Practices More Effectively, Taking into Account Transparency and Substance ACTION 5: 2015 Final Report (2015).

http://www.abc.net.au/news/2016-02-12/treasury-modelling-presents-taxing-dilemma-government/7161640

http://www.abc.net.au/news/2016-02-12/treasury-modelling-presents-taxing-dilemma-government/7161640

http://www.abc.net.au/news/2015-12-09/eight-options-for-tax-reform-explained/7013380

http://www.abc.net.au/news/2015-12-09/eight-options-for-tax-reform-explained/7013380



To establish coherence of the corporate tax it is necessary to know what the purpose of the corporate

tax is. Commonly two goals are stated. The first has to do with the realisation basis of the income tax

and the treatment of companies as separate taxpayers from their shareholders. If there were no

corporate tax, income tax could simply be avoided at both company and shareholder levels by the

company retaining all its income and the shareholders not selling their shares. The corporate tax is

thus necessary as a tax on retained income of companies. This is largely a domestic justification for

the tax in relation to resident shareholders.11

The second purpose is to effectively tax foreign

shareholders: it is much easier administratively to collect the tax from a company operating in a

country than from its foreign shareholders and reflecting this the international tax system has been set

up to significantly limit cross border tax on dividends, especially intragroup dividends and capital gains

on shares held by foreigners.

The corporate tax is also essentially a source based tax even though it is nominally levied on a

residence and source basis in most countries. This is shown most clearly by the participation

exemptions now common for foreign active income of resident companies, and the exclusion of active

income from CFC attribution. For active income the residence tax is levied on the ultimate

shareholders of the corporate group rather than the companies in the group. I have argued this

proposition at length elsewhere12

If it is accepted, then it has a number of consequences for the policy

of the BEPS project. It justifies taxing profits where value adding activities occur (as this is essentially

restoring international standards on source based taxation which is the objective of Actions 6-10). It

also justifies the work on interest deductions which is essentially focused on stripping income from

source countries even though applied generally to ensure it does not offend various non-

discrimination tax rules, particularly in the EU, and the work on patent boxes which effectively requires

that reduced taxes be given only for R&D activities in a country and not as a means of attracting

income without activity from other countries, even though written on an entity rather than location

basis for similar reasons.13

When it comes to Action 2 and Action 3, the underlying policy seems to be that the relevant income

which exploits gaps or differences between tax regimes should be taxed somewhere but it does not

matter much where. This is hardly a tax-policy principled approach though it may be justified by game

theory where players are better off through co-operation. For that reason these Actions in my view are

going to prove the hardest to implement, apart from their technical complexity. Further policy

differences over the purpose of CFC regimes explain why it was not possible to get consensus on the

Action leaving it as a best practice (ie optional) recommendation, rather than an obligatory standard or

an almost obligatory common approach in BEPS-speak. Some countries consider the purpose of CFC

rules is to prevent domestic to foreign stripping (round tripping), that is, undermining the source tax

base of the company’s residence country,14

whereas other countries consider that CFC regimes are

11 The corporate tax also operates domestically as a tax on distributed income. In Australia the imputation system turns the

corporate tax into a withholding tax on income distributed to resident shareholders. Other countries nowadays generally have

lower taxes on dividends paid to non-corporate shareholders in recognition of corporate tax having been paid. 12

Vann, Taxing International Business Income: Hard-Boiled Wonderland and the End of the World (2010) 2(3) World Tax

Journal 291-346. 13

The article in the previous note also argues that in the real world the residence of corporations effectively operates as a

sourcing principle in international taxation. In the case of the Action 5 the substantial activity test is applied to activities of the

entity in question, not its associated entities, which indirectly operates as location test. 14

Two recent examples in the Australian context are the Chevron case [2015] FCA 1092 and the Orica case [2015] FCA 1399

both of which involved an Australian parent company paying interest to a US subsidiary (though in the first case there was an

ultimate US parent). It is noteworthy that in neither did the ATO seek to apply the Australian CFC regime for reasons which are



also intended to deal with foreign to foreign stripping, that is, tax in the residence country of a parent

company discourages stripping of income by the group from a source country into a CFC where it is

subject to no or low taxation. One difficulty with the latter policy of taxation based on residence rather

than source when there are chains of companies resident in various countries is determining which

residence country CFC regime should apply, which in itself demonstrates the frailty of corporate

residence as a genuine taxing nexus. The answer in ch 7 of the Action 3 report is all of them but with

foreign tax credits for unrelieved double taxation in the chain subject to the usual foreign tax credit

limit, which seems to mean tax at the highest rate of all countries in the chain.

The lack of firm policy principle in real corporate residence taxation is also evident in the report on

Action 2. Consider a debt-equity hybrid instrument within a corporate group (debt in the payer country,

equity in the payee country) which prior to the BEPS project produced a deductible/non-inclusion

(D/NI) outcome. There seem to be three recommendations for this case. First, the payee country

should modify its participation exemption to deny it when the payment is deductible in the other

country; then the payer country should deny the deduction if there is a hybrid mismatch, that is, D/NI

outcome; finally the payee country should eliminate the exemption if there is a hybrid mismatch which

the payer country has not eliminated (even though the hybrid outcome in the second and third steps

seems to result from the lack of action of the payee country under the first step).15

Compare this to

Action 4 on interest deductions where the focus is the payer (source) country.

This is not to say that there may not be cases where real corporate residence taxation is appropriate

– income truly without a source in a country such as from international transport or activities in terra

nullius (Antarctica, space) may be examples, but such taxation on the basis of failure to tax at source

due to gaps or differences in tax systems (foreign to foreign stripping and D/NI hybrids) but not in

other cases where the source country does not tax is clearly more debatable. It will be interesting to

compare country implementation of Action 2 and Action 3 with other BEPS Actions.

While the analysis in the Action 11 Report is clear that policy in the corporate tax is complex and

contestable and seeks seriously to come to grips with the policy and associated measurement and

modelling issues raised by BEPS, obviously it was not going to be critical of the project. Nonetheless

its nuanced approach to the corporate tax is much more sophisticated than and a healthy corrective to

the simple minded material we have been getting in the domestic tax reform debate on the corporate

tax.

more obvious in the Orica than in the Chevron case, and instead relied on transfer pricing rules in Chevron and Part IVA in

Orica. 15

Recommendations 2(1), 1(1)(a), 1(1)(b) respectively.



3 Hybrid Entities and Tax Treaties

3.1 BEPS treaty provisions

In relation to the tax treaty treatment of hybrid entities the OECD/G20 Report on Action 2 ch 14 has

adopted the following Article 1(2), which is expected to be included in the BEPS multilateral treaty,

probably on an optional basis:

For the purposes of this Convention, income derived by or through an entity or arrangement

that is treated as wholly or partly fiscally transparent under the tax law of either Contracting

State shall be considered to be income of a resident of a Contracting State but only to the

extent that the income is treated, for purposes of taxation by that State, as the income of a

resident of that State.

It appears in article 1(2) of the Australia Germany 2015 treaty with the addition of “(including profits or

gains)” after the first reference to “income”, and a variant of it is in article 1(2) of the 2009 Australia

New Zealand treaty.

The provision is designed to ensure that hybrid entities are not used to get treaty benefits when the

income is not being taxed in the residence state just because the states characterise the entity

differently with respect to particular income for tax purposes (as transparent in one state and as

opaque in the other). As an example assume that interest income is derived from source state S by an

entity based in state E with its members resident in state R. S and E regard the entity as transparent

and therefore attribute the income to the members resident in state R. State R regards the entity as a

tax opaque company resident in state E and therefore does not tax the members resident in state R

on the income when it is derived by the entity (assuming ant CFC rules in state R are not activated).

Under this provision treaty benefits cannot be claimed in state S under the treaty between state S and

state R due to the words “but only” etc in the new provision. Conversely the provision is intended to

ensure that treaty benefits flow where otherwise they might be denied. Suppose in the example in the

previous paragraph state S regarded the entity as a tax opaque company but state E and state R

regarded it as tax transparent. Even though state S would attribute the income to the entity in state E,

state R would tax the members in state R. The provision in this case ensures that the members get

the benefit of the treaty between state S and state R. This double operation is made clear in the

OECD Commentary to the new provision para 26.6.

Both these recent Australian treaties lack one important additional element – the provision based on

the US saving clause which is recommended in the OECD/G20 Report on Action 616

pp 86-89 as

Article 1(3) of the OECD Model:

This Convention shall not affect the taxation, by a Contracting State, of its residents except

with respect to the benefits granted under paragraph 3 of Article 7, paragraph 2 of Article 9

and Articles 19, 20, 23 A [23 B], 24 and 25 and 28.

16 OECD/G20 Base Erosion and Profit Shifting Project Preventing the Granting of Treaty Benefits in Inappropriate

Circumstances ACTION 6: 2015 Final Report (2015).



This has an important part to play in the treatment of hybrids (as is recognised in the Action 2 Report

p 143). By way of variation on the previous examples assume the entity is resident in state S which

regards it as a tax opaque company whereas state R regards it as transparent. The saving clause has

the result that state S is not obliged in this case to apply the treaty between state S and state R as

article 11 is not mentioned as an exception. While it can be argued whether this is the right result, the

OECD view is based on the premise that a state should not generally be prevented by treaty from

taxing its own residents (which also has important applications in relation to CFC regimes and the

like). In the case of the New Zealand treaty this issue is “solved” by an agreement between the

negotiators reflected in the EM to the act implementing the treaty para 2.25:17

During negotiations, the two delegations noted that:

‘It is understood that (this) paragraph shall not affect the taxation by a Contracting

State of its residents.’

Presumably a similar fix will be applied to the new German treaty (no draft EM has appeared to date)

but it is not clear why the saving clause was not adopted in the treaty.

3.2 Relationship to OECD Partnership Report and other treaty

provisions

Those familiar with the OECD 1999 Partnership Report18

will recognise that the examples and

solutions given in the previous section come from that report which derived them as a general matter

of treaty interpretation rather than as following from express provisions. The ATO has accepted the

conclusions in that sense but confined them to partnerships in TD 2011/25. Further the Partnership

Report applies on an all or nothing basis, the issue of whether an entity that is transparent for some

income but not for other income being left for future analysis (which has never been finalised or

published). Trusts fall into this category as well as not being partnerships and that is why the New

Zealand treaty adopted a specific provision to ensure broader coverage of the principles, see EM para

2.10. From an OECD perspective the fact that not all countries accepted the conclusions of the

Partnership Report provided an additional reason for inclusion of the provision, Action 2 Report p 139

para 435.

The New Zealand EM para 2.10 and the new OECD Commentary paras 26.4-26.7 are clear that the

treaty provision is intended to produce the same outcomes as the Partnership Report but as will

appear that is not completely obvious and in any event both the German and New Zealand versions

vary to some degree from the OECD language and there are other even more differently worded

provisions in Australia’s treaties dealing with partnerships and other transparent entities, which raises

the question to what extent the principles of the Report are displaced by express treaty provisions. In

fact the OECD in its 1999 Report warned against express treaty provisions creating problems rather

than solutions, which is repeated in the new Commentary para 26.4.

17 Explanatory Memorandum (EM) to International Tax Agreements Amendment Bill (No 2) ch 2.

18 OECD, ISSUES IN INTERNATIONAL TAXATION No. 6 The Application of the OECD Model Tax Convention to Partnerships

(1999).



In particular Australia’s treaties with France (2006) and Japan (2008) have detailed provisions dealing

with the issue. The latter treaty is also designed to get the same results as the Partnership Report

(and the New Zealand treaty) though with much more detailed drafting as a comparison of the Japan

and New Zealand EMs will show (there is significant duplication of text and examples, despite the

quite different treaty language).19

The Australian treaty with France Article 29 has similarities with the

Japan treaty approach, though not as much as more recent French treaties which are almost identical

to the Japanese language, eg France United Kingdom (2008).20

Some features of the France treaty

are discussed under the next heading.

This interaction issue was raised but not discussed in the Resource Capital Fund III LP Case.21

Both

the 1953 and 1982 treaties between Australia and the United States contained provisions on

partnerships. The provision in 4(1) of the 1982 Australia United States treaty states:

(b) a person is a resident of the United States if the person is: …

(iii) any other person (except a corporation or unincorporated entity treated as a corporation

for United States tax purposes) resident in the United States for purposes of its tax, provided

that, in relation to any income derived by a partnership, an estate of a deceased individual or

a trust, such person shall not be treated as a resident of the United States except to the

extent that the income is subject to United States tax as the income of a resident, either in its

hands or in the hands of a partner or beneficiary, or, if that income is exempt from United

States tax, is exempt other than because such person, partner or beneficiary is not a United

States person according to United States law relating to United States tax.

The trial judge commented on this and the 1953 provision as follows:

Under art II(1)(g) of the 1953 Convention, a partnership created or organised in or under the

laws of the US (a US domestic partnership) was a resident of the US for the purposes of the

1953 Convention whether or not the partners were liable to US tax on the income of the

partnership. If the partners in the US domestic partnership were foreign companies (ie,

incorporated outside the United States) and the partnership income was not effectively

connected with the conduct of a trade or business carried on in the US, neither the

partnership (because it was fiscally transparent) nor the partners would be liable to US tax on

the partnership income, but because the partnership was a resident of the US for the

purposes of the 1953 Convention, it was entitled to the benefits of the 1953 Convention vis-à-

vis Australian source income. The negotiators of the [1982] Convention were conscious of this

anomaly when drafting art 4(1)(b)(iii); thus, under the Convention, even a US domestic

partnership will only be a resident of the US for the purposes of the Convention to the extent

that the income of the partnership is subject to US tax in the hands of a partner or, if that

income is exempt from US tax, is exempt other than because such partner is not a US person

according to US law relating to US tax.

19 Compare EM to International Tax Agreements Amendment Bill (No 1) 2008 paras 1.43-1.51 with New Zealand EM paras 2.8-

2.33. 20

Compare Article 4(5) in both treaties. 21

Resource Capital Fund III LP [2014] FCAFC 37, 16 ITLR 876, reversing [2013] FCA 363, 15 ITLR 814; leave to appeal to

High Court refused [2014] HCA Trans 235. For an analysis from which the comments in this paper on RCF are drawn, see

Vann, Hybrid entities in Australia: Resource Capital Fund case in Lang et al, eds, Tax Treaty Case Law 2015 (2016, IBFD

forthcoming).



The problem with the 1953 provision was that it gave treaty benefits even if there were no US

taxpayer liable to tax in the United States. As demonstrated by the RCF case the 1982 provision had

the opposite vice of being too narrow in the sense of achieving a similar outcome to the Partnership

Report; it only operated to give treaty benefits to the LP directly if both the LP and the partners were

resident under US domestic tax law. As RCF was a Cayman Islands LP, the 1982 provision did not

apply to it.

Clearly it was possible to argue on the wording of the Australia United States 1982 treaty that its

express provision on partnerships excluded the operation of the Partnership Report principles to the

extent that they were more extensive. Neither party took this position and the courts seemed willing to

accept the view that the Partnership Report was relevant to the partners, though the judges of the Full

Federal Court expressly indicated that they were not deciding this issue. While the provision now

proposed by the OECD is designed to overcome this particular issue, the same issue will arise if and

to the extent that it is more limited than the principles in the Partnership Report.

3.3 What does fiscally transparent mean?

To come within the new OECD provision the entity must be “fiscally transparent” so it is critical to

know what this phrase means. The new Commentary is fairly brief:

26.10 The concept of “fiscally transparent” used in the paragraph refers to situations where,

under the domestic law of a Contracting State, the income (or part thereof) of the entity or

arrangement is not taxed at the level of the entity or the arrangement but at the level of the

persons who have an interest in that entity or arrangement. This will normally be the case

where the amount of tax payable on a share of the income of an entity or arrangement is

determined separately in relation to the personal characteristics of the person who is entitled

to that share so that the tax will depend on whether that person is taxable or not, on the other

income that the person has, on the personal allowances to which the person is entitled and on

the tax rate applicable to that person; also, the character and source, as well as the timing of

the realisation, of the income for tax purposes will not be affected by the fact that it has been

earned through the entity or arrangement. The fact that the income is computed at the level of

the entity or arrangement before the share is allocated to the person will not affect that result.

States wishing to clarify the definition of “fiscally transparent” in their bilateral conventions are

free to include a definition of that term based on the above explanations.

This language has two sources. The first part of the second sentence comes from the Partnership

Report para 40. The second part of the sentence is a shorthand reference to the language in the US

regulations under Internal Revenue Code s 894(c)22

which defines the meaning of fiscally transparent,

s 1.984-1(d)(3)(ii):

an entity is fiscally transparent under the laws of the entity's jurisdiction with respect to an

item of income to the extent that the laws of that jurisdiction require the interest holder in the

entity, wherever resident, to separately take into account on a current basis the interest

holder's respective share of the item of income paid to the entity, whether or not distributed to

22 26 CFR s 1.894–1(d)(3) and the examples in s 1.894-1(d)(5).



the interest holder, and the character and source of the item in the hands of the interest

holder are determined as if such item were realized directly from the source from which

realized by the entity

The examples concerning trusts in particular state:

Example 4. Treatment of grantor trust. (i) Facts. Entity A is a trust organized under the laws of

Country X, which does not have an income tax treaty in effect with the United States. M, the

grantor and owner of A for U.S. income tax purposes, is a resident of Country Y, which has an

income tax treaty in effect with the United States. M is also treated as the grantor and owner

of the trust under the laws of Country Y. Thus, Country Y requires M to take into account all

items of A's income in the taxable year, whether or not distributed to M, and determines the

character of each item in M's hands as if such item was realized directly from the source from

which realized by A. Country X does not treat M as the owner of A and does not require M to

account for A's income on a current basis whether or not distributed to M. A receives interest

income from U.S. sources that is neither portfolio interest nor effectively connected with the

conduct of a trade or business in the United States.

(ii) Analysis. A is not fiscally transparent under the laws of Country X within the meaning of

paragraph (d)(3)(ii) of this section with respect to the U.S. source interest income, but A may

not claim treaty benefits because there is no U.S.-X income tax treaty. M, however, does

derive the income for purposes of the U.S.-Y income tax treaty because under the laws of

Country Y, A is fiscally transparent.

Example 5. Treatment of complex trust. (i) Facts. The facts are the same as in Example 4

except that M is treated as the owner of the trust only under U.S. tax law, after application of

section 672(f) [26 USCS § 672(f)], but not under the law of Country Y. Although the trust

document governing A does not require that A distribute any of its income on a current basis,

some distributions are made currently to M. There is no requirement under Country Y law that

M take into account A's income on a current basis whether or not distributed to him in that

year. Under the laws of Country Y, with respect to current distributions, the character of the

item of income in the hands of the interest holder is determined as if such item were realized

directly from the source from which realized by A. Accordingly, upon a current distribution of

interest income to M, the interest income retains its source as U.S. source income.

(ii) Analysis. M does not derive the U.S. source interest income because A is not fiscally

transparent under paragraph (d)(3)(ii) of this section with respect to the U.S. source interest

income under the laws of Country Y. Although the character of the interest in the hands of M

is determined as if realized directly from the source from which realized by A, under the laws

of Country Y, M is not required to take into account his share of A's interest income on a

current basis whether or not distributed. Accordingly, neither A nor M is entitled to claim treaty

benefits, since A is a resident of a non-treaty jurisdiction and M does not derive the U.S.

source interest income for purposes of the U.S.-Y income tax treaty.

A complex trust in US tax law includes a discretionary trust and is in contradistinction to a simple trust,

which, in the relevant year, is required by the terms of the trust to distribute all its trust-law income

currently other than by deductible charitable donation, and which in that year does not distribute other



amounts.23

There is a serious possibility based on these examples that the term “fiscally transparent”

will not cover discretionary trusts. Unfortunately the EM to the Japan treaty does not even refer to

trusts in this context while the EM to the New Zealand treaty refers to trusts but not to discretionary

trusts explicitly, though it does say in para 2.14:

In general, paragraph 2 relates to particular items of income of entities that are fiscally

transparent under the laws of one or other country. Entities falling under this description in

Australia and New Zealand include certain partnerships and trusts. In the case of Australia it

includes partnerships subject to Division 5 of Part III of the Income Tax Assessment Act 1936

(ITAA 1936) (but not corporate limited partnerships subject to Division 5A of Part III), and

trusts which are subject to Division 6 of Part III where the beneficiary of the trust is presently

entitled to the income and assessable accordingly (but not a corporate unit trust or public

trading trust subject to Division 6B or 6C of Part III).

The French treaty in Article 29 actually includes the character, source and timing language in the

treaty itself in relation to third state partnerships and Australian partnerships [my emphasis]:

In the case of a partnership … which is treated in that third State as fiscally transparent … a

partner who is a resident of a Contracting State and whose share of the income, profits or

gains of the partnership is taxed in that Contracting State in all respects as though those

amounts had been derived directly by the partner, shall be entitled to the benefits of this

Convention with respect to their share of such amounts arising in the other Contracting State

as though the partner had derived such amounts directly, subject to the following conditions:

… the partner’s share of the income, profits or gains of the partnership is taxed in the same

manner, including the nature or source of those amounts and the time when those amounts

are taxed, as would have been the case if the amounts had been derived directly

In the case of a partnership or similar entity … which is treated in Australia as fiscally

transparent … a partner who is a resident of Australia and whose share of the income, profits

or gains of the partnership is taxed in Australia in all respects as though such amounts had

been derived by the partner directly …

This language could be read as imposing one, two or three separate conditions in the italicised parts

for third state partnerships and one or two for Australian partnerships. Though the EM recognises the

different language it does not really throw much light on whether it is “elegant” variation for the same

concept or is imposing different conditions.24

The Japan treaty avoids all of this terminology and uses

the much more neutral “derived through an entity … and treated as the income … of the beneficiaries,

members or participants”.

The other treaty which may provide some guidance is the US 2001 protocol which varies the normal

trust PE provision in the business profits article to read as follows [my emphasis]:

a resident of one of the Contracting States is beneficially entitled, whether directly or through

one or more interposed fiscally transparent entities, to a share of the business profits of an

23 26 USC s 651(a), 26 CFR s 1.651(a)-1.

24 EM to International Tax Agreements Amendment Bill (No 1) 2007 paras 1.274-1.286.



enterprise carried on in the other Contracting State by the fiscally transparent entity (or, in the

case of a trust, by the trustee of the trust estate) [my emphasis]

The concluding words could be read as suggesting that trusts are not fiscally transparent entities,

though it seems much more likely that it is a recognition that Australia taxes the trustee rather than the

trust, compare Income Tax Assessment Act 1936 s 317 definition of trust, Income Tax Assessment

Act 1997 s 960-100. Neither the Australian nor US explanations provide assistance on this issue.

It seems likely that the narrowness or otherwise of the interpretation of fiscally transparent will depend

on how close a match between derivation of income directly and derivation through an entity is

required. There are differences in timing (generally the partner or beneficiary derives its share of the

income at the end of the income year rather than when the partnership or trust derived the income),

the treatment of losses (do not pass through trusts, and subject to additional tests when passing

through limited partnerships taxed on a transparent basis in Australia) and in several other respects. If

a strict approach is taken as suggested by the US regulations then it may be found that not many

Australian entities are fiscally transparent in that strict sense. That has not been the assumption of the

Treasury, ATO or private professionals to date but Australia may find itself hostage to the US

regulations through the medium of the OECD Commentary.

3.4 Other problems with fiscally transparent entities

The RCF case also raises two other issues in the area of hybrid entities: to what extent do hybrid

entity treaty provisions deal with various special conditions for treaty relief (a matter with which the

Partnership Report struggled, paras 79-92); and how are treaty benefits asserted procedurally when

the parties to a treaty regard different persons as the relevant taxpayer.

3.4.1 Special conditions for treaty relief

There is a variety of such conditions in treaties, particularly in the dividends article which generally

has beneficial ownership and a condition for source tax rates below the normal treaty default of 15%.

In the OECD Model the conditions are expressed as the “beneficial owner is a company (other than a

partnership) which holds directly” a certain proportion of the company paying the dividend. Australia’s

treaties show some variation in this condition, though the 2015 German treaty uses this quoted part of

the OECD language.

This issue was raised by the trial judge in RCF in discussing whether the Australia US treaty was to

be applied with respect to the LP or with respect to the partners in reference to Article 10(2)(a) (which

is similar to Article 10(2)(a) of the OECD Model though referring to 10% of voting power rather than

25% of capital and omitting the reference to a partnership). He said:25

The [US] Technical Explanation 2001, discussing art 10 of the Convention, provides that

‘[c]ompanies holding shares through fiscally transparent entities such as partnerships are

considered for purposes of this paragraph to hold their proportionate interest in the shares held

25 [2013] FCA 363, para. 73. The current Article 10 was substituted by a 2001 Protocol which is why the reference is to that

year. The 1982 definition of resident quoted above remained unchanged by the Protocol so far as relevant here.



by the intermediate entity (Technical Explanation 2001, art 6). This is consistent with the US

position that ownership measurement is performed on a look-through basis ...

From Australia’s perspective RCF was a company which directly held more that 10% of the voting

shares in the Australian mining company that it sold. If RCF had been a US resident partnership and

had received a dividend, it is strongly arguable from the Australia US treaty provision on partnerships

quoted above, that RCF was the person claiming treaty benefits under Article 10 and hence it is

arguable that it should have been entitled to the reduced rate of tax under Article 10(2)(a). The US

Technical Explanation language quoted by the judge is common in US Technical Explanations

generally and is drawn from the Technical Explanation to the US Model 2006. There, however, it is

justified by reference to the fiscally transparent entity provision in that Model from which the OECD

proposed provision is derived, whereas in the RCF case it had to be derived from general principles

(as the equivalent partnership provision in the treaty did not apply since RCF was not a US

partnership) and arguably would not have produced the same result if RCF had been a US

partnership.26

This discussion is not intended to provide conclusions on these issues but simply to point out that the

proposed OECD provision will raise as many questions as it answers, and currently many of the

questions are not dealt with explicitly or implicitly in the proposed Commentary to accompany the new

provision.

3.4.2 Procedure

Australian tax law provides relatively strict rules on who may challenge action by the ATO; for a tax

assessment, generally only the taxpayer may appeal against an assessment made in relation to the

taxpayer.27

Hence if the partners in RCF wish to raise their treaty rights under Partnership Report

principles in relation to an Australian tax assessment on RCF, the procedural question is how would

the issue come before the court. Probably RCF could raise the issue, but it may not be willing to do so

and there is no immediately obvious way under tax law for the partners to force it to do so. For

example, if RCF only had one small US investor and mainly investors from non-treaty countries, it

may not be interested in appealing on the treaty issue for the benefit of that investor alone.

This procedural issue may have influenced the reasoning of the judges, although it only came to be

clearly articulated in the application for leave to appeal to the High Court of Australia. If it is the case

that the partners have no standing to assert their treaty rights under normal domestic appeal

procedures because RCF is the taxpayer, then one has some sympathy with the view of the trial

judge that domestic law should be required to assess the partners directly and not RCF. Similarly, the

26 Further issues would also arise under Article 10(2)(a) of the OECD Model regarding the meaning of “holds directly” (which

also appears in the Australia US treaty) and the exclusion of partnerships (which does not). The protocol to the 2015 German

treaty para 3 provides, “It is understood that where dividends derived by or through a fiscally transparent entity or arrangement

are treated, for the purposes of taxation by a Contracting State, as the income, profits or gains of a resident of that State, Article

10 shall apply as if that resident had derived the dividends directly.” It is understood that this is necessary because otherwise

the words “holds directly” would not be satisfied in the German view. The protocol language adopted goes further than the ATO

has to date on this point, see TD 2014/13 accepting that shares held by custodians or nominees count for this purpose. 27

Income Tax Assessment Act 1936, s. 175A(1). Courts in recent times have sought to overcome procedural hurdles, but it is

not automatic that a way will be found.



equivocation of the Full Federal Court on whether the partners could raise Partnership Report

principles to avail themselves of treaty benefits may reflect concerns about procedure.

In the application for leave to appeal, counsel for the taxpayer put this matter clearly:28

... because of the way in which the assessment has been raised on the collective relationship,

the partners are unable to test properly their individual liability to tax.

This concern was not directly addressed by the ATO’s counsel though there was some general

discussion of the partners challenging the assessment.29

The only clear avenue identified was the

mutual agreement procedure and counsel for the taxpayer not unreasonably maintained:30

we would respectfully say that that is not an appropriate solution. It is a matter for individual

negotiation in individual cases between the Australian Tax Office and the US Internal Revenue

Service, and that is inappropriate as a principal solution to the issue.

Counsel for the ATO made reference to the practical material in TD 2011/25 but this simply tells the

partners (and LP) what information the ATO needs and undertakes that refunds will be made if

necessary; it provides nothing on the legal means of enforcing the partner’s treaty rights.

28 [2014] HCA Trans 235, p. 14.

29 Supra n. 4, [2014] HCA Trans 235, pp. 12-13.

30 Supra n. 4, [2014] HCA Trans 235, p. 8.



4 Tax Treaty Abuse

It is clear from the Australia Switzerland 2013 tax treaty protocol para 1, the Australian Germany 2015

treaty Article 23(2) and the MAAL discussed below that Australia will pursue the principal purpose test

(PPT) approach to treaty abuse among the menu that has been provided by the OECD/G20 Report

on Treaty Abuse.31

The German treaty Article 23(3) also indicates that preservation of domestic anti-

avoidance rules from being overridden by treaties may also be part of the Australian package.

Australia started including more limited PPT provisions in its treaties from 2003 with the Australia

United Kingdom treaty and has consistently done so since. That treaty also included the general

preservation of domestic anti-avoidance rules but that provision has not been used consistently, often

being limited to the non-discrimination article. In any event it is clear under International Tax

Agreements Act 1953 s 4(2) that Part IVA will always trump a treaty when it is successfully applied.

The Treasurer has indicated that Action 6 will be adopted in future treaty negotiations without

specifying exactly what that means, though the German treaty is probably a good guide.

In this section the BEPS Action 6 Report is discussed and then some factual scenarios are analysed

to see what it all means.

4.1 Action 6 Report

Treaty abuse has been one of the most contentious areas in the BEPS project and the OECD Report

also had to wrestle with a number of delaying factors:

The US released proposed changes to its Model in the anti-abuse area in May 2015 with

comments due by September (after the OECD work was due to be finished – perhaps a

strategic delaying tactic by the US); the final version was released on 18 February 2016 just

after presentation of this paper;

A simplified limitation of benefits (LOB) rule was proposed in 2015 for states wishing to

combine the LOB rule with a principal purpose test (PPT) rule, which is one of the options on

the OECD abuse menu; this suggestion emerged too late for the development of

Commentary on the new version;

Work on the application of the LOB rule to a wide variety of investment funds was more

complex than anticipated; and

The variety of constitutional and institutional issues, domestic anti-abuse rules and

administrative capacity complicates the choice of rules for many states.

These complexities mean that there is still much substantive work to do in this area (though with a

short deadline of the first quarter of 2016) and an even greater degree of optionality over details than

announced in 2014. Nonetheless the 2014 new minimum standard remains in place and treaty abuse

rules are slated for inclusion in the multilateral treaty. The standard is inclusion of a preamble to the

effect that treaties are not meant to produce unintended double non-taxation and one of:

31 OECD/G20 Base Erosion and Profit Shifting Project, Preventing the Granting of Treaty Benefits in Inappropriate

circumstances ACTION 6: 2015 Final Report (2015).



Detailed LOB treaty rule plus anti-conduit rule in treaty or domestic law;

PPT treaty rule; or

Simplified LOB and PPT treaty rules.

The 2014 standard has been watered down in some respects:

States are only required to adopt it if requested by other states to do so during negotiations (if

not parties to the multilateral treaty);

It applies to new and existing treaties but there is no fixed timeframe to include it in existing

treaties; and

States are not obliged to apply the rule when it appears in their treaties if they have no

objection to treaty shopping as the state of source of income.

In terms of the details, the LOB material has become so complex that it may well have the effect of

scaring countries off this option, except of course the US which seems to revel in the detail (the new

2016 US Model version is considerably longer than the 2006 version). There are a number reasons

for the complexity. The existence of two versions of the LOB rule has made its presentation

unreadable. The several parts of the two rules are scattered in the Commentary so that if readers

wish to see the complete version of either rule in one place they have to cut and paste the document.

The material on the application of the LOB to just widely held regulated collective investment vehicles

runs to four pages and contains several variant provisions designed to cover off the existing treaty

variants in the OECD Commentary on Article 1 for treating CIVs as treaty entitled residents;32

while

the material for other funds including pension funds is only in embryo at the moment. And the fact that

the LOB has to be combined with the PPT or an anti-conduit rule then makes the Commentary on the

PPT confusing as it tries to cover off both possibilities, including apparently duplicated examples.

Drafting the options for the anti-abuse rule in the multilateral treaty is going to be a challenge. It may,

however, distract states from pursuing some of the detailed anti-abuse rules also proposed (but not

part of the minimum standard), such as period testing for benefits under some treaty rules (dividends

and capital gains), a PE abuse rule and adoption of some of the 2015 proposed US anti-abuse rules

which made it into the final Action 6 report – but as suggestions for future consideration! Some of the

more familiar of these specific provisions are likely to receive more attention, such as the proposal for

the change to the dual resident tie-breaker for companies referred to in relation to in the Report on

Action 2 and the saving rule which also supports the Action 2 proposals (see above).

4.2 Application of LOB and PPT Tests

This section considers briefly three scenarios and how the OECD full LOB (that is, the US style

version) and the PPT may apply to them.

Scenario 1: Bad Inc is a former listed company resident in Utopia which is now insolvent and

in liquidation, and was formerly an investment bank; the liquidator has sold its business

assets in Utopia and subsequently sold the business assets of Badsub Ltd, a 100%

subsidiary of Bad resident in Australis which is also in liquidation; after the sale of its assets

32 OECD, Model Tax Convention on Income and on Capital (2014 Condensed Version) pp 50-60.



Badsub’s funds are paid out to Bad by way of a liquidation distribution which is treated partly

as a dividend and partly as a capital gain in Australis.

It is difficult to see any abuse here but equally it is difficult to satisfy the LOB. Former listing is not

enough for the listing test for a qualified person. The order of sale (parent first, subsidiary second)

probably means the activity exception (which unlike the qualified person tests covering all items of

income applies on an item of income basis) is not satisfied and even if it is, whether it will apply to

these items of income. The competent authority discretion has almost invariably not been exercised

by the US and administrative law challenges to the US instransigence on the discretion are not having

great success.33

It seems unlikely that the PPT would be applied in this case given the lack of abuse.

Scenario 2: Resources Inc is listed and resident in Utopia and via a 100% subsidiary Eursub

BV resident in Europa holds a 100% interest in Resourcesub Ltd resident in Australis; under

the treaties between Utopia and Europa, Europa and Australis and between Utopia and

Australis, royalties are not taxable at source but otherwise there would be a 30% withholding

tax in Australis; Resourcesub pays a royalty for the use of a patent to Eursub which recently

acquired the patent from Resources; because of a patent box regime, the royalty is not

taxable in Europa, even though all the research for the patent was done in Utopia.

This scenario raises the problem that even where there is a listed company in the structure, it has to

be resident and listed in the country whose treaty is being applied (Europa Australis here) or a treaty

country subsidiary of such a listed company. The equivalent beneficiary addition in recent US treaties

which is included in the OECD version solves this problem but has been controversial as patent boxes

can create incentives to move IP as in this example. The OECD Action 6 Report p 43 leaves it open to

countries to limit the equivalent beneficiary test to non-deductible dividends – how this will play out in

the multilateral instrument is unclear at this stage, and is likely to depend in part on how successful

Action 5 on patent boxes is. The PPT may well be applicable to this example, given the existence of

the patent box in Europa and the shift of the IP into the patent box regime.

Scenario 3: Car plc is listed and resident in Europa and wishes to lend $10m to its subsidiary

Carsub which is resident in Australis; there is no tax treaty between Europa and Australis but

Europa has a tax treaty with Utopia which also has a tax treaty with Australis containing an

exemption for tax on interest at source if the lender is a bank resident in Utopia; Car deposits

$10m at interest with Bank Inc which is resident and listed in Utopia and then Bank lends

$10m to Carsub; the treaty between Europa and Utopia has a zero withholding tax rate on all

interest.

Despite the fact that this example prima facie seems to involve a back-to-back loan being used to

obtain double treaty benefits, it will not be caught by the LOB in either treaty since Bank satisfies the

listing test in Utopia and Car in Europa. Of course if the financial institution exemption in the Australis

Utopia treaty followed the Australian approach there would be no zero rate under that treaty because

of the back-to-back transaction exception but many treaties with such a financial institutions rule do

not include the back-to-back test. This example shows why the Action 6 minimum standard requires

countries adopting the LOB and rejecting the PPT (like the US) to have an anti-conduit rule either in

their treaties or domestic law (as is the case for the US with its conduit financing regulations). The

33 Starr International (United States District Court for the District of Columbia) 2 Feb 2016, partly reversing earlier decision,

Starr International 18 Sept 2015 https://casetext.com/#!/case/starr-intl-co-v-united-states-1.

https://casetext.com/#!/case/starr-intl-co-v-united-states-1



PPT test seems likely to apply in this case, which is why countries adopting the PPT are not required

under the minimum standard to have anti-conduit rules.

Based on these scenarios the PPT may seem to be superior to the LOB. The US objection to the PPT

is that it confers too much discretion because of its lack of objective tests (despite the OECD

Commentary picking up the somewhat incongruous Australian Part IVA language on “objective

purpose”.) Australian advisers with experience of Part IVA are likely to sympathise with the US

objections, but the weight of international government opinion seems to be in favour of the PPT.

4.3 PE and special regime abuse rules

The focus on the Action 6 report has mainly related to the LOB and PPT rules because they are so

broadly applicable. It also, however, contains some other more limited rules that financial institutions

in particular need to have regard to. The potential operation of these rules is demonstrated in the

following scenarios, though no detailed analysis is provided because this work is still ongoing (being

dependent on the outcome of the US revisions to its Model which have just been finalised), Action 6

Report pp 75-78, 96-98 on PEs, special tax regimes and future changes to domestic tax law.

Scenario 4: Under the treaty between Australis and Europa interest on loans made by a bank

resident in one state to a borrower resident in the other state are exempt from source tax on

interest; a bank resident in Europa makes a loan to a company resident in Australis; the loan

is effected by the bank’s branch in Asea. Asea does not tax the interest received because of

an offshore banking regime there, and Europa does not tax the interest received because

under the treaty between Europa and Asea the income of the branch in Asea is exempt in

Europa;

This is the kind of scenario that the PE abuse rule will deal with, but there is an exception for banks,

insurance companies and securities dealers carrying on an active business of that kind through the

PE. Thus pure booking operations are likely to be caught but normal branch operations of such

businesses will still be entitled to normal treaty benefits. Note that the Australian OBU regime would

not satisfy the 60% of the normal tax rate test (assuming Asea had a similar regime) and it would be

necessary to rely on the banking exception in the provision.

Scenario 5: Under the treaty between Australis and Europa interest on loans made by a bank

resident in one state to a borrower resident in the other state are exempt from source tax on

interest; a bank resident in Europa makes a loan to a company resident in Australis; the funds

for the loan were raised by the bank from outside Europa and Europa does not tax the

interest received by the bank because of an offshore banking regime there;

This case would be potentially caught by any special regimes measure in the treaty. It will be a matter

for negotiation between states to clarify what regimes are caught and what regimes are not. The

OECD has previously cleared the Australian OBU regime as not harmful under Action 5 (though

without applying the substantial activity test that is now the centre of the new regime for harmful tax

practices).

Scenario 6: Would it make a difference in scenarios 4 and 5 if the offshore banking regimes

were introduced after the treaty between Australis and Europa had been signed?



The US inspired proposal that the OECD is looking at for new tax regimes provides:

If at any time after the signing of this Convention, either Contracting State provides an exemption

from taxation to resident companies for substantially all foreign source income (including interest

and royalties), the provisions of Articles 10 (Dividends), 11 (Interest), 12 (Royalties) and 21 (Other

Income) may cease to have effect pursuant to paragraph 3 of this Article for payments to

companies resident of either Contracting State.

To activate this provision all that is required is giving a notice through diplomatic channels to the

treaty partner which then comes into effect six months after the notice and also triggers an obligation

to negotiate on the issue. This seems to be so even if the treaty includes the provisions mentioned in

relation to scenarios 4 and 5 and they do not apply to the new regime, for example, because the

taxpayer is a bank in the case of the PE abuse rule.

It is to be noted that the US proposals have been more targeted in the final version of the 2016 US

Model as a response to comments.



5 Permanent Establishment

There are conflicting tendencies evident in the OECD work in the permanent establishment (PE) and

transfer pricing areas which are central to the problems that the BEPS project is seeking to solve. At

least in the private sector (and putting aside some Australian peculiarities) there are several

assumptions about international tax rules that are widely shared (subject to any treaty rules expressly

to the contrary):

Each company is to be treated separately in the application of residence and PE rules;

Each location and potential agent is to be treated separately in the application of PE rules,

and agency is to be interpreted strictly in a legal sense of principal and agent;

It is necessary to find a transaction for a company or dealing for a PE which is to be the

subject of a transfer pricing analysis;

Recharacterisation of that transaction or dealing is only possible in very limited

circumstances; and

Absent recharacterisation, transfer pricing of transactions or dealings is to be confined to what

happened and to price.

The OECD work seems to be challenging these approaches and moving away from a formal legal

analysis to a substance economic analysis, which at the extreme could be regarded as saying or at

least inclining towards a position that once the residence or PE threshold is passed, all activities of

the multinational in a country related to the threshold passing presence (or maybe even unrelated to

it) is taxable and has to be priced based on a purely economic assessment of what is done and not

the legal relations involved. But the push-back from the private sector, and indeed several

governments of major OECD countries, especially the US, means that in almost every case we end

up in a halfway house, though not exactly sure where it is.

As indicated earlier, transfer pricing will not be covered in this paper but the PE work will. That work

will be contrasted with the MAAL which is Australia’s answer to part of the problems being dealt with

in the OECD PE work.

5.1 BEPS on Permanent Establishment

The BEPS Action 7 PE Report34

contains important, if limited, changes to the PE definition and is

another Action which will be included in the proposed multilateral treaty with at least part of it

compulsory it seems for signatories (the agency and anti-fragmentation rules). The Treasurer has

indicated that Australia’s treaty practice is already in line with the OECD approach. Although it is true

that Australia’s treaty language has been moving in the last dozen years in a similar direction as the

OECD, it is doubtful that the outcome is exactly the same, and certainly the Australia Germany treaty

moves straight to the BEPS language rather than continuing the recent Australian treaty language. As

with treaty abuse there is still much work to do in elaboration of the changes that have been agreed,

34 OECD/G20 Base Erosion and Profit Shifting Project, Preventing the Artificial Avoidance of Permanent Establishment Status

ACTION 7: 2015 Final Report (2015).



especially further expansion of the Commentary on the changes. We may get some insight into that

expansion if the draft EM to the Germany treaty is released before any further BEPS drafts. In this

section the changes will again be illustrated with some scenarios.

As already had been signalled earlier in 2015, the work on attribution of profits to PEs that is part of

Action 7 has not been done and is left over to 2016 along with a lot of other transfer pricing work.

5.1.1 Time thresholds

The OECD has concluded that splitting time thresholds in treaties through the use of different

companies, which is only relevant to construction sites in the OECD Model but also applies to

substantial equipment and natural resources PEs in Australia’s treaties, can be handled by the PPT

rule discussed above. The Commentary, however, contains a specific provision that can be used for

this purpose if states which use the PPT nonetheless prefer an express rule on the problem. Australia

is in this category. It has been including such a provision in its treaties for some time now and it also

appears in the Australia Germany 2015 treaty. The Commentary notes that such a provision “should”

be used by states which do not accept the PPT rule such as presumably the US. This is illustrated by

the following scenario.

Scenario 7: Projects plc resident in Europa has recently won a tender to carry out a 15 month

construction project in Australis for Manufacturer Ltd. With the consent of Manufacturer the

project has been broken into three periods of 5 months each. Projectsub1, Projectsub2 and

Projectsub3, which are subsidiaries of Projects and resident in Europa contract with

Manufacturer to carry out one 5 month construction contract each.

5.1.2 Preparatory and Auxiliary Activities

While the amendment to make the exceptions to the PE definition only apply if they are all

“preparatory or auxiliary” is contained in the Action 7 Report, that change is no longer compulsory for

states to follow. This change is designed for the following kind of scenario.

Scenario 8: Digital Inc resident in Utopia sells books, music, films and TV programs over the

internet through a website on its servers located in Utopia. Customers in Australis have the

choice of downloading electronic versions of their purchases from Digital’s servers in Utopia

or having a hardcopy book, CD or DVD owned by Digital delivered from a warehouse where

Dsub, a subsidiary of Digital resident in Australis, stores the goods in Australis on behalf of

Digital.

Amazon has already indicated at least in Europe that it will ensure that it has a PE in such cases thus

exposing some of the sale profit for hard copy products to tax on the seller (as opposed to tax on the

small amount of profit arising in the warehousing subsidiary). It should be noted that it is not inevitable

that there will be a PE in the scenario after the BEPS change which deals with the fact that the current

warehousing exception is not qualified by the preparatory/auxiliary language. For the subsidiary’s

premises to constitute a PE of the parent, it is necessary that the warehouse be “at the disposal” of

the parent, and it would seem fairly easy to avoid that outcome. The subsidiary would not constitute a

PE under the BEPS agency rule as it is not involved in the process leading to the sale at all, just the

delivery after the sale. It seems to be conceded that local warehousing is core to the speedy delivery



which is a critical part of the marketing strategy at least for some products. Where products are

warehoused and shipped to the consumer from offshore, there will not be exposure to a PE from the

warehousing activity.

The minimum necessary for states to do in this area is adopt the “anti-fragmentation” rule which

aggregates all activities in a state carried on by an enterprise and closely related parties constituting

“complementary functions that are part of a cohesive business operation” when determining whether

activities in a state are preparatory or auxiliary. The OECD Report adopts the wider version of this

provision out of the two possibilities originally floated which does not require that there otherwise be

any PE in the state. Scenario 9 demonstrates the kind of situation at which it is directed.

Scenario 9: Clothes SA resident in Europa sells fashion garments over the internet from its

servers in Europa to customers in Australis. For this purpose it has several separate offices in

Australis, each carrying out a separate function. One office organizes advertising of the

garments in various forms of local media, another office warehouses and delivers the most

popular lines of garments, and another office deals with aftersales service.

Here it could be the case that the aftersales service office constitutes a PE already, Action 7 Report p

31, and the warehouse may now constitute a PE as indicated in the previous scenario but whether or

not that is the case, the operation of the preparatory/auxiliary exception is now determined taking

account of all the activities in the state through fixed places of the enterprises and its closely related

enterprises. One of the fixed places will still need to be involved in carrying on the mainstream

business of the enterprise in order to qualify as a PE under Article 5(1) but that is the case here,

compare a warehouse that simply stores records of an enterprise as part of a back-office function.35

To the extent that there are closely related enterprises with places of business, each will have its own

PE and be taxed separately. Further what profits are attracted to the PE(s) in such cases will be a

matter for debate depending on how important the particular functions they perform are in the overall

sales activity of the enterprise (and perhaps how much is being taxed to any local subsidiaries

performing such functions). To the extent that the local operations are not essential to the sales, it

may be possible to relocate them offshore as a way of removing the PE or reducing the profit taxable

to any PE.

5.1.3 Agency PEs

There are some changes in the Final Report from the most recent (May 2015) OECD discussion

paper in this area. First, the wording of the revised agency PE rule has been settled as a person who

“habitually concludes contracts, or habitually plays the principal role leading to the conclusion of

contracts that are routinely concluded without material modification by the enterprise”, leading to a

contract in the name of the foreign enterprise or provision of goods or services by that enterprise

(even if it is not a party to the contract – a provision designed to catch commissionnaire structures). It

is confirmed that low risk distributors are not caught by the new provision – that issue is left to the

transfer pricing changes arising from BEPS. Whether this will prove a large loophole in the BEPS

outcomes remains to be seen. Apart from the commissionnaire situation, this change is the one that

will potentially catch Google style operations as in the following scenario.

35 Compare Unisys [2002] NSWSC 1115.



Scenario 10: Searchengine Inc resident in Utopia has a de facto monopoly over internet

searching by people in Australis. It advertises on the search engine website and for this

purpose, its subsidiary in Australis canvasses potential local advertisers, provides them with

recommendations for placement and timing of advertisements and with information on pricing.

If a person wishes to place an advertisement on the website it is advised by the staff of the

subsidiary to go online to Searchengine’s client website and contract for the placement of the

advertising.

The question for Google-type structures is whether the subsidiary through its staff “habitually plays the

principal role leading to the conclusion of contracts that are routinely concluded without material

modification by the enterprise.” It is possible to imagine a reallocation of functions that may assist in a

negative answer to this question though for companies it is now as much a reputational question as a

technical one. It is interesting to compare this with an insurance scenario.

Scenario 11: Life Ltd resident in Asea has a network of 100 insurance agents in Australis who

canvass for customers and obtain applications for life insurance. The agents are not

employees of Life but the only work they do is for Life. The applications are filled in online by

customers with the assistance of the agents. The applications are risk assessed in the head

office of Life in Asea and accepted or rejected depending on the outcome of the risk

assessment, with 5% of applications being rejected in this way (in line with industry norms for

rejection of application in the risk assessment process).

It is difficult to say in such cases that contracts are routinely concluded without material modification

by the enterprise, and the case law in Canada is clear that no PE arises under current law in such

cases.36

There are no changes to deal with insurance enterprises as originally discussed by the

OECD. These are regarded as adequately covered by the changes to the agency PE rule. Australia

continues in the German treaty to exclude insurance business from the operation of the treaty, leaving

the matter to domestic law, though it is noticeable that life insurance is excluded from the exception

(as is also the case in the Switzerland 2013 treaty, perhaps indicating a change in Australian policy in

this regard).

The other change is to prevent the independent agent exception applying if the agent and principal

are closely related and the agent acts exclusively or almost exclusively for closely related enterprises.

This is the third example in the BEPS Action 7 redraft where there is an incursion into the general

position under treaties that the tax position of a company is determined on a stand-alone basis and

not by reference to activities of related companies. In each case, however, the change is peripheral to

the operation of the PE definition (time thresholds, preparatory/auxiliary exception, independent agent

exception). From a policy perspective the issue is why is the same approach not taken in the basic PE

inclusive definitions. It may be that the anti-fragmentation provision will often have a similar effect and

in that sense it may turn out to be the most important change to the definition.

36 American Income Life [2008] TCC 306, 11(1) ITLR 52, Knights of Columbus 2008 TCC 307, 10(5) ITLR 827.



5.2 At Sixes and Sevens: The Australian MAAL

5.2.1 Off on a frolic?

Australia’s multinational anti-avoidance law (commonly called the MAAL and/or the Google tax) has

received criticism not only from the private sector but also from foreign government officials for

jumping the gun or going on a private frolic, and is even the subject of a recorded spoof from a

Canadian singing in an appalling Australian accent based on Waltzing MAALtilda:

Once a fiscal swagman found a tax-free billabong.

Under the shade of a dodgy PE.

And he sang as he saved and waited till his scheme was foiled:

"I found a-waltzing Matilda, PE!" etc

Australia of course is not alone and much of the criticism is over the top. The UK Diverted Profits Tax

(DPT) preceded us, and now the whole of Europe is getting into the act with a 37 page proposal for a

Council Directive released by the European Commission at the end of January 2016 summarised as

follows:37

The schemes targeted by this Directive involve situations where taxpayers act against the

actual purpose of the law, taking advantage of disparities between national tax systems, to

reduce their tax bill. Taxpayers may benefit from low tax rates or double deductions or ensure

that their income remains untaxed by making it deductible in one jurisdiction whilst this is not

included in the tax base across the border either. The outcome of such situations distorts

business decisions in the internal market and unless it is effectively tackled, could create an

environment of unfair tax competition. Having the aim of combating tax avoidance practices

which directly affect the functioning of the internal market, this Directive lays down anti- tax

avoidance rules in six specific fields: deductibility of interest; exit taxation; a switch-over

clause; a general anti-abuse rule (GAAR); controlled foreign company (CFC) rules; and a

framework to tackle hybrid mismatches.

Australia is being relatively modest! At first glance the MAAL appears narrower than the DPT, which

might be called the Google and Starbucks tax and covers base stripping through royalties as well as

avoided PEs, but the MAAL does deal with royalty payments indirectly to the extent the effective

deeming of a PE activates the royalty withholding tax for payments by the foreign enterprise based on

Australian sales, see the Explanatory Memorandum to the Tax Laws Amendment (Combating

Multinational Tax Avoidance) Bill 2015, Example 3.9. Indeed it would not surprise if more tax is

collected on the withholding front than under the corporate tax though restructuring may attempt to

deal with that exposure.

There is a trend apparent here of tackling BEPS substantive Actions through GAARs rather than

directly. Within BEPS it is only Action 6 which relies on the GAAR approach, and then mainly in the

PPT, not so much the LOB. Otherwise the BEPS Actions propose detailed rule changes which are not

37 European Commission, Proposal for a COUNCIL DIRECTIVE laying down rules against tax avoidance practices that directly

affect the functioning of the internal market, Brussels, 28.1.2016, COM(2016) 26 final, 2016/0011 (CNS) p 3. It should be noted

that the Commission often makes proposals that go nowhere or take many years to come to fruition.



dependent on purpose. To the extent that the issues being tackled in these measures relate to tax

treaties, the obvious reason is to effectively amend treaties through domestic law in a way which

seeks to attract OECD Commentary expressing the view that GAARs are not overridden by treaties.

(Within Europe there are no doubt a host of EU law reasons as well). That Commentary only dates

back to 2003 and is proposed to be buttressed by BEPS so in some countries there will be debates to

what extent this approach is effective. In Australian domestic tax law the overriding effect of Part IVA

is clear.

In terms of the BEPS Action Plan, the MAAL is a combination of Action 6 on treaty abuse and Action

7 on PEs discussed above. One obvious question is why have we mixed up Action 6 and Action 7 in

this way? One possibly attractive feature of the MAAL approach for a government is that it is a one

way street – it deals with avoidance of PEs on the inbound side (thereby potentially increasing

Australian taxation of foreign multinationals) but does not create foreign PEs of Australian

multinationals potentially increasing foreign tax at the expense of Australian tax. Of course if the other

country to a treaty introduces a MAAL then symmetry will be restored. When a treaty is renegotiated,

or (depending on its structure) the multilateral instrument is signed, symmetry is more or less

automatic.

Once proposed substantive treaty changes are implemented as in the case of the Australia Germany

2015 treaty, the scope for the operation of the MAAL given Part IVA’s last resort status in domestic

law is not so clear. It is interesting to consider the operation of the MAAL in the case of the scenarios

outlined in relation to the BEPS PE work above. So far as time thresholds, the preparatory/auxiliary

exception and the independent agent’s exception is concerned, it may be that the MAAL will then add

little. The real question is in relation to the agency PE. If, for example a multinational restructures its

Australian operations so that it falls outside the new treaty agency PE rule, can the MAAL still be

activated? Does the MAAL apply to insurance operations of the kind outlined above?

Again The MAAL’s less obvious application to withholding tax may be an issue even after treaties are

amended. It is the domestic PE definition that applies to the limb of the interest and royalty

withholding tax for payments made by an Australian PE of a non-resident (Income Tax Assessment

Act 1936 s 128B(2)(b)(ii), 128B(2B)(b)(ii), compare the treaty definition that applies to the exclusion

from withholding tax on royalties for royalties received by an Australian PE, International Tax

Agreements Act s 17A(4). To the extent that the treaty PE definition is wider than the domestic

definition as a result of the BEPS PE changes interest or royalties may be covered by the interest or

royalties article of a treaty but not be caught by Australian withholding tax provisions (though perhaps

leading to tax by assessment of the non-resident).

5.2.2 Operation of MAAL

The MAAL operates in relation to a foreign entity which is a significant global entity and obtains a tax

benefit involving the requisite principal purpose (borrowed from the PPT) if:

(i) a foreign entity makes a supply to an Australian customer of the foreign entity; and

(ii) activities are undertaken in Australia directly in connection with the supply; and



(iii) some or all of those activities are undertaken by an Australian entity who, or are

undertaken at or through an Australian permanent establishment of an entity who, is an

associate of or is commercially dependent on the foreign entity; and

(iv) the foreign entity derives ordinary income, or statutory income, from the supply; and

(v) some or all of that income is not attributable to an Australian permanent establishment of

the foreign entity.

It is interesting briefly to note changes in the MAAL from the Exposure Draft, some of which broaden

its operation, some of which narrow its operation and one at least of which has an unclear effect. In

relation to a significant global entity, the threshold is now expressed in terms of “income” rather than

“revenue”. While an accounting meaning seems intended the reason for the change is not explained

and the impact of the change is unclear. AASB 118 p 7 under Objectives summarises the concepts in

this way:

Income is defined in the Framework for the Preparation and Presentation of Financial

Statements as increases in economic benefits during the reporting period in the form of

inflows or enhancements of assets or decreases of liabilities that result in increases in equity,

other than those relating to contributions from equity participants. Income encompasses both

revenue and gains. Revenue is income that arises in the course of ordinary activities of an

entity and is referred to by a variety of different names including sales, fees, interest,

dividends and royalties.

In terms of narrowing the scope of the MAAL the following can be noticed:

Supply still has its GST meaning but now excludes supplies of debt and equity interests which

narrows the concept and protects financial transactions to that extent from the operation of

the MAAL.

Activities in Australia must now be “directly” in connection with the supply.

There is now no reference to other domestic tax avoidance (such as stamp duty)

In terms of broadening the MAAL, the following are relevant:

“Australian customer” is used instead of “Australian resident” to describe the recipient of the

supply and defined to include anyone “in Australia” as well as an “Australian entity” in the

CFC sense.

The exclusion to identify non-group customers is now “not a member of the global group”

versus “not an associate”.

There is now no “design” test in the MAAL.

Similarly for no low or no tax test.

Deferral of foreign tax is now caught.

Various comments flow particularly from the Explanatory Memorandum. Firstly, Apple-type structures

with domestic subsidiary distributors are not covered, see Example 3.1, just as the expanded PE

definition in Action 6 does not include stripped risk distributors. The language of “directly connected”

and “in Australia” has a GST connotation flowing from the rules on GST-free exports but this meaning

is not picked up. Similarly “commercially dependent” seems likely in the context of agency PEs to take

a tax treaty meaning but the EM says it has its ordinary meaning (whatever that is).



There are some interesting wrinkles concerning the interaction of activities and PEs. First, activities in

Australia covered by the MAAL do not include work by fly-in-fly-out personnel if there no PE in

Australia or resident to which that activity is connected. Conversely, a seller can have an actual PE in

Australia but the MAAL can still apply to the extent to which there is income not attributable to the PE

related to activity in Australia. The additional factors in s 177DA(2) to determine purpose which apply

to the MAAL and not to Part IVA effectively reintroduce as factors tests in the ED that were removed

from the Bill. Although there is no design test, contrivance in the allocation or division of activities will

be a factor pointing towards application of the MAAL. Similarly the reference to the result under

foreign tax law is likely to reintroduce the no or low tax test.

For the application of the MAAL in terms of a tax benefit, the “might reasonably be expected” branch

of the concept will be the likely approach in most cases. The EM para 3.92 says:

In [the] typical case, the notional permanent establishment could include all of the activities of

the Australian-based entity that is described in subparagraph 177DA(1)(a)(iii) as well as the

functions, assets and risks of the foreign entity associated with formally concluding the

contracts. Another alternative may be that the notional permanent establishment includes all

of the activities that are undertaken by the foreign entity, the Australian-based entity or

another entity in connection with the supply.

We have recently learned from the Assistant Treasurer that there are potentially 380 targets of the

MAAL – the number has been growing.38

One suspects that many of those targets will seek to

negotiate an approach with the ATO for the future that involves either setting up an actual PE much

as Amazon has indicated it is doing in Europe and paying tax in the normal way for a PE, or

alternatively perhaps seeking to negotiate on the transfer pricing for the Australian subsidiary which is

creating the concern so that the ATO is happy to leave the matter at that. While the ATO and

government may be keen to test the MAAL in court, it may be that taxpayers can imagine nothing

worse.

38 Assistant Treasurer, ‘The importance of free enterprise, fairness and planning for the future’ – Address to the National Press

Club Canberra, 3 February 2016, “the tax office has already identified 80 taxpayers as having arrangements in the general

scope of the law and a further 300 taxpayers are being profiled.”

2016 financial services taxation conference …€¦ · · 2016-02-242016 financial services...

Documents