(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on March 12, 2018: https://manageyourtax.com/HKEJ Forum 7 )
Originally we would be discussing in this Tax Tips the new Public Notice No.9 of 2018 issued by the State Administration of Taxation on 3 February 2018 titled “Public Notice Relating to “Beneficial Owner” Under Tax Treaties” (“PN9”) which will be applicable tax treaty benefit claims on tax obligations arising on or after 1 April 2018. However, as the various concepts under PN9 are not easy to be understood without background, we explain the relevant concepts in this article, and the discussion on PN9 will be deferred to the next Tax Tips.
Tax Tips 2 mentioned that in June 2017 representatives of Mainland’s State Administration of Taxation signed the “Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting” (“Multilateral Convention”) on behalf of Hong Kong, and Mainland China also signed the convention on the same day, to implement BEPS(1) Action 15 “Developing a Multilateral Instrument to Modify Bilateral Tax Treaties”. One of the purposes of the Multilateral Convention is to prevent abuse of preferential tax treatments under Double Tax Treaties and Arrangements, below collectively referred to as “DTA”, (BEPS Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances), and at the same time, it also contains provisions for implementing BEPS Action 2 (Neutralising the Effects of Hybrid Mismatch Arrangements), Action 7 (Preventing the Artificial Avoidance of Permanent Establishment Status) and Action 14 (Making Dispute Resolution Mechanisms More Effective). In short, many parts of the DTA shall be amended.
Hong Kong taxpayers would likely be most concerned about whether the DTA benefits they currently enjoy would be lost: reduced withholding tax rate on dividend, interest and royalties (e.g. when withholding tax on dividend is 10%, and the dividend declared is $100, the payor shall withhold $10 of tax and only remit $90 to the shareholder). As the purpose of the amendment is to prevent treaty abuse, in theory, if there is no abusive structure, the amendment should not cause any concern (whether the tax office takes the same view is, of course, another matter). In general, a situation in which a person who is not entitled to the benefits of a tax treaty makes use of an arrangement to obtain treaty benefits that are not available directly would be considered to be engaged in “treaty shopping” and have abused the DTA. The simple diagram below illustrates what is treaty shopping.
Elaboration: Enterprise in Country A enjoys the reduced WHT rate on dividend by setting up a company in Country B
Beneficial Owner
Most DTAs will have the following sentence at the beginning: “The Government of A and the Government of B, desiring to conclude an Agreement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income, have agreed as follows:”. The purpose of the DTA is to enhance trade between the two countries by providing clear guidelines on tax treatment (e.g. taxing right) to taxpayers of the one side engage in economic activities on the other side, and reduce the chance of taxpayers having to pay tax on both sides on the same income. Since both sides would like to encourage economic activities, preferential tax rates would be provided to treaty partners, and focus on taxes that would be paid on a withholding basis: dividend, interest and royalty. The opportunity to reduce tax attracts abusive behaviour. DTAs are not silent on anti-abuse provision; the OECD Model Tax Convention introduced the concept of Beneficial Owner in 1977, and most DTAs in the world now require that only the Beneficial Owner of the dividend, interest and royalty income can enjoy the preferential withholding tax rates. Why would there be situations of granting treaty benefits in inappropriate circumstances when the anti-abuse mechanism is in place?
The problem stems from the definition of Beneficial Owner. “Beneficial Ownership” is a term from English trust law. In many countries, the term is not defined. Although the OECD raised the concern as early as 1986 when the organisation issued the Double Taxation Conventions and the Use of Conduit Companies, at that time treaty-abuse was not in the limelight and most countries did not scrutinise into whether the recipients granted the DTA benefits were the Beneficial Owners as long as they could provide the Tax Resident Certificates.
For many years, the commentary to the OECD Model Tax Convention has explained what is beneficial ownership. In the latest condensed version of the OECD Model Tax Convention and Commentary (over 650 pages long), Para 12.3 of the Commentary to Article 10 Dividend stated that “conduit companies cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties”. And in Para 12.4 of the Commentary to the same article, it is stated that “ where the recipient of a dividend does have the right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person, the recipient is the “beneficial owner” of the dividend”. This definition of “beneficial owner” has basically remained the same throughout the years. However, it is a reality that companies can carefully structure their arrangements such that they can treaty-shop and meet the beneficial ownership requirement at the same time. Certain countries have introduced additional reporting requirements over the past decade or so on treaty benefit claims, by setting criteria for assessing whether the applicant has the right to use and enjoyment of the relevant income, with no obligations to pass it on to others. Hong Kong companies should be familiar with this because of the Circular (2009) 601 titled Notice on the Interpretation and Recognition of Beneficial Ownership under Tax Treaties issued by the State Administration of Taxation of the Mainland China.
Multilateral Convention to Combat Treaty Shopping
Riding on the momentum of the BEPS Project, tax jurisdictions are gearing up efforts in combating treaty shopping. Action 6 recommend the following approaches in dealing with treaty shopping:
First, a clear statement that the States that enter into a tax treaty intend to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including treaty shopping arrangements, will be included in tax treaties.
Second, a specific anti-abuse rule, the limitation-on-benefits (LOB) rule, that limits the availability of treaty benefits to entities that meet certain conditions will be included in the OECD Model Tax Convention. These conditions, which are based on legal nature, ownership in, and general activities of the entity, seek to ensure that there is a sufficient link between the entity and its State of residence.
Third, in order to address other forms of treaty abuse, including treaty shopping situations that would not be covered by the LOB rule described above, a more general anti-abuse rule based on the principal purposes of transactions or arrangements (the Principal Purposes Test or “PPT” rule) will be included in the OECD Tax Convention. Under that rule, if one of the principal purposes of transactions or arrangements is to obtain treaty benefits, these benefits would be denied unless it is established that granting these benefits would be in accordance with the object and purpose of the provisions of the treaty.
Tax jurisdictions that have signed the Multilateral Convention have all accepted the PPT. Some, however, have opted for adding the Simplified LOB on top. In simple terms, under the Simplified LOB, unless the person is an individual, listed company, or an entity conducting an active business and the income from the other side either emanates from or is incidental to that business, no treaty benefits would be granted. The term “active conduct of a business” shall not include the following activities or any combination thereof: i) operating as a holding company; ii) providing overall supervision or administration of a group of companies; iii) providing group financing (including cash pooling); or iv) making or managing investments. If a resident of a Contracting State derives an item of income arising in the other State from a connected person, benefits would be granted with respect to such item only if the business activity carried on by the resident in the first-mentioned State to which the item is related is substantial in relation to the same or complementary business activity carried on by such connected person in the other Contracting State. If both sides intend to adopt the LOB (i.e., stronger than Simplified LOB), the two sides shall separately negotiate.
Hong Kong as a financial center has limited industries and will be hard to satisfy Simplified LOB. For example, if a Hong Kong investor invests in coal-mining in Country A, and the investor would conduct activities such as holding, supervision, financing and managing the investment but without actual coal-mining activities in Hong Kong, the investor would unlikely be able to claim that it conducts active business in Hong Kong. If the DTA between Hong Kong and Country A adopts Simplified LOB, the Hong Kong investor would unlikely be able to enjoy the treaty preferences. In other words, even there is no tax avoidance, the Hong Kong investor would be denied treaty benefits.
Both the Mainland and Hong Kong wisely rejected the Simplified LOB. Depending on the choice of the parties to the tax treaties under the Multilateral Convention, when the local legal procedures in each country or region are completed, taxpayers in Hong Kong who want to enjoy preferential tax treaties may need to prove that obtaining the concession is not one of the principal purposes of the arrangement or transaction. What if the Contracting States such as Indonesia and Mexico choose the Simplified LOB? The Multilateral Convention allows countries to choose the applicable provisions and then pair with the Contracting States. Although both Indonesia and Mexico have opted for the Simplified LOB, both countries have chosen Article 7 (6) of the Multilateral Convention, which means the Simplified LOB applies only when both parties to a DTA select the Simplified at the same time. In other words, it is very likely that the DTAs between Hong Kong and Indonesia and Mexico will adopt PPT.
What Exactly is PPT?
Using the DTAs between Hong Kong and Indonesia and Mexico as examples, both DTAs will adopt Article 7(1) of the Multilateral Convention, which reads:
Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.
In fact, Hong Kong’s DTAs with Indonesia and Mexico already have anti-avoidance clauses. For example, paragraph 7 of Article 10 – Dividends of the DTA between Hong Kong and Indonesia states “The provisions of this Article shall not apply if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the shares or other rights in respect of which the dividend is paid to take advantage of this Article by means of that creation or assignment.” When both parties to the DTA (for example, Hong Kong and Indonesia) have completed domestic legal procedures, the anti-avoidance clauses of the original DTA would be replaced by Article 7(1) of the Multilateral Convention, which has relatively minor impact.
The DTA between Hong Kong and the Mainland
Lastly, as the DTA between Hong Kong and the Mainland is not a Covered Tax Agreement of the Multilateral Convention (as it is not a treaty between two sovereign states), Hong Kong and the Mainland shall negotiate to incorporate the BEPS measures into the DTA. As both sides have accepted PPT, it can be envisaged that DTA will adopt the PPT provision, replacing Article 4 of the Fourth Protocol of the DTA, which reads:
In relation to Articles 10, 11, 12 and 13 of the Arrangement, if the creation or disposition of the interests acquired is caused by any person with the main purpose of taking advantages of any of such Articles, the Article shall not apply.
So is the forthcoming amendment good news or bad news to Hong Kong companies? On the face of it, under Article 4 of the Fourth Protocol, the benefits would be denied if the main purpose of making certain arrangement is to take advantage of the DTA. Under PPT, benefits would be denied if one of the main purposes is to take advantage of the DTA. In theory, as the bar is lower under PPT, it would be harder to obtain treaty benefits in the future.
Other than PPT, Hong Kong investors looking to enjoy benefits under the Hong Kong and Mainland DTA would also need to pass the “Beneficial Ownership” test. This will be discussed in the next issue of Tax Tips.
(1) See Tax Tips (1) and (2)
Tax Tips: Hong Kong taxpayers who invest directly overseas and enjoy preferential tax treaties benefits should not be hard pressed to prove that they did not set up the investment framework for the purpose of enjoying benefits available under the DTA between Hong Kong and that overseas location. However, to prepare for requests in the future to substantiate why the structure is set up, Hong Kong investors should start reviewing the structures and prepare documentation supporting on the commercial rationales and business reasons for the current structure or arrangement. In cases where the Hong Kong investors entered overseas markets through intermediate overseas vehicles, or foreign groups using a Hong Kong subsidiaries as a springboards to invest into the Mainland, and enjoy DTA benefits, it is time to start studying the sustainability of the structures and prepare for questions from the tax offices as to why this intermediate holding company was set up. It is now time to take action. Finally, this article focuses only on certain articles of the Multilateral Convention. There are other articles in the Convention that may impact and create uncertainties for taxpayers. Taxpayers need to carefully analyze the changes to each applicable DTA, in order to prepare appropriate responses.
Author: Edwin Bin
Ref:
Multilateral Convention:
Model Tax Convention on Income and on Capital: Condensed Version 2017:
HK-Mainland DTA Fourth Protocol:
https://www.elegislation.gov.hk/hk/cap112CU!en@2015-12-11T00:00:00