The fight against treaty-shopping

Published on the Business Today, issue Wednesday, 20 February 2008

The worn out cliché goes that the only inevitable events in our life are death and taxes. The past 20 years have seen a measured, yet invigorating growth of the island as a financial centre.
I remember clearly how in 1988, the year that ushered the birth of MIBA as a new institution, heralding the start of an offshore regime. This opened the way for a regulatory framework aimed at attracting reputable players in the international market. It gave birth to a unique opportunity for lawyers and accounting firms to compete in this highly competitive sector with other centres such as Dublin, Cyprus, Gibraltar, Dutch Antilles, Isle of Man and Channel Islands.In anticipation of our bid to join the EU the regulations were revamped in 1994 introducing an ‘onshore’ structure .This followed general criticism on the merits of tax havens which was associated with the offshore pattern of secrecy.

The efforts of the regulator to update the legislation in line with the changing demands and requirements at EU level were a momentous one.
Malta has made the grade and is currently reaping the fruits of its cautious and steady approach as an onshore regime. This is manifest by its expending tax treaty network.
All this is evidenced by heightened activity in mergers and acquisitions, funds management and in attracting captives in the international arena. Our legislation has been reflecting the dynamism of a changing financial environment.
Such change is reflected in thousands of wealthy individuals who now live in or have retired to small countries with benign tax systems. Regulations have been fine tuned to attract substantial new investment from wealthy individuals and holding companies.
Let us examine the tools that have led to the success achieved in sectors including funds, insurance, investment services and banking. The primary steps was the negotiation and signing of 50 tax treaties (with 15 under negotiation).

Tax treaties provide benefits to both taxpayers and governments by setting out clear ground rules that will govern tax matters relating to trade and investment between the two countries. A tax treaty is intended to focus the tax systems of the two countries in such a way that there is little potential for dispute regarding the amount of tax that should be paid to each country. The objective is to ensure that taxpayers do not end up caught in the middle between two governments, each of which would like to tax the same income. Once a treaty relationship is in place and working as it should, governments need to spend little additional resources negotiating to resolve individual cases because the general principles for taxation of cross-border transactions and activities will have been agreed in the treaty.
Did this policy to negotiate and sign cross-border treaties attract inward investment? The answer is simply yes. One of the crucial functions of tax treaties is to provide certainty to eliminate double taxation. Treaties solve this double taxation question by establishing the minimum level of economic activity that a resident of one country must engage in within the other country before the latter country may tax any resulting business profits.In simple words it defines where in the two contracting states a taxpayer has established a permanent establishment.

In general terms, tax treaties which follow the OECD model provide that if the branch operations have sufficient substance and continuity, the country where the activities occur will point to the primary jurisdiction to tax. In other cases, where the operations are relatively minor, the home country retains the sole jurisdiction to tax its residents.This allocation of profits takes several forms. First, the treaty has a mechanism for determining the residence of a taxpayer that otherwise would be a resident of both countries. Secondly, the treaty provides rules for determining which country will be treated as the source country for each category of income. Given that taxpayers are tempted to indulge in abusing the treaties, why so much fuss is made in international waters to combat treaty shopping ?
The reason is simple and a little legal background helps explain the ongoing crusade against treaty shopping.

The 1970s saw a proliferation of tax avoidance strategies involving third-country nationals’ use of tax-haven entities to gain advantages typically under tax treaties between the United States and the proliferation of tax-haven jurisdictions. This practice referred to earlier as “treaty shopping” has irked many so called high tax countries both in EU and the United States .The US insisted on inclusion of detailed “limitation on benefits” (“LOB”) provisions in tax treaties; these LOB provisions generally restrict treaty benefits to entities that are owned to a sufficient degree by residents of treaty jurisdictions and that do not abuse their residence country tax base through multiple payments to tax havens located in the treaty jurisdictions. Back to Malta regulations are in place that discourage the setting up of ‘sham’ companies.

Most treaties have anti-abuse measures so that investors do not use Malta’s tax advantages without properly setting up and having substance and management control here.
At a EU level we find many states that impose (controlled foreign company ) CFC legislation to combat tax leakages principally through passive income.A recent tax case was the UK/Irish case of Cadbury Schweppes decided by ECJ. It ruled that the UK CFC rules were compatible, but only to the extent that they apply to wholly artificial arrangements intended to circumvent UK domestic law. Prima-facie this case over ruled the UK cfc implications. Yet, much attention has been devoted to try define what is meant by ‘wholly artificial arrangements’.

Another important aspect is the provision addressing the exchange of information between the tax authorities. Such information is exchanged but only as may be necessary for the proper administration of that country’s tax laws, subject to strict protections on the confidentiality of taxpayer information. As a member in the European Community, Malta strives to eliminate economic distortions and help guarantee the principle of neutrality of taxation. It offers many advantages to investors such as the elimination of withholding taxes and capital gains on non-residents. It does not apply CFC transfer pricing or thin capitalisation rules.
On the other side of the Atlantic we find a constant duel between the United States and tax-haven jurisdictions. The latter lament the imposition of LOB provisions.
Unquestionably in recent years, treaty LOB provisions by US authorities have become increasingly complex and detailed, and in some cases quite restrictive. Recently-signed US treaties with Italy and Slovenia contain so-called “main purpose” provisions targeted at these transactions.
At the tax court level, one can cite the Canadian tax authorities.

These argued that treaty benefits otherwise available to a taxpayer under the Canada-Luxembourg treaty should be denied by virtue of Canada’s domestic “general anti-avoidance rule” (GAAR) or an inherent treaty anti-abuse rule. The tax court rejected these arguments on the facts of the case. In the course of its decision, the court stated that the “shopping or selection of a treaty to minimize tax on its own cannot be viewed as abusive.” The Federal Court of Appeal upheld the decision. The decision in this Canadian case alongside the Cadbury Schweppes case should be comforting to taxpayers that rely or seek to rely on benefits available under bilateral tax treaties. It remains to be seen whether other decisions on treaty-shopping will follow. Needless to say it is becoming more challenging and it is evident that fly-by night operators are not welcome. There should be solid commercial reasons to form the basis for choosing to incorporate in a treaty country. Malta therefore insists that each company has sufficient substance such as office accommodation and decision makers to perform the tasks it undertakes to do.

This is the best indemnity against the stigma associated with ‘treaty shopping’.
One can conclude that the issue of combating treaty shopping is particularly important for policing cross-border trade and minimising unfair tax competition.