The Principal Purpose Test: Accessing the benefits of Double Tax Agreement just got a bit trickier
A new test is in play in a cross border tax context which, on the face of it, makes organising a transaction or a series of transactions to take advantage of bilateral tax treaties much more challenging. It is the so-called “Principal Purpose Test” (PPT). Taxpayers are used to the idea that they are perfectly entitled to arrange their tax affairs in a manner which enables them to take maximum advantage of existing tax laws. This is, in general, perfectly legal, provided the arrangements entered into by the taxpayer are genuine (i.e. not simulated to disguise the true intention behind that arrangement) or provided the sole or main purpose behind the arrangement was not to obtain a tax benefit.
“Treaty shopping” is the target. That is, where the main reason behind a series of transactions was merely to obtain a benefit under a bilateral tax treaty (e.g. a reduced withholding tax). Generally however, provided a taxpayer could demonstrate a commercial rationale for entering into the transaction, the taxpayer was perfectly entitled to take advantage of the tax treaty. The PPT now makes this more difficult.
The PPT has been widely adopted through the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI). This effectively modifies the application of thousands of existing bilateral tax treaties of most countries. This newsletter covered the Mauritian implementation of the MLI.
Article 7 of the MLI contains the PPT which most countries have adopted. The PPT provides that a benefit under a tax treaty will not be granted if it’s reasonable to conclude that obtaining the benefit was one of the principal purposes of the arrangement or transaction that resulted directly or indirectly in that benefit. Unless the granting of the benefit was in accordance with the object and purpose of the treaty. This means that any arrangement that was made for purposes which include a principal purpose of obtaining a tax benefit under a treaty, which amounts to an abuse of that treaty, will infringe the PPT and likely result in a cancellation of that treaty benefit.
Tax treaties have been the cornerstone of many companies’ tax planning arrangements. The gravity of the impact of the PPT on global tax planning will turn on what ‘principal purpose’, ‘tax benefit’ and ‘object and purpose’ mean. While the OECD has given some guidance in its explanatory materials to the MLI, it will ultimately be up to the tax and judicial authorities in each participating jurisdiction to construe what these terms mean for the purposes of their tax treaties. Nevertheless, some lessons can be learnt from Australia. Australia’s tax regulator – the Australian Tax Office (ATO) – has issued a Practice Statement outlining its view of the PPT (see here). The ATO’s guidance is useful in South Africa given that Australian tax law is often considered by South African courts and has, in the past, formed the basis of the design of some of South Africa’s tax laws.
The ATO says that ‘tax benefit’ is wide and could include a limitation on the taxing rights of a source jurisdiction (such as a tax reduction, exemption, deferral, or refund) or relief from double taxation provided to residents. An arrangement may have more than one ‘principal purpose’ and it is sufficient if at least one purpose was to obtain the benefit, even if it was not the dominant purpose. The test is an objective one. What a company says is the purpose of a transaction is irrelevant if, based on an objective analysis of all the facts and circumstances, one of the principal purposes of the arrangement was to obtain a tax benefit. This means an arrangement may fall foul of the PPT even it was entered into by a company for commercial objectives consistent with commercial gain but was implemented in a particular way so as to obtain a treaty benefit. The general comfort previously relied upon by taxpayers – namely that an arrangement can be justified on commercial grounds – cannot be relied upon so easily.
However, the ATO recognises that a distinction must be made. Arrangements used to secure treaty benefits that amount to an improper use of the treaty or treaty abuse must be distinguished from arrangements that are entered into or carried out for the purpose of obtaining treaty benefits that are consistent with the object of the treaty. The MLI Principal Purpose Test will not apply where an arrangement has been adopted merely with an eye to its tax advantages unless it amounts to an abuse of the treaty. It is difficult to fully understand when this will or will not be the case. Some case law, which hopefully will be forthcoming as the impact of the Principal Purpose Test starts to be felt, will prove helpful.
Nevertheless, relying on some OECD commentary on the question, where the arrangement is inextricably linked to a core commercial activity and the particular form in which the scheme is implemented is conventional and straightforward and not driven by such tax benefit considerations, then it is unlikely that one of its principal purposes was to obtain the tax benefit.
Justifying the commercial rationality to cross border transactions has always been relevant. However, the Principal Purpose Test seems to put far more scrutiny on the degree to which the stated commercial objectives of the taxpayer can reasonably be relied upon. A more difficult task in our view
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