The OECD’s drive to counter perceived base erosion and profit shifting globally (known as the BEPS Project) has as one of its fundamental aims the prevention of ‘treaty abuse’: where taxpayers claim the benefit of tax treaties in circumstances where – it is alleged – it was not intended those benefits should be available.
This is potentially of direct relevance to financial institutions operating cross-border, as they will typically rely on tax treaties to reduce, or wholly eliminate, withholding taxes that would otherwise apply to cash flows from the jurisdiction in which the underlying investment is located.
This could have a particularly pronounced effect on fund managers and other financial institutions post-Brexit, when it is likely greater reliance will need to be placed on tax treaties, as EU directives restricting the application of withholding taxes cease to apply to UK entities.
But the problem is they may now face greater scrutiny as to why they are resorting to tax treaties when dealing with dividends and other cross-border payments, and may not be able to benefit from them in as straightforward a manner as in the past.
Specifically, countries have been offered the choice by the OECD of adopting a principal purpose test or a limitation of benefits test (or a combination of the two), to limit the availability of tax treaty benefits where it is considered that ‘abuse’ of the treaty would otherwise arise.
These recommendations are currently being implemented by a significant and increasing number of countries.
Special purpose vehicles are typically used in cross-border investment structures since, if investments were made and held directly by a limited partnership fund vehicle, the fund would often suffer withholding tax, by way of example on credit investments in countries such as the UK, as the provisions of the relevant treaty reducing or eliminating withholding tax may not be granted to the fund or its limited partner investors.
It is therefore common to invest via an intermediate SPV, with the intention that the vehicle should be capable of accessing the benefits of the relevant tax treaty; therefore the OECD-derived changes are particularly important in the investment fund and asset management context, with the potential to deny an SPV currently sitting in the structure beneath the main fund access to treaty benefits.
These developments would in themselves have been enough to warrant financial institutions’ keen attention so far as future structuring is concerned; but with Brexit around the corner, there is a double whammy of not only future investments, but existing structures being potentially affected.
The upshot is that institutions are faced with the prospect of having to make greater use of tax treaties, precisely at a time when their use is being reined in.
The ability to continue to rely on tax treaties in the context of such structures is therefore key.
The principal purpose test
The PPT provides that a benefit under a treaty is not to be granted if it is reasonable to conclude that obtaining that benefit was one of the principal purposes of the arrangement or transaction giving rise to the benefit.