Source state perspective - OECD compatibility analysis

4. OECD compatibility analysis

4.2. Source state perspective

Finally, further consideration should be given to the source state perspective adopted by the misalignment approach. Although the analysis in chapter 2 has clarified that the “beneficial owner” term

104 Ibid. at p.497.

105 This approach is confirmed by the 2017 OECD Commentary. See: Para. 13 OECD Model: Commentary on Article 1 (2017).

106 Article 29 OECD Model (2017).

107 Para. 70 OECD Model: Commentary on Article 1 (2017).

has to be interpreted autonomously and that its attribution-of-income function should be aligned with the application of Article 1(2), this section will intend to reinforce these conclusions by referring to the OECD Partnership Report.

To sum up, the misalignment approach adopts a source state perspective for two principal reasons.

First, because the beneficial ownership refers to treaty benefits that are granted in the source state, thus this train of thought considers that “…it appears almost self-evident that the identification of the beneficial owner should be an exclusive task of the source state”.¹⁰⁸ Second, since paragraph 13¹⁰⁹ (discussed in section 2.2.5. above) establishes that Article 1(2) does not prejudge the issue of whether the recipient is the beneficial owner of the relevant income, this suggests -in the view of some scholars- that the source state should identify the beneficial owner based on its own qualifications and attribution rules, regardless of the residence state’s qualifications and attribution.¹¹⁰ This approach creates incompatibility problems with Article 1(2), as such article follows the domestic law of the residence state.

In such respect, there are sound arguments to sustain that the latter position should be erroneous if one supports the conclusions set forth in chapter 2. As Brabazon states, “If one accepts that the primary and positive meaning of beneficial ownership reflects residence state attribution, it will be seen that the conditions for recognition of attribution of particular income to a resident of residence state R under the transparent entity clause also establish the positive elements of beneficial ownership of that income by a resident of R. Both tests end up depending on fiscal attribution under the law of R.”.¹¹¹

Brabazon coincides with the line of thinking suggested in this thesis, in the sense that the international concept of beneficial ownership refers to the residence state’s attribution rules, even if it is qualified by the forwarding and conduit restrictions which the author identifies as a negative condition that does not refer to the internal law of a specific contracting state.¹¹²

Nonetheless, the winning hand in this debate is found in the OECD Partnership Report. As discussed in section 2.2.2., scholars often underestimate the reference made by the 2017 OECD Commentaries to such report. However, the interpretation criteria suggested by the Commentary on Article 1(2) is crystal clear: “The provisions of the paragraph ensure that income of such entities or arrangements is treated, for the purposes of the Convention, in accordance with the principles reflected in the 1999 report of the Committee on Fiscal Affairs entitled “The Application of the OECD Model Tax Convention to Partnerships”.¹¹³

This cross-reference ensures that any principle reflected in the OECD Partnership Report must be observed when applying Article 1(2). Therefore, if the examples included in such report reflect that he beneficial ownership requirement is aligned with Article 1(2), this alignment should be preserved in the application of the latter provision.

108 See Parada, supra n. 47, at p. 9.

109 Para. 13 OECD Model: Commentary on Article 1 (2017).

110 Id. Also see Nikolakakis et al., supra n. 39, at sec. 5.8.

111 Brabazon, supra n. 38, at sec. 4.4.3.

112 Id. The treaty practice of some countries also reflects the same understanding. For instance, in order for a trust to claim treaty benefits under the Portuguese treaty network, the Portuguese tax authorities require from such trust to deliver a certificate of residence issued by the other contracting state that establishes that the trust is treated as a taxable entity in the residence state, is fully subject to tax therein and is the beneficial owner of the relevant income. These requirements are proved by completing specific forms that were created by the Portuguese tax authorities and which need to be certified by the country of residence. See: F. de Sousa da Câmara, The Taxation of Trusts in Portugal, 57 Eur. Taxn. 11 (2017), Journals IBFD (accessed 7 July 2020).

113 Para. 2 OECD Model: Commentary on Article 1 (2017).

In such respect, the OECD Partnership Report includes a triangle case that has a fact pattern substantially similar to the example described in section 3.1.2. above (drawn in Figure 2), which was proposed by Parada to illustrate the compatibility problems arising from the joint application of the beneficial ownership requirement and Article 1(2). Therefore, it would be interesting to see the solution proposed by the OECD Partnership Report on a similar scenario and identify its underlying principles, as these principles must be observed when applying Article 1(2). The example 9 of the OECD Partnership Report is illustrated below:¹¹⁴

The OECD Partnership Report considers this example as a case of double entitlement to treaty benefits with respect to the same item of income.¹¹⁵ The Partnership should be considered by State S (source) to be entitled to the benefits of the treaty between State P (residence 1) and State S (source), as it is liable to tax on those dividends (in State P) and should therefore be considered the recipient and beneficial owner of the income. Partners A and B should also be considered to be entitled to the benefits of the treaty between State R (residence 2) and State S (source) with respect to the Partnership’s income as they are also liable to tax with regard to such income (in State R). Thus, the report concludes that both treaties will restrict State S (source) right to tax the dividends, regardless of whether State S (source) taxes these dividends in the hands of the Partnership or of its partners A and B.¹¹⁶ The report emphasises that “the tax treatment of partnerships in State S will not have any impact on this result so that both conventions would still be applicable if State S treated partnerships as transparent rather than taxable entities”.¹¹⁷

The principles adopted by the OECD Partnership Report clearly contradicts the building blocks of the misalignment approach. First of all, it confirms that the beneficial owner should be identified by reference to the residence state’s -and not the source state’s- attribution of income rules, as it suggests that a person should be identified as a beneficial owner if it is liable to tax on the relevant item of income in the residence state.

What is more important, though, is that the report confirms that the residence state approach should prevail even in the context of hybrid situations. By concluding that both treaties will restrict the taxing rights of States S (source), the report recognises the existence of two categories of beneficial owners

114 OECD Partnership Report (1999), supra n. 10, at Example 9.

115 OECD Partnership Report (1999), supra n. 10, at para. 73.

116 In this case, the OECD Partnership Report suggests that the double entitlement to treaty benefits will be satisfied if State S (source) imposes the lowest amount of tax allowed under the two treaties. In the example proposed by Parada in Figure 2 above, it would imply the application of the lowest withholding rate of 5% provided by the treaty Z-X. See OECD Partnership Report (1999), supra n. 10, at para. 74.

117 OECD Partnership Report (1999), supra n. 10, at para. 73.

Figure 3. Example 9 of the OECD Partnership Report

Partnership

Company X

A B

State R

State P

State S

P: transparent

P: opaque

P: opaque Dividends

over the same item of income. On the one hand, the Partnership as the beneficial owner of the treaty between State P (residence 1) and State S (source); and, on the other hand, the partners A and B as the beneficial owners of the treaty between State R (residence 2) and State S (source). This double entitlement to treaty benefits could only exist if (i) the beneficial ownership requirement is necessarily connected with the residence state’s attribution of income rules; and, (ii) both residence states consider that the relevant recipient is liable to tax in their jurisdiction.

As a second matter, the OECD Partnership Report undermines the importance of the source state’s qualifications and attribution rules by establishing that the tax treatment of the Partnership in the source state will not have any impact on the result (i.e. double treaty entitlement). This clearly clashes with the misalignment approach which suggests that the beneficial ownership test is a factual determination that should be made by the source state; based on its own qualifications, attribution rules and principles;

and ignoring the residence state’s domestic law.

Indirectly, the OECD Partnership Reports also confirms that paragraph 13¹¹⁸ (discussed in section 2.2.5.) could not be construed as insinuating a source state approach when identifying the beneficial owner, since this will clearly contradict the principles reflected in such report. These principles shall be duly observed when applying Article 1(2) pursuant to the OECD Commentaries.¹¹⁹

In view of the foregoing, the following major conclusions could be drawn: first, that the misalignment approach contradicts the approach suggested by the 2017 OECD Model and its Commentaries with respect to the joint application of the beneficial ownership requirement and Article 1(2); and, second, that the interpretation of the OECD materials should lead to compatible results when those provisions interact amongst themselves, mainly by suggesting that a residence state approach should be followed by both provisions, even in the context of hybrid scenarios.

The compatibility of the beneficial ownership requirement and Article 1(2) allows to perform an integrated assessment of the treaty.¹²⁰ In this regard, one could say that the source state’s taxing rights should be restricted in terms of Articles 10(2), 11(2) and 12(1) in the context of fiscally transparent structures whenever:

(i) A person resident in the other contracting state is identified as the recipient of the income pursuant to the laws of the residence state.

(ii) The person identified in (i) fulfils with the forwarding and conduit restrictions.

(iii) The person or transaction complies with the anti-abuse measures contemplated in Article 29 of the 2017 OECD Model, as applicable.

Conclusions

The use of fiscally transparent structures is becoming more frequent by investors that are aiming to preserve their domestic tax regime while investing abroad. These investors are required to analyse the treaty provisions that are designed for addressing the fiscal situation of income obtained through fiscally transparent entities, such as Article 1(2) of the OECD Model, and to ensure the fulfilment of the relevant conditions to claim treaty benefits, such as the beneficial ownership requirement. The interaction of those provisions faces difficulties because of the country differences in the tax classification of entities, which leads to the existence of hybrid situations.

118 Para. 13 OECD Model: Commentary on Article 1 (2017).

119 Para. 2 OECD Model: Commentary on Article 1 (2017).

120 Brabazon also sees the possibility of applying the beneficial ownership requirement and Article 1(2) on a harmonised fashion. See: Brabazon, supra n. 38, at sec. 4.4.4.

This thesis suggests that the analysis of the latter provisions should be careful not to confuse the international rules that are proposed by the OECD through the 2017 OECD Model with the treaty practice that has been adopted and developed by each jurisdiction. There are sound arguments to sustain that, under a pure OECD approach, Article 1(2) to hybrid entities and the beneficial ownership requirement set forth in Articles 10, 11 and 12 are compatible, mainly because both provisions attribute income under the perspective of the residence state. This is not the case, though, in jurisdictions like the U.S. whose treaty practice requires that the beneficial ownership requirement should be analysed pursuant to the laws of the source state after applying the provision on hybrid entities. The U.S.

departure from the OECD approach pursues specific policy reasons and should not be considered whatsoever as the general rule in the joint application of these provisions.

It is curious, not to say unrealistic, that the beneficial ownership requirement continues creating contradictory positions as of these days. Although significant efforts were made in 2014 to ensure an autonomous international meaning of the term “beneficial owner”, scholars are still tempted to refer to the domestic law of the contracting states with the slightest hint they can find to do so. This reflects somehow a bias in their analysis, as some authors try to find arguments to support what they think should be the correct way of interaction between the provisions at issue and not what is necessarily reflected in the 2017 OECD Model. It is not bad to propose the way in which the referred interaction should work from a theoretical perspective, or even from the perspective of a particular jurisdiction, though it should be clarified that the relevant analysis is prepared on these grounds and that does not intend to address the most direct interpretation of the 2017 OECD Model. This clarification could minimise confusions in the application of the beneficial ownership requirement and Article 1(2) by the financial industry and tax authorities, which, in practice, do not have sufficient time to conduct a detailed analysis and rely significantly in academic publications.

Finally, the different approaches that have arose for the identification of the beneficial owner in the context of hybrid structures also raise the question on the usefulness of said requirement. The 2017 OECD Model has been enhanced through the incorporation of new GAARs, such as the LOB and PPT clauses, and the introduction of stricter conditions for claiming treaty benefits (e.g. minimum holding periods) that could work as a substitute of the beneficial ownership requirement; consequently, it is questionable if the latter requirement is indispensable at this point in time, especially, if one considers that it still creates difficulties on its application that could lead to the denial of treaty benefits in fiscally transparent structures that were put in place for sound business reasons.

Bibliography

1. Avery Jones, John, Chapter 20: The Beneficial Ownership Concept Was Never Necessary in the Model in Beneficial Ownership: Recent Trends (M. Lang et al. eds., IBFD 2013), Books IBFD (accessed 26 April 2020).

The author describes the origin of the beneficial ownership requirement in the OECD Model. This reference was included to understand the background of the aforesaid requirement; this is, that it was intended to be an alternative to a subject-to-tax clause required at that moment by the U.K.

2. Avery Jones, John, et al., OECD Discussion Draft “Clarification of the Meaning of Beneficial Owner” letter to the OECD (15 July 2011), available at: www.oecd.org/dataoecd/49/41/48420432.pdf.

These authors suggested some amendments to the OECD Commentaries to, inter alia, clarify that the “beneficial owner” term requires that income should be attributed under the perspective of the residence state. This is in line with the approach adopted by the thesis in the sense that the

“beneficial owner” term works as an attribution-of-income instrument that should be determined under the domestic law of the state of residence.

3. Brabazon, Mark, Application of Tax Treaties to Fiscally Transparent Entities – Global Tax Treaty Commentaries, Global Topics IBFD (accessed 1 May 2020).

The author analyses the compatibility of Article 1(2) and the beneficial ownership requirement. The author coincides with the main conclusions of this thesis, as it supports that there should not be any compatibility problems if one holds the position that both provisions are mainly governed by the residence state’s law.

4. Brauner, Yariv, Chapter 9: Beneficial Ownership in and outside US Tax Treaties in Beneficial Ownership: Recent Trends (M. Lang et al. eds., IBFD 2013), Books IBFD (accessed 5 May 2020).

The author analyses how the beneficial ownership requirement has been applied in the U.S. and indicates related case law. This chapter is important for the thesis as it recognises that the U.S. adopts a source state approach and that some domestic regulations (e.g. those coming from the IRC Section 7701(l)) have deviated from the generally accepted interpretation of the treaty beneficial ownership requirement.

5. Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital (26 Sept. 1980) (as amended through 2007), Treaties & Models IBFD.

This double tax convention is referred to by the thesis as, based on the position of some scholars, it includes provisions that address problems arising from the application of the beneficial ownership requirement and the article to hybrid entities.

6. Da Silva, Bruno & Van Wanrooij, Josine, Clarification of the Meaning of “Beneficial Owner” in the OECD Model Tax Convention – discussion draft letter to the OECD (15 July 2011), available at http://www.oecd.org/tax/treaties/48414319.pdf.

The letter sent by these authors to the OECD suggests to eliminate from the draft of the 2014 OECD Commentaries any reference to the domestic law of either Contracting State in order to achieve the desired consistency and an international tax meaning of the term “beneficial owner”. The autonomous interpretation of the beneficial ownership requirement is vital to achieve a harmonious application of Article 1(2) and the beneficial owner requirement. This letter supports the position that the OECD aims to have an autonomous interpretation of the term at issue.

7. Department of the Treasury Technical Explanation of the Convention Between the United States of America and the Republic of Poland for the Avoidance of Double Taxation and The Prevention of Fiscal Evasion with Respect to Taxes on Income (13 Feb. 2013), Treaties & Models IBFD.

This technical explanation confirms that the U.S. has adopted a source state approach when analysing the beneficial ownership requirement;

specifically, it exemplifies that the indications made by the 2006 U.S. Technical Explanations with respect to the analysis of beneficial ownership in hybrid scenarios is included in the U.S. treaty network.

8. IBFD, International Tax Glossary, Glossary IBFD.

The IBFD Glossary was used to define the term of “transparency” used in the thesis from a theoretical standpoint. The content of such definition describes also the scope of a hybrid entity which is medullar for the thesis.

9. Jain, Kiran, The OECD Model (2017) and Hybrid Entities: Some Opaque Issues and Their Transparent Solutions, 73 Bull. Intl. Taxn. 3 (2019), Journals IBFD (accessed 1 May 2020).

The author makes an analysis of issues arising for hybrid entities in the context of the 2017 OECD Model. In particular, the article addresses the issue of the interaction between Article 1(2) and the beneficial ownership requirement and sustains a position contrary to the criterion suggested in this work. The author supports the “misalignment approach” by considering that the beneficial ownership test should be done with the lens of the source state.

10. Li, Jinyan, Beneficial Ownership in Tax Treaties: Judicial Interpretation and the Case for Clarity in Tax Polymath:

A life in international taxation: Essays in honour of John F. Avery Jones (P. Baker & C.S. Bobbett eds., IBFD 2010), Books IBFD (accessed 21 Apr. 2020).

The author describes the different approaches that tax authorities and courts have adopted when applying the beneficial ownership requirement. As this article was prepared prior to the 2014 OECD Model it reflects the lack of uniformity and the need for an autonomous meaning of the term

“beneficial owner”. This reinforces why it is important to avoid referring to the domestic law of countries when it comes to such term.

11. Martín Jiménez, Adolfo, Chapter 14: Beneficial Ownership as an Attribution-of-Income Rule in Spain: Source

and Residence Country Perspectives sec. 14.4.1. in Beneficial Ownership: Recent Trends (M. Lang et al. eds., IBFD 2013), Books IBFD (accessed 26 Apr. 2020).

The author suggests that the beneficial ownership requirement implies an attribution-of-income function that should follow the residence state law.

This approach supports the criterion adopted by the thesis in such regard, in addition, it provides arguments to establish that the source state may not be affected as it still has other anti-avoidance measures to protect its source’s taxing rights.

In document Is the Beneficial Ownership Requirement Compatible with the Application of Article 1(2) to Hybrid Entities? (Page 29-37)