Leo Neve analyses tax treaty developments in particular with regard to the residence of a corporate entity and the limitation of benefits.
In this article, I want to discuss two elements for qualification under a tax treaty. The first element is the residence of a corporate entity. In situations of dual residence, the so-called ‘tie-breaker’ rule will determine in which State the entity will ultimately be a resident for the purpose of application of the treaty. The second element is the limitation of benefits. Once a corporate entity is deemed to be a resident, the benefits of a treaty may be restricted to so-called ‘qualifying’ residents. These two elements make tax planning a challenging exercise.
The purpose of a residence definition in a tax treaty ( art 4 OECD) is that it determines the personal scope of a tax treaty, and it resolves issues of dual residence. The contracting States to the treaty may have different concepts of residence, for example, in the USA residence is based on nationality (place of incorporation), whereas in Turkey residence of a corporate entity is based on ‘the registered office’ criterion, while Canada has reserved the right to deny companies with dual residence the benefits of a tax treaty.
If source-States and situs-States each apply different criteria, a corporate entity could become a resident of both contracting States (dual-residence). In order to determine which State has priority, so-called tie-breaker rules have been developed. The standard tie-breaker rule is explained by paragraph 3 of art 4 of the OECD Model:
“Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State in which its place of effective management is situated.”
But what is the ‘place of effective management’? In the Observations on the Commentary, France considers that the definition of the place of effective management in paragraph 24 of the Commentary, according to which “the place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole are in substance made”, will generally correspond to the place where the person or group of persons who exercises the most senior functions (for example a board of directors or management board) makes its decisions. The Netherlands, however, interprets the place of effective management as meaning where day-to-day effective management occurs - the place where board meetings are held is of less importance.
Instead of a general rule for resolving the issue of dual residence of companies, some countries include a competent authority procedure. These countries endeavour to determine by mutual agreement the State of which the entity will be deemed to be a resident. This as general rule, based on the OECD Model and Commentary. The new Agreement between the Netherlands and the United Kingdom, however, deviates from this rule.
New UK-NL Treaty
In the new treaty between the UK and the Netherlands, the corporate tie-breaker rule is replaced by a mutual agreement procedure. The competent authorities of the contracting States will determine the residence of a dual resident company by mutual agreement. If no agreement is made, the entity will not be entitled to treaty benefits. The residence will be determined on the basis of facts and circumstances. If the entity has moved for reasons of achieving unjustified benefits, it will be refrained from obtaining these benefits.
Wholly artificial arrangements will be ignored. An arrangement is considered ‘wholly artificial’ if avoidance of tax is the justifying reason for setting up the arrangement. A non-tax reason is necessary for the reason not to be ‘wholly artificial’.
The decision of the competent authorities cannot be appealed. In many instances, the reason for creating corporate structures is tax oriented. And in many instances the structure can be said to be ‘artificial’. However, if there is a business reason, with the tax benefits as a happy consequence, the structure cannot be said to be ‘wholly artificial’.
Limitation of benefits
A second big and expanding issue is the limitation of the benefits (LOB) that can be obtained under the treaty. Stringent conditions are increasingly applied in tax treaties especially with respect to an entitlement to reduce withholding taxes for dividends (art 10), interest (art 11) and royalties (art 12),.
Most of our readers will be familiar with some form of limitation in the use of tax treaties. In the famous 1963 Swiss anti-abuse rules it was already stated that any benefit would be denied if the ultimate purpose of the structure was to obtain the benefits of the treaty.
This has evolved into the famous LOB articles in the USA-Netherlands treaty. What was in those days an exception is becoming more and more common in modern treaty practice. A limitation based on beneficial ownership is common. Beneficial ownership in this sense means that the receiving entity is at liberty in the use and disposal of the proceeds. In case the use of the proceeds is restricted, the receiving entity cannot be seen as the ‘beneficial owner’ of the received funds.
A limitation based on purpose is of more recent times.
This trend is also apparent in the new treaty between Cyprus and the Russian Federation. In this treaty, non-Cypriot entities that have become a resident of Cyprus for Cyprus tax purposes, will not qualify directly for benefits, but only after competent authority proceedings have established that the main purposes for the creation of the entity has been to obtain benefits under the Agreement not otherwise available. This so-called ‘Purpose Test’ has become an essential element in tax planning.
Many new treaties today contain LOB clauses, which are construed by defining who is entitled or ‘qualified’ to benefit from a treaty, ‘Qualified’ persons are usually residents that are natural persons. Legal persons will qualify if they fulfill additional criteria, for example, pension funds can qualify if the majority of participants are resident or make contributions. Listed companies can qualify if their primary place of management and control is in the Contracting State, of which it is a resident. Non-qualifying persons can still qualify if the shares in that entity are held by so-called ‘equivalent beneficiaries’, being residents of a third country that has a treaty with the source State, providing for similar or better conditions. Also non-residents can qualify if the benefits derived can be allocated to an active business in the Contracting State.
When an EU State makes a treaty with a non- EU State, the EU State must observe the general non-discrimination rules. Residents of another EU State may not be discriminated against residents of the Contracting State. And companies controlled by other EU residents cannot be discriminated against companies controlled by residents of the contracting State. A limitation of benefits clause must be proportionate which means that it can only be applied in wholly artificial arrangements.
On this issue the Court of Justice recently held :
27 The need to prevent the reduction of national tax revenues – a reduction which, in the main proceedings, the grant of the tax credit at issue to Tankreederei would result in – is not an overriding reason in the public interest capable of justifying a restriction on a freedom instituted by the FEU Treaty (see, to that effect, Case C‑136/00 Danner  ECR I‑8147, paragraph 56, and Case C-318/07 Persche  ECR I‑359, paragraph 46).
28 As regards the need to prevent abuse, it is true that it is apparent from settled case-law that a restriction on the freedom to provide services can be justified where it specifically targets wholly artificial arrangements which do not reflect economic reality and whose only purpose is to obtain a tax advantage (see, inter alia, Jobra, paragraph 35 and the case-law cited).
We have seen that the developments in tax treaty practices circles around defining ‘residence’ and specifically targets dual resident companies. On the other hand benefits are restricted for those who seek to benefit artificially from a given treaty. It means that prevention of abusive usage of treaties is possible, but only in those limited cases where there is a wholly artificial arrangement, that has no economic substance and whose only purpose is to obtain a tax advantage. Tax planners beware!
 See also Commentary on art 4 (3) of OECD Model Tax Convention on Income and Capital.
 Commentary on article 4, para 26.3
 Treaty signed in London on 26 September 2008, with protocol. The treaty is effective in the Netherlands for fiscal years starting on or after 01-01-2011 and for the United Kingdom for fiscal years starting on or after 6th of April 2011.
 case Court of Justice EU, 22 Dec 2010, C-287/10, (Tankreederei SA).
Leo Neve LL.M
Owner & Managing Partner