New anti-abuse rules question the legitimacy of considering tax issues when deciding where to establish a holding company and put such structures at risk. Individuals and corporations must be aware of these rules when contemplating new investments and the sustainability of existing holdings.
Striking the right balance
Dividends distributed by operating companies are generally subject to withholding taxes. The disposal of a participation may also trigger income or real estate gain taxation in the country where the investment is located. When participations are held through a holding company, the levy of these taxes entails the risk that the same profits be subject to multiple layers of taxation, which is detrimental to international trades and investments.
In a cross-border context, this risk may be reduced or eliminated on the basis of double taxation treaties or other international agreements. Hence, when it comes to determining the location of a holding company, the availability of a large double tax treaty network is an important element to take into consideration.
On the other hand, countries are keen to combat aggressive tax structures. They do not want to reduce their taxing rights where a double taxation convention is abused and used beyond its initial purpose (i.e. to eliminate tax barriers to cross-border commercial activities). Whether a holding structure may lead to abuse in that area may, for instance, result from a lack of substance at the level of the (holding) entity claiming the benefit of a tax treaty or from the circumstances of a corporate restructuring.
Preventing treaty shopping and abuse
In the framework of its crusade against aggressive tax planning, the OECD identified a whole set of measures to prevent base erosion and profit shifting (so-called BEPS project). Some of these measures require amendments of countries’ domestic tax laws, while others are to be implemented in double taxation treaties.
Regarding the latter, 93 jurisdictions (including Switzerland) have signed a Multilateral Convention to modify more than 1,200 double taxation agreements. This convention includes the Principal Purpose Test (PPT rule), a new general anti-abuse rule that forms one of minimum standards to be implemented by jurisdictions committed to applying the Multilateral Convention to their tax treaties. It provides that:
"Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement."
The new anti-abuse rule is a principal purpose test, which focuses on the reasons why a specific arrangement or transaction was implemented or is maintained. It provides, in essence, that the benefit of the applicable double taxation convention shall be denied if one of the principal purposes of the arrangement or transaction was to obtain such benefits.
This clause is also being inserted in other double tax treaties on the basis of bilateral discussions and a similar provision is to be found in the EU Parent-Subsidiary directive (as amended on 25 January 2015 by the Council Directive (EU) 2015/121). It aims to provide States with the legal basis to challenge – in a comprehensive manner – all treaty abuse not captured by other more specific provisions.
Timing and broad application
As far as withholding taxes on dividends are concerned, the PPT rule will apply to distributions made as from 1 January of the year following the latest date on which the Multilateral Instrument entered into force for a party to the double taxation treaty concerned. For example: the instrument entered into force for Switzerland on 1 December 2019 and on 1 August 2019 for Luxembourg. The new anti-abuse clause therefore applies to dividends paid as from 1 January 2020. The PPT rule had to be taken into consideration for the application of 48 double taxation conventions with regards to withholding taxes on dividends paid as from 1 January 2019. The number of double taxation conventions concerned is in excess of 300 as from 1 January 2020.
Potential impact, controversy and challenges
The interpretation of the PPT rule is subject to controversy. For example, the issue arises as to whether a holding company shall be barred from claiming treaty benefits on the grounds that its main purpose was to avail of a large network of double taxation treaties or if this could already result from the fact that this was only one of its principle purposes. This boils down to questioning the legitimacy of considering tax issues when choosing to establish a holding company in one jurisdiction over another.
Presently, the PPT rule triggers an uncertainty that will likely remain until it becomes the object of administrative guidelines and consistent case law. Meanwhile, we expect to see the application of the PPT rule to vary from one State to another as, so far, States are not addressing treaty abuse in a consistent manner. Tax authorities may also struggle to make precise distinctions when addressing cases of abuse between treaties to which the PPT rule will apply and other treaties which include different clauses or even none.