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These solutions could enable governments globally to fix loopholes in tax treaties

 In principle, the MLI seeks to modify application of bilateral tax treaties worldwide by transposing results and solutions from the BEPS project.
  • By Sumit Singhania

In the wake of strong global commitment to put an end to tax avoidance strategies predominantly built around mismatches in domestic tax rules, the Organization for Economic Co-operation and Development (OECD)/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) developed the Multilateral Instrument (MLI) in 2016. In principle, the MLI seeks to modify application of bilateral tax treaties worldwide by transposing results and solutions from the BEPS project. These solutions will enable governments globally to fix loopholes in international tax treaties by implementing certain minimum standards to counter treaty abuse and improve dispute resolution mechanisms. These solutions will also provide governments flexibility to accommodate specific tax treaty policies, either through the MLI itself, or by way of bilateral negotiations.

India, along with 67 other countries, signed the MLI in 2017. After completing the domestic procedure for ratification nearly a fortnight ago, India deposited the instrument for ratification of MLI with the OECD Secretariat. Along with the ratification, India has submitted its final positions vis-à-vis MLI provisions, which would have implications for all 93 tax treaties (of the total 95 tax treaties) that would qualify as ‘covered tax agreements’ (CTAs). With regard to reference dates, MLI shall enter into force for India, from 1 October 2019, and will come into ‘effect’ vis-à-vis CTAs notified by India earliest with effect from 1 April 2020, in case of CTAs where treaty partners have consummated the ratification process.

To date, of the 89 signatories to MLI, 29 jurisdictions have deposited their ratification instruments. The ratification is a critical milestone in MLI’s timeline. This is because only after both the parties (to a CTA) have deposited their ratification instruments with the OECD Secretariat, the MLI comes into force (and eventually enters into effect).

In the context of India, of the 93 CTAs notified by India, 23 jurisdictions have already ratified the MLI as on data. Consequentially, Indian tax treaties with these jurisdictions (for example, Australia, Belgium, France, Japan, Luxembourg, the Netherlands, Singapore, United Kingdom, etc.) will be modified by MLI provisions with effect from 1 April 2020. For the remaining CTAs, effect of MLI will take place as and when such other jurisdictions ratify the MLI. The timeline below depicts the events related to the date of entry into force and effect of MLI for India:

To evaluate the extent of modification of the Indian tax treaties, the country’s MLI positions would need to be compared with those taken by its tax treaty partner. Depending on the position a jurisdiction takes under MLI, India’s tax treaty should get modified in the following prominent ways:

Prevention of treaty abuse: MLI seeks to address tax treaty abuse by: a) amending the preamble to tax treaties to redefine the bilateral tax treaty’s objective, and b) introducing a ‘Principal Purpose Test’ (PPT) in tax treaties. The revised preamble sets out that the CTA seeks to prevent double taxation and curbs possibilities of no-taxation or double non-taxation. Overlaying this, the PPT rule mandates testing the ‘one of the principle purposes’ for a tax benefit keeping in mind the object and purpose of tax treaties. In select instances, the rule shall be supplemented with simplified limitation of benefit (SLOB) rule (e.g., India−Norway tax treaty) to the extent another treaty partner also opts so or agrees to an asymmetric application. SLOB is more restrictive and seeks to limit treaty benefits to only ‘qualified persons’ (defined to include select taxpayers, viz. listed companies; taxpayers with substance, etc.), whereas certain categories of persons, such as pure investment holding company, are excluded from ‘qualified persons’.

From an implementation standpoint, even before the MLI entered into effect vis-à-vis relevant Indian tax treaties, taxpayers were facing a host of challenges in interpreting the PPT rule, particularly due to sweeping coverage, absence of grandfathering of existing structures/investments, limited or no administrative guidance at present. Moreover, the interplay between PPT and domestic anti-abuse provisions (i.e., GAAR) also needs to be addressed. For instance, pre-2017 investment structures are grandfathered under the GAAR regime, whereas no such exception is proposed under the PPT rule in the MLI.

Expanded permanent establishment (PE) rule: Under the MLI, India’s position is intended to make PE rules far reaching, more encompassing, and largely aligned with international practices. This important policy change would entail – a) broader agency PE rule to address artificial avoidance of PE status through commissionaire arrangements and similar contracting strategies; b) narrowing scope of exceptions to PE rule by proposing to read ‘auxiliary or preparatory’ activity test relative to taxpayers’ overall business; and c) addressing situations of artificial splitting-up of contracts among closely related enterprises to avoid PE trigger under the relevant tax treaty.

Other crucial updates include resolving dual residency situations (for non-individuals) by resorting to mutual agreement procedure (MAP) and modifying indirect transfer rules for offshore land-rich entities. India has opted not to apply provisions on mandatory binding arbitration (in case competent authorities are unable to reach a decision under MAP).

This is not all at the centre of storm. In parallel, the OECD’s Inclusive Framework is working hard to develop a consensus-based solution to tackle tax challenges posed by rapid digitalisation of the economy; incidentally, these challenges can no longer be ring-fenced to ‘digital economy’ alone. Such a solution will have two central pillars. The first pillar will redefine the nexus and income allocation rules considering marketing intangibles, user contribution, and significant economic presence. The second pillar will address the remaining BEPS issues and develop a remedy for market and the home country if income is subject to no or very low taxation.

It will be interesting to see how well these consensus-led solutions can be incorporated into the MLI to ensure a more consistent and cohesive implementation of concepts of the two pillars-based solution to track tax challenges of digitalisation. With so much changes, businesses must keep pace with the rapidly evolving and new rules of international taxation. These new rules are likely to put forth challenges and hopefully, new opportunities too to reorganise business value chain.

(The author is Partner, Deloitte India. Mansi Kakkar and Prabhanu Sikaria contributed to this article. The views expressed are the authors’ own)

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Source: Financial Express