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ROBERT GORDON UNIVERSITY

Dept. of law

BSM151 - Full Time: Comparative International Tax Law

CITL Coursework 2013

Scotia a small oil & gas producing state, has a number of DTR Conventions which follow the form

of the OECD Model. Its convention with its neighbor Anglia is particularly advantageous reflecting

the good relationship with this neighboring state. However Scotia has become concerned about the

way some individuals and corporations from beyond its boundaries are using its convention with

Anglia.

Despite heavy flows of money through the treaty route, there appears to be little advantage to either

Scotia or Anglia.

1. Consider why this might be the situation.

2. Discuss the formal steps and legal techniques Scotia might take, to reduce what it sees as

an abuse of its treaty network using specific examples from the international experience,

current and past.

3. What particular issues might be relevant to the situation in relation to UKCS and oil & gas

production.

Words:5623

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“When there is an income tax, the just man will pay more and the unjust less on the same

amount of income.” Plato

This essay tries to summarize and analyze the issues of treaty shopping, which is one of the

major problems that countries face today while trying to save their volatile budgets1. It is

being suggested that the imaginable (but very realistic) Scotia and Anglia may have to

accept different approaches to tackle the problem, none of these approaches sufficient

alone to solve the problem. In the last part of this essay a similar issue about the unstable

amount of revenue coming from the UKCS is observed. The whole European fiscal system

is jeopardised today and scholars are ‘called to arms’ to invent new and reintroduce old

solutions for these tough problems.

1. The purpose of a tax treaty

Nowadays people and corporations operate more globally than ever before. This fact

brings real challenges to modern revenue authorities in order for each country to tax the

persons (where ‘persons’ is defined as individuals, companies or other entities) generating

income (or corporate profits), both, home and abroad. Reasonable and economically

justified taxation means not being taxed twice on the same income (corporate profits). The

legal mechanism used to avoid this undesirable effect of person's international economic

activity is finding a compromise between countries by negotiating a bilateral or more

rarely multilateral tax treaties 2 which are governed by public international law (usually the

rules of the Vienna Convention on the Law of Treaties apply). 3 The balance between

stimulating higher economic activity and granting fair taxation is hard to be achieved. The

main purpose of an international double tax treaty is not only to protect the governments'

taxing rights and to protect against attempts to avoid or evade tax liability. It is also the

1 This essay is written in the times of the EU budget crisis, one of the most current developments of which

was the outburst of the "Offshore-leaks" scandal in the media, which recently lead to resignation of the

French finance minister, followed by the call for "eradication of tax havens by governments" of the French

President Fr. Hollande, echoed by the BBC http://www.bbc.co.uk/news/world-europe-22094194 2 There are more than 2,500 Double Taxation Treaties world-wide and the UK has the largest network of

treaties, covering over 100 countries. The UK seeks to encourage and maintain an international consensus on

cross-border economic activity and to promote international trade. To this end the UK plays an important role

in the Organisation for Economic Co-operation and Development (OECD)

http://www.hmrc.gov.uk/taxtreaties/dta.htm 3 W Craig, ‘Taxation Theory and the UK System’, Revenue Law Essentials (2nd ed., Dundee University

Press, Dundee 2010)

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legal tool for contracting the ways for avoiding, or at least minimizing as much as possible,

double taxation by using some of the known and approved methods - tax exemption, tax

credit or tax deduction4. In order for the international trade to be stimulated, a good tax

treaty is meant to remove this major obstacle for exchanging goods and services across

different countries5.

International taxation rules are developed on a global scale primarily by international

organizations such as UN, EU, the IMF and the OECD. The important role of taxation for

the economy is a constant theme on the political programs of governments after the

outbreak of the Global Financial Crisis in 2008 and the following Public Debt Crisis in

Europe which still continues full steam6. Amending and adjusting the revenue system has

become a more frequent practice for countries searching for adequate reaction to the new

challenging occidental fiscal reality.

2. The OECD Model Convention in general

The OECD Model7 and the UN Model

8 Conventions are the most powerful legal tools in

the hands of the governments to create, improve and uniform tax treaties. For most of the

developed countries, and we assume that Scotia and Anglia are also such countries, the

OECD Model is a strong base for drawing up tax treaties. The UN Model, on the other

hand, is designed to serve the same purpose for the similar needs of developing countries.

Every such model treaty, though, shall be enriched with each county's specific legal tax

characteristics to acquire its final appearance.

The OECD Model and its in-depth ‘article-by-article’ Commentary designed for ‘precise

interpretation’ purposes inspire almost all tax treaties among developed counties except the

US, that uses a different, but in the same time very similar to the OECD Model convention

(the US Model Tax Convention). The usage of the OECD Model is preferred

internationally for a couple of reasons:

4 A Miller and L Oats, ‘5.3 The Double Tax Problem’, Principles of international Taxation, (3rd edition,

Bloomsbury Professional Ltd., Haywards Heath 2012).

Tax deduction is a method which excludes any foreign taxes paid from the tax base in the country or

residence; Tax exemption is a method of non taxation of income derived from another country; Tax credit is

method by which the income is first taxed in full in the home country and than the income tax paid abroad is

deducted. 5 RL Doerberg, Overriding tax treaties: The U.S. Perspective, (9 Emory Int'l L. Rev. 71 1995)

6 e.g. the current Cyprus' talks with the EU, ECB and IMF aimed at securing another bailout for Cyprus after

the bailouts for Greece, Spain, Ireland and Italy. 7 OECD Model Convention on the Prevention of Double Taxation

8 United Nations Model Double Taxation Convention Between Developed and Developing Countries

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the interpretation of the Model is well-established in its Commentary and

respectively clear of vagueness;

it includes main parameters of financial reasoning in a tax treaty as well as general

legal framework, established by leading world experts and further updated and

developed since 1963;

it brings predictability for international businesses and individuals of how ‘double

taxation’ is treated and understood in every different country they operate.

The main feature of the OECD model is the fact that is brings a high level of certainty in

terms of a country's legal tax order to companies and individuals, which aids and

stimulates trade across national boundaries. If two jurisdictions use a DTR Convention

based on the OECD Model, than a person who resides in one of them will have a certain

lucidity of what to expect in terms of local revenue requirements in case he/she decides to

settle down in the other jurisdiction. Not only are the main principles of ‘avoidance of

double taxation’ going to be generally comprehensible for any such person, but also their

interpretation. The possibility for relief of 'double taxation', in hypotheses not envisaged by

the treaty by contacting the two tax authorities involved, to find a common solution,

represents another strong argument for using the OECD Model.9

3. The problem of ‘treaty shopping’

Regardless of all positive features of the OECD Model it still has not found a perfect

solution for all double taxation problems. The fact that we have two neighbouring

countries which have concluded a particularly advantageous DTR convention based on the

OECD Model reflecting the good relationship between them does not mean that there is

not a ‘dark side of the Moon’. Good relationships may attract attention, greed and envy. In

terms of international taxation this 'dark side of the Moon' for a good DTR Convention is

called ‘treaty shopping’.

The term ‘treaty shopping’ originates from the US legal doctrine. It derives from another

term - ‘forum shopping’ which indicates a situation in which a litigant may search for a

more convenient jurisdiction for his case to be judged with a view to a possibility for a

9 A Miller and L Oats, ‘7.13 Double Tax Treaties’, Principles of international Taxation, (3rd edition,

Bloomsbury Professional Ltd., Haywards Heath 2012)

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more advantageous decision. 10

A short description of the term ‘treaty shopping’ has been

given by Rosenbloom, 11

who states that it represents “the practice of some investors of

‘borrowing’ a tax treaty by forming an entity (usually a corporation) in a country having a

favourable tax treaty with the country of source – that is, the country where the investment

is to be made and the income in question is to be earned”12

. In short, it is the situation of

being ‘shopped’ by a person for a convenient tax treaty to benefit from its provisions,

either by establishment of a corporate entity or using an existent one, and usually

accompanied by application of different sophisticated schemes to reduce or fully avoid

taxation. Tax treaties are designed to only benefit persons who reside in a country which is

a party to the treaty. That is why, according to the OECD, treaty shopping is an undesirable

phenomenon which is subject to strong efforts for prevention by the tax authorities of each

of the countries affected. 13

As a totally opposite view, the (1988) UN Treaty Shopping Report promotes the idea that

in some instances treaty shopping may even be beneficial. Many underdeveloped states try

to attract investments by introduction of taxation based on low or no withholding taxes on

income even in case that the beneficial owner is based in another country. This is why

treaty shopping may be considered as a normal practice in such jurisdictions. The UN

report further explains that, if the main idea behind a tax treaty is to introduce “freer flows

of international trade and investment, it may be generally arguable that it does not matter if

the desirable result is achieved by the direct use of tax treaties or by their indirect use” 14

(e.g. treaty shopping). For many developing states treaty shopping might be regarded as an

opportunity to draw investments. As an example for this position, in the case Union of

India v. Azadi Bachao Andolan, the Supreme Court of India has held that treaty shopping

is "a necessary evil in a developing economy" and in general is a tolerable practice under

the Indian tax treaty network.15

Nevertheless, in the long term, treaty shopping is generally

10

H Becker and F Würm, Treaty Shopping: An Emerging Tax Issue and its Present Status in

Various Countries (Kluwer, Deventer 1988) 11

Mr. David Rosenbloom used to serve as an international tax advisor at the US Treasury Dept. (1977-1981) 12

HD Rosenbloom, Derivative Benefits: Emerging US Treaty Policy, (Essays on International Taxation,

Kluwer, Deventer 1993) 13

Reuven S Avi-Yonah and Christiana H Panayi, Rethinking treaty-shopping lessons for the European union,

(2010) Public Law and legal theory working paper series Working Paper No. 182 14

UN, Department of International Economic and Social Affairs, Contributions to International Co-

operation in Tax Matters: Treaty Shopping, Thin Capitalization, Cooperation between Tax Authorities,

Resolving International Tax Disputes (UN: New York, 1988), at 7. 15

Union of India v. Azadi Bachao Andolan, [2003] 6 ITLR 233. It is interesting that the Chinese position is

fully opposite - it says that treaty shopping is a totally unacceptable practise and represents a tax treaty abuse.

For further comments, see Yang, H., “New Developments in the General Anti-Abuse Rules and the Impact

on International Tax Planning” Asia-Pacific Tax Bulletin (May/June 2009) p. 176.

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believed to have more negative than positive effects on a country's economy and as a

‘plague’ to be dealt with.16

The term ‘treaty shopping’ does not appear by direct reference in the OECD Model and its

description and legal interpretation is not directly and widely discussed in the OECD

Model Commentary. Even though, it might be said that the OECD Model addresses the

problem of ‘treaty shopping’ indirectly - by searching to eliminate its effects through

applying specific provisions for its prevention and by defining the purpose of the tax

treaties as “…is to promote, by eliminating international double taxation, exchanges of

goods and services, and the movement of capital and persons. It is also a purpose of tax

conventions to prevent tax avoidance and evasion.” 17

. An example for such and other

indirect reference would be the Commentary on Article 1 which concerns the possible

application of the limitation-of-benefits (LOB) clauses which are meant to tackle the issue

of treaty shopping in a ‘comprehensive way’. 18

3.1. General forms of treaty shopping

There are multiple forms of treaty shopping, but the main two may be defined as these

identified inexplicitly under Para 9, Para 11 and Para 20 of Article 1 of the OECD

Commentary as such (1) including usage of conduit legal entities and/or base companies

19and (2) such not including usage of conduit structures and tax havens.

20

Treaty shopping through usage of conduit legal entities, though, is the most frequent type

of abuse and therefore the most fundamental form of treaty shopping 21

which is why this

short essay will be concentrated only on that certain ‘conduit’ type of treaty shopping and

its prevention.

16

Jinyan Li, Beneficial ownership in tax treaties, (University of York, Osgoode Law School, Research paper

series, 4/2012) 17

(2010) OECD Commentary to Article 1, paragraph 7 18

(2010) OECD Commentary to Article 1, paragraph 20 19

Simone M. Haug, The United States Policy of Stringent Anti-Treaty-Shopping Provisions: A Comparative

Analysis, (1996, Vand. J. Transnat'l L., p. 191): ‘A base company is a company through which certain

activities are carried out on behalf of related companies in high-tax countries. A base company seeks to

minimize tax in the country of residence-the country in which the investor actually resides, while the main

function of the conduit company is to serve as a pass-through entity that redistributes the income it receives

from a related company in one country to its shareholders in another country.’ 20

Christiana H. J. I. Panayi, ‘Chapter 2: Tax treaties and treaty shopping’, Double Taxation, Tax Treaties,

Treaty Shopping and the European Community, (Wolters Kluwer Law & Business, 2007) Such treaty

shopping without conduit as described in the OECD Commentary would be e.g. ’an individual who has in a

Contracting State both his permanent home and all his economic interests, including a substantial

shareholding in a company of that State, and who, essentially in order to sell the shares and escape taxation in

that State on the capital gains from the alienation (by virtue of paragraph 5 of Article 13), transfers his

permanent home to the other Contracting State, where such gains are subject to little or no tax.’ 21

Ibid.

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Regardless of the fact that treaty shopping may encompass a huge spectrum of ‘conduit’

structures, two main forms of treaty shopping through such ‘conduit’ legal entities might

be observed according to the (2010) OECD Commentary - these are two general recipes

that a person who is a resident in one jurisdiction could use in order to benefits from tax

treaty arrangements between two other jurisdictions. The forms are being identified by the

legal doctrine as: (1) the method of direct conduit structure and (2) the method of the

stepping stone conduit structure.

The method of direct conduit structure is based on establishing a legal entity in a

jurisdiction to take advantage of its beneficial DTR Convention with another country. A

basic example (provided that there are multiple different scenarios existing) might be

described as follows: jurisdictions X and Y (just like Scotia and Anglia) have concluded an

advantageous DTR Convention which guarantees individuals and legal entities established

in their tax legal systems with preferential tax treatment of minimal or no levy on income

(or corporate profits) gained in the other tax jurisdiction. A company incorporated in

jurisdiction Z (let’s say a tax haven jurisdiction) wants to invest substantial amount in

jurisdiction X and expects to gain profits which should be levied with an extortionate 30%

of withholding tax, because it does not have a DTR Convention with jurisdiction X. In the

same time jurisdiction Z has an advantageous tax treaty with jurisdiction Y. So, in order to

avoid the 30 % withholding tax the company resident of jurisdiction Z establishes a branch

(a ‘conduit’ entity) in jurisdiction Y. This ‘conduit’ entity is treated as a resident in

jurisdiction Y according to the tax treaty between X and Y which is why the investment in

jurisdiction X could be made through it. In order for the parent company in jurisdiction Z

to be able to benefit from that situation, the income derived from the ‘conduit’ legal entity

in jurisdiction Y shall either be fully exempt of taxation according to the other tax treaty

between Y and Z (more improbable) or simply according to the national laws of Y which

may provide a low or zero rate of withholding tax on profits gained by a branch of a

foreign company. In that case the ‘conduit’ entity established in jurisdiction Y will be

entitled to be allocated a full tax exemption or at least tax optimized net profit to its parent

company in jurisdiction Z which, in that way, gains substantial benefits from the X - Y tax

treaty. 22

22

A Miller and L Oats, ‘16.1 Treaty shopping’, Principles of international Taxation, (3rd edition,

Bloomsbury Professional Ltd., Haywards Heath 2012)

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The method of the stepping stone conduit structure is similar to the method of direct

conduit, but while the latter uses a tax exemption in the connecting jurisdiction, the former

reduces the tax due in that jurisdiction by counterbalancing the expenses. The difference

between both methods may be defined using the following basic example: A legal entity in

jurisdiction X, a high-tax jurisdiction is a subject to full high taxation on its corporate

profits derived in jurisdiction Y. In the same time jurisdiction Y allows deductions on

corporate expense and the company decides to balance its total net corporate profit by

making substantial ‘ostensible’ expenses to a connected legal entity in a third low tax

jurisdiction (let’s say jurisdiction Z). In that way the corporate profits gained in jurisdiction

X are transmitted to jurisdiction Z fully free or substantially reduced of taxation, because

of the advantageous DTR Convention between the high tax jurisdictions, X and Y, and the

tax base balancing performed through the conduit legal entity in jurisdiction Y”.23

A corporation that uses the method of stepping stone benefits, because: “(1) the

stepping stone company can deduct all of its expenses against its receipts; (2) the stepping

stone country does not impose a significant withholding tax on the outbound payments;

and (3) the stepping stone company's receipts must be received free of host-country

withholding tax (or subject to significantly reduced withholding tax) by virtue of an

existing tax treaty.” 24

There are many more complex variations of treaty shopping structures including some

which take advantage of both ‘direct’ and ’stepping stone’ conduit methods in order for

funds to be transferred fully free of taxation or taxation optimized between multiple

‘channel’ jurisdictions. In the process different ‘conduit’ companies may be created (e.g.

holding companies, subsidiaries, etc.) 25

The income which is a subject to treaty shopping

may take many different forms during the transfers (e.g. corporate profit, dividend,

interest, etc.). That is why Anglia and Scotia may wish to carefully plan, examine and

decide on the possible methods for prevention of treaty shopping according to the specific

situation they are facing.

23

Opt. Cit. Simone M. Haug, page 205 24

Ibid. 25

Ibid.

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3.2. Methods for prevention of treaty shopping

There are two global approaches that can be used by countries in the situation of Anglia

and Scotia to tackle treaty shopping: (1) the US limitation of benefits 26

approach (which

basically introduces specific anti-treaty shopping provisions in each DTR Convention

concluded) and (2) the OECD Model approach (which firstly encouraged mainly

introduction of domestic anti-treaty shopping tax legislation and more recently also

included anti-treaty shopping provisions in its Model convention) 27

- an example for a

more recent attempt for establishing national rules is the UK HMRC's proposal of

introduction of a special domestic legislation chapter to the UK Finance Act 2012

dedicated to ’Tax Treaties Anti Avoidance’ generally based on denial of treaty benefits in

case of a scheme directly or indirectly constructed for the purposes of gaining treaty

benefits. This reasonable UK HMRC proposal though has not been adopted yet into a valid

UK legislation and remains inactivated. 28

The first treaty shopping prevention methods are as old as the 1977 OECD Model, namely,

the beneficial ownership and the limitation on residence. These two simplified provisions

had been further upgraded by extra measures represented by the 1986 OECD Conduit

Companies Report which followed the main idea that only companies having connections

close enough in terms of ownership and/or economic activity with the jurisdiction of

residence shall be able to benefit from a particular tax treaty. Consequently extended and

improved versions of prevention methods had been approved and incorporated in the

current OECD Model and its Commentary. These anti-treaty shopping provisions still do

not offer a universal solution to solving the treaty shopping problem. Thus, they form only

a base framework of possible approaches for prevention of treaty shopping. The OECD

commentary states that a combination of different measures may have to be used by the

contracting jurisdictions in order for various avoidance schemes to be prevented.29

However, the approaches derived by the OECD theory and practice are to be summarized

as: (1) the beneficial ownership approach, (2) the look-through approach, (3) the channel

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the LOB are clauses designed to identify the persons allowed to benefit from the treaty (i.e. the benefits of

the treaty are limited to such persons) and not to focus on specific scenarios where conduits might be

involved. It is basically a more detailed approach based on the ‘channel approach’ which is discussed below 27

Opt. cit. Christiana H. J. I. Panayi, page 43 28

Opt. cit A. Miller and L. Oats, p. 483 29

Opt. cit. Christiana H. J. I. Panayi, page 44

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approach, (4) the limitation on residence approach, (5) the exclusion approach and (6) the

subject-to-tax approach.

3.2.1. The beneficial ownership approach

The ‘beneficial ownership’ provision is the most popular instrument for limiting the

benefits of the reduction of withholding taxes on interests, dividends and royalties given to

the beneficiary according to a tax treaty. It is basically included in almost every OECD

based tax treaty and generally restrains the expansion of treaty benefits to legal structures

(such as conduit entities) which are not ‘beneficial owners’ of the particular income, even

though it is formally attributed to them under the tax treaty (and in that way prevents treaty

shopping). Although, a legal definition of the term is not to be found in any DTR

convention some understanding on the term can be derived by Art. 3(2) of the OECD

Model, but a consensus on its firm legal meaning is hard to be achieved. This mist had

begun to be unveiled by case law like the Indofood30

UK Court of Appeal's decision,

followed by cases such as Real Madrid31

, Bank of Scotland32

and Prevost Car case.33

All

these cases concentrate on the question of whether a conduit legal entity established in a

country that is a party to a tax treaty (the United Kingdom in Bank of Scotland the

Netherlands in Indofood and Prevost car case and the Republic of Hungary in Real

Madrid) can be interpreted as a beneficiary according to the relevant DTR Convention. All

the judgments are based on different ideas of the judges on how ‘beneficial ownership’ is

to be interpreted.

The most important UK judgment on ‘beneficial ownership’ is Indofood, mainly because it

is the first that manages to somehow define the term for ’beneficial owner’. Although the

factual content of the case is long and complicated, in general, it focuses on to the main

question whether a conduit legal entity, established especially for the purposes of a

particular deal, may be interpreted as a beneficial owner of an interest payment to be

received by it, and further transmitted through it, according to a double tax treaty. The

essence of the decision is that the UK Court of Appeal denied accepting that a conduit

entity can be interpreted as a ‘beneficial owner’. The judges' decision had been highly

30

Indofood International Finance Ltd v. JP Morgan Chase Bank NA London Branch, [2006] EWCA Civ

158; 31

Real Madrid F.C. v. Oficina Nacional de Inspeccion (18 July 2006), Westlaw Aranzadi JUR\2006\204307 32

Conseil d’Etat, 29 December 2006, Ministre de L’Economi, des Finances et de L’Industrie v. Societe Bank

of Scotland, no.283314. See 9 1 TLR 1. 33

Prévost Car Inc. v. Canada, 2008 3080 (TCC), aff’d by FCA, 2009 DTC 5053.

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influenced by the following part of the OECD Commentary and its interpretation by

Professor P. Baker 34

:

“Where an item of income is received by a resident of a Contracting State acting

in the capacity of agent or nominee it would be inconsistent with the object and

purpose of the Convention for the State of source to grant relief or exemption

merely on account of the status of the immediate recipient of the income as a

resident of the other Contracting State. The immediate recipient of the income

in this situation qualifies as a resident but no potential double taxation arises

as a consequence of that status since the recipient is not treated as the owner

of the income for tax purposes in the State of residence. It would be equally

inconsistent with the object and purpose of the Convention for the State of

source to grant relief or exemption where a resident of a Contracting State,

… simply acts as a conduit for another person who in fact receives the benefit

of the income concerned. For these reasons, the [Conduit Companies Report]

concludes that a conduit company cannot normally be regarded as the beneficial

owner if, though the formal owner, it has, as a practical matter, very narrow

powers which render it, in relation to the income concerned, a mere fiduciary

or administrator acting on account of the interested parties.” 35

The judges held that “the concept of beneficial ownership is incompatible with that of the

formal owner who does not have the full privilege to directly benefit from the income”. 36

The key part saying that beneficial owner shall be interpreted as “the actual owner of the

interest who truly has the full right to enjoy directly the benefits of that interest income”

can not be found in the Commentary. It actually comes from a letter written by the

Indonesian tax authority in response to the question of the UK Court of Appeal if the

former is ready to interpret the conduit legal entity on the case as beneficial owner of the

interest. Another reason for this decision to be so important is the fact that for the first time

judges agreed that the term ‘beneficial ownership’ shall be marked with having an

‘international fiscal meaning’.37

3.2.2. The ‘look-through’ approach

The look-through approach simply denies treaty benefits to legal entities that are direct or

indirect ownership of persons who do not reside in one of the contracting countries.

34

Philip Baker, Beneficial Owner: After Indofood, (2007, Grays Inn Tax Chamber Review, Vol. VI, No. 1, p.

15) 35

Indofood., Para. 42. The Court noted that Philip Baker suggests that the term should be accorded an

international fiscal meaning not derived from the domestic laws of contracting states. 36

Ibid., Para. 42. 37

Opt. cit. Jinyan Li, ‘3. Judicial interpretation’

12

The weakness of this approach is the fact that is does not take into account the legal status

of the respective legal entity and that is why it is held by most commentators as too

restrictive. In order for this approach to work a current info of the identity of the

shareholders should be provided. A typical clause for prevention of treaty shopping using

the ‘look-through’ approach would be:

“A company that is a resident of a Contracting State shall not

be entitled to relief from taxation under this Convention with

respect to any item of income, gains or profits if it is owned or

controlled directly or through one or more companies,

wherever resident, by persons who are not residents of a

Contracting State.” 38

This provision is often modified by the parties in order to account for bona fide businesses,

because of its radical approach. It is meant to be used primarily in treaties with one of the

parties being a low or no-tax jurisdiction, where a the risk of establishment of conduit legal

entities is bigger.39

3.2.3. The ‘channel’ approach

Highly recommended by the OECD, the ‘channel’ approach, also known as ‘base erosion’

is aimed at dealing with conduit legal entities with their tax base reduced in order for third

state residents to benefit (e.g. parent companies or connected legal entities). The reduction

is most likely to be made by payments of interest, royalties or emission of obligations (or

any other tax deductible form). This approach activates a provision for refusal of a country

where the conduit is established to allow tax treaty benefits in case that more than for

example 50 % of the conduit company's income is transferred to third countries as tax

deductions.

A typical example for a channel provision is, again, to be found in the OECD

Commentary:

“ Where income arising in a Contracting State is received by a company

that is a resident of the other Contracting State and one or more persons

who are not residents of that other Contracting State

a) have directly or indirectly or through one or more companies, wherever

38

(2010) OECD Commentary to Article 1, paragraph 13 39

Opt. A. Miller, L. Oats, p 494

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resident, a substantial interest in such company, in the form of a

participation

or otherwise, or

b) exercise directly or indirectly, alone or together, the management or

control of such company any provision of this Convention conferring an

exemption from, or a reduction of, tax shall not apply if more than 50 per

cent of such income is used to satisfy claims by such persons (including

interest, royalties, development, advertising, initial and travel expenses, and

depreciation of any kind of business assets including those on immaterial

goods and processes).”40

It must be indicated that no matter that the channel approach is extremely good for fighting

conduit legal entities, it may also affect bona fide business operations which is why an

inclusion of a bona fide provision is recommended. 41

3.2.4. The ‘limitation of residence’ approach

If a conduit company is considered to be a resident of a country - party to the tax treaty

according to its domestic laws, it usually is able to benefit from the tax treaty. That is why

counties may adopt a ‘limitation of residence’ clause, by which the term ‘residence’ is

limited in the tax convention or in the domestic law. The limitation usually encompasses

persons who are obliged to pay taxes because of residence, domicile, place of management

etc. The approach is represented in Article 4 of the OECD Model.42

The effectiveness of that provision is a subject of argument, because it is believed that it

may be too widely interpreted and “exclude from the scope of the Convention all residents

of countries adopting a territorial principle in their taxation”. 43

That is why is “it has to be

interpreted in the light of its object and purpose, which is to exclude persons who are not

subjected to comprehensive taxation (full liability to tax)”.44

40

(2010) OECD Commentary to Article 1, paragraph 17 41

Opt. A. Miller, L. Oats, p 495 42

Art. 4, OECD Model: "… the term "resident of a Contracting State" means any person who, under the laws

of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other

criterion of a similar nature, and also includes that State and any political subdivision or local authority

thereof. This term, however, does not include any person who is liable to tax in that State in respect only of

income from sources in that State or capital situated therein." 43

(2010) OECD Commentary to Article 4, paragraph 8.3 44

Ibid.

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3.2.5. The ‘exclusion’ approach

In order for a conduit legal entity to succeed benefiting from a tax treaty it should be a

subject to low or zero taxation in the country in which it is a resident. This is usually made

possible by making use of not having to pay dividends (direct conduit method) or by

transferring income making use of tax deduction for expenses (stepping stone method) or

by establishment of a specific conduit company which is tax-exempt according to the

treaty. The exclusion method provides that countries may just decide to exclude particular

forms of legal entities and unable them to benefit from the convention. The scope of

exclusion may encompass only some or all types of income, which is why the exclusion

provision offers higher chances for soft-adjustment than the limitation of residence

above45

.

3.2.6. The ‘subject-to-tax’ approach

The ‘subject-to-tax’ approach is used to establish a requirement for direct connection

between the need of a payment of income tax by the liable person in his country of

residence and the opportunity for double taxation relief in the country where the income is

derived from (i.e. a conduit can benefit from a treaty only if it is a subject to taxation in its

resident jurisdiction as, well???). The ‘subject-to-tax’ is based on the understanding that

the main aim of a tax convention is to prevent for a tax to be paid twice and not to totally

exclude the income from taxation. Both, the U.N and the OECD 46

generally do not

recommend the ‘subject-to-tax’ provision, because it may lead to unjust treatment of legal

entities that are subject of some special domestic rules that allow them not to be taxed (e.g.

charity organizations, pension funds or maybe other entitles that are offered with such

incentive for purposes of boosting the economy). The provision is also incapable of dealing

with stepping-stone conduits and is usually hard to be administered, because tax legislation

45

Opt. cit. Christiana H. J. I. Panayi, p.53, a typical exclusion provision from the Conduit Companies Report:

“No provision of the Convention conferring an exemption from, or reduction of, tax shall apply to income

received or paid by a company as defined under section [ . . . ] of [ . . . ] the Act, or under any similar

provision enacted by [ . . . ] after signature of the Convention.” 46

The (2010) OECD Commentary recommends the following safeguarding provision:

“ Where income arising in a Contracting State is received by a company resident of the other Contracting

State and one or more persons not resident in that other Contracting State

a) have directly or indirectly or through one or more companies, wherever

resident, a substantial interest in such company, in the form of a participation

or otherwise, or

b) exercise directly or indirectly, alone or together, the management or control of

such company,

any provision of this Convention conferring an exemption from, or a reduction of, tax shall apply only to

income that is subject to tax in the last-mentioned State under the ordinary rules of its tax law.”

15

(e.g. tax thresholds, deduction allowances) is too different in each country for the balance

to be easily found.47

3.3. Supplementary tests

Because of the fact that all the approaches above may lead to restrictions on bona fide

48legal entities, which are not conduits established for tax avoidance purposes, application

of supplementary tests is recommended. Their goal is to tell apart bona fide from conduit

structures. Examples for such test are the business activity test49

, a detailed ‘subject to tax

test’, a stock market test50

etc.

4. Challenges on taxation in the UKCS and oil and gas production

Following the privatisation of the British National Oil Company (BNOC) in 1982, and

because of the introduction of the current licensing regime, the UK government relies

mainly on taxation to share the wealth from the petroleum industry. Both state and industry

are interested in securing a ‘fair’ share of the gains. The main issue is defining what is

‘fair’ since each of the parties always wants more. Mutually beneficial agreement can be

achieved only through designing of a competitive tax system which should be capable to

both answer the current industry's needs and attract new investors. If the taxation is too

rough, the willingness of the companies to invest in exploration, extraction and expansion

may be restricted which usually results in investments being made in another tax

jurisdictions with more preferable tax systems or in suspension and manipulation of the

established production, which may become ineffective.51

The UK and UKCS oil and gas taxation regime is based on three types of taxation methods

- Ring Fence Corporation Tax (RFCT) of 28%, Supplementary Charge to Corporation Tax

(SCT) of 32 % and Petroleum Revenue Tax (PRT) of 50% where applicable. The ‘ring

47

Opt. cit., Simone M. Haug, p. 228 48

Bona Fide companies are having genuine business intentions in contrast to conduits and therefore special

provisions usually apply to maintain the tax benefits for such companies. 49

Under the activity test a company is required to prove that it is engaged in substantial business operations

in the Contracting state of which it is a resident and the relief sought from the other Contracting country is on

a lawfully derived income. 50

The detailed subject-to-tax test compares the taxes saved under the treaty benefits and the taxes paid by the

‘suspected’ conduit legal entity in the state where resides; the stock market test excludes from the list of

‘suspects’ companies listed on a stock exchange since they are highly unlikely to act as conduits. 51

Daniel, Philip Keen, Michael Mcpherson, Charles., Taxation of Petroleum and Minerals: Principles,

Problems and Practice, The [e-book]. Taylor & Francis; 2010, page 89, [cited 2013 Apr 1]. Available from:

MyiLibrary. <http://lib.myilibrary.com?ID=258631>

16

fence’ system allows taxation of oil and gas extraction income without inclusion of losses

generated by the operating company outside ‘the fence’. The supplementary charge is

levied in addition to the RFCT on ‘ring fence’ profits with exclusion of the financial costs.

The PRT is an oil and gas field based tax. The profits from every tax field which is

licensed before 16.03.1993 are levied with a 50% PRT. It does not apply to fields licensed

after this date. After the 23rd of March 2011 the maximum tax levied on (old) fields that

shall pay the PRT may be up to 81% (from 75% before 23rd of March 2011) and the

maximum tax that can be levied on new (with no PRT) fields is up to 62% (from 50%

before 23rd of March 2011). The UK oil and gas offshore industry is the most heavily

taxed industry in the UK.

Currently, the UK government tends to use the taxation regime on oil and gas in a way that

does not provide good cash-flows predictability for the oil companies, because of the

constant significant changes to the system. An example for that is the introduction of the

supplementary charge in 2002, levied first at 10% and doubled in 2006 and increased

more recently (on 23rd of March 2011) at 32%. In response the industry, notwithstanding

having a tacit agreement to rather not try to evade taxation, regularly uses different

perfectly legal internal mechanisms for adjusting its total oil and gas sector tax expenditure

to an average of 8.7 billion pounds per year after 2006.

This trend might be examined in numerous studies and may easily be observed via

statistics:

United Kingdom, Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Crude oil production,

total (in million tonnes

(toe) 115,944 106,073 95,374 84,721 76,577 76,832 71,664 68,197 62,963 52,003

Historical annual

average world market

brent crude oil prices

per barrel, 2012

inflation adjusted $ 32.41 $ 38.78 $ 50.52 $ 69.73 $ 78.66 $ 86.24 $ 103.35 $ 65.91 $ 83.29 $ 113.18

Total revenues from oil

and gas production,

excluding gas levy

(in million pounds) 5,370 5,054 4,223 5,115 9,323 8,864 7,408 12,925 6,491 8,786

Sources: http://www.hmrc.gov.uk/statistics/prt/og-stats.pdf, accessed 01.04.2013

Institute of Petroleum IP Statistics 14, www.bls.gov,

BP Statistical Review of World Energy 2012,

17

It is easily visible that the revenue on oil has significantly increased in years 2006 and

2007, boosted mainly by the doubling of the supplementary charge from 10 to 20 %. The

decrease from 2008 is considered to be caused by the high decrease in production and the

higher production costs. A considerable increase is to be observed in revenues for 2009,

mainly because of the record oil and gas prices in 2008, but the tax yield have been

reduced twice 2010 after the oil price dropped again. As a result the production has once

more been decreased. Despite rising expenditure and the continuing falls in production,

yield increased again in 2011 as prices got on an increase trend after 2009. There is

obviously a misbalance between the UK tax policy and the industry - higher profits for the

companies do not necessarily lead to higher revenue.52

Certainty in the taxation system is needed in order for future tax rises not to result in

welfare loss and under-investment. This under-investment may lead to two situations: (1)

the total development of the UKCS falling because of non-optimal production and (2)

investments on single oil-fields going under the optimal line. Loss of welfare and under-

investment, because of uncertain taxation strategies, affects the real economy by

production decisions being distorted (e.g. the tax uncertainty may result in that the resource

is being extracted faster, distorting the oil field optimal production).53

5. The solution

There is no perfect tax system, but in order for the UK government to achieve both better

revenue and good investment pace in the UKCS, the balance should be found. Nowadays,

with the financial and budgetary crisis on hand, this balance is harder to be achieved than

ever before. Only wise measures, taken from both sides, can sustain the development of the

UKCS, especially now when the production, the investment and the revenue are in decline

with the ever stronger global competition, high costs of production in the UKCS and the

high and constantly changing taxes. Development of potential new fields (e.g. West of

Shetlands) should be stimulated by the UK government, because sustainability in the

UKCS is of great national interest. Some good signs for government reaction to the current

situation are already to be observed with the creation of some new incentives for the

52

HM Revenue & Customs: Business taxes, Statistics of Government revenues from UK oil and gas

production, (HM Revenue and Customs 100 Parliament Street, London 2012),

http://www.hmrc.gov.uk/statistics/business-taxes.htm accessed 01.04.2013 53

Opt. cit. Daniel, Philip Keen, Michael Mcpherson, Charles, page 425

18

industry (such as the announced decrease of the CT from 28% currently to 23% from April

2014; the decommissioning costs relief, the 2009 ‘field allowance’ etc.), but this is still not

enough to encourage more production and to attract new investors. Meanwhile, creating

more fine adjustment mechanisms like the supplementary charge to the tax system can

only bring more possibilities to finding the ‘golden’ middle line.

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