The OECD recently released a public discussion draft entitled the “BEPS Action 6 Discussion Draft on non-CIV examples” to clarify when investors like private equity funds, real estate funds and hedge funds should be entitled to tax treaty benefits.
The release of the 2017 Discussion Draft is timely, given that many of the tax treaties relied upon by PE investors when using holding companies to access treaty benefits may soon be amended by the OECD’s multilateral instrument (MLI), which is expected to be signed by many countries in 2017.
Where it applies to a treaty, the MLI will implement a general anti-abuse rule commonly referred to as the “principal purpose test” or PPT.
Clear guidance from the OECD on the scope of the broadly-worded PPT is a vital and urgent concern. Unfortunately, the 2017 Discussion Draft does very little to address the significant uncertainty currently arising from the PPT, which could adversely impact cross-border investment, in particular by PE investors.
2017 discussion draft: examples
The 2017 Discussion Draft includes three examples that aim to illustrate the application of the PPT to common transactions involving PE investors. In each of the examples, the OECD concludes that (absent additional adverse facts) the PPT ought not to apply to deny treaty benefits, despite the fact that such benefits were taken into account in structuring the relevant investment.
(For a detailed description and our insight on all three examples, we refer you to our full Osler Update.)
The focus of this Osler Update is on the only OECD example that deals with the treaty structure most directly relevant to PE investors, namely, one involving a holding company established in a treaty country by a fund that has investors from many jurisdictions.
Real estate fund: holding company example
A real estate fund is treated as a flow-through entity under the tax laws of State C, where it has been organized for the purpose of collective investment in a portfolio of real estate investments. The fund makes investments indirectly through its holding company, which holds and manages all of its real property assets and provides debt-equity financing to the underlying investments.
The holding company was established for a number of commercial and legal reasons, such as to protect the fund from the liabilities of and potential claims against its real property assets, and to facilitate debt financing (including from third-party lenders) and the making, management and disposal of investments. The vehicle also exists for the purposes of claiming treaty benefits with respect to its real estate investments.
All of the real estate fund’s investors would have been entitled to equivalent treaty benefits as the holding company if they had invested in the underlying assets directly, and the countries where the real estate investments are based can tax the directly earned income on those investments (e.g. rent).
Based on those factors, and the fact that the holding company’s real property investments are made for commercial purposes, the OECD concluded that in this example the PPT should generally not apply to deny treaty benefits to the holding company.
Examples fail to dispel uncertainty
Unfortunately, the three examples provide some guidance, but little certainty.
The OECD’s position as to the non-application of the PPT in each of the examples is based on the quite limited facts and circumstances described therein. That being the case, a tax authority may well consider that the PPT should apply to similar real-world fact patterns, depending on additional facts or circumstances showing that the holding company’s investments are part of an arrangement, or relate to another transaction, arguably undertaken for a principal purpose of obtaining the benefit of the applicable treaty.
In that regard, the OECD provides little guidance with respect to either the relevance of particular facts to the application of the PPT or what elevates a particular tax consideration to the level of constituting a “principal purpose” of an arrangement or transaction for purposes of the PPT (noting, of course, that there may also be more than one “principal purpose”).
As a result, there may be considerable leeway for tax authorities to distinguish the OECD’s examples from an actual arrangement or transaction undertaken by a PE investor, thereby potentially seeking to deny such a fund treaty benefits in respect of practically any cross-border investment.
Bilateral approach to granting treaty benefits
The OECD has suggested that countries may address the granting of treaty benefits for PE investors on a bilateral basis. While such an approach could work, it is unclear why the OECD would not include sample provisions in its model tax treaty (and the MLI) for this purpose.
For example, the MLI could include a presumption that the PPT would not apply if at least 75 percent of the investors in a PE fund would have been entitled to the same or similar treaty benefits had they not invested on a collective basis. Countries would then be free to include such a rule or follow an alternative approach as desired.
In addition, if countries were to address the issue on a bilateral basis they could provide further examples or other guidance on the intended application of the rule in particular circumstances. While such a bilateral approach would be helpful, it would nevertheless be preferable for the OECD to simply provide such guidance on a multilateral basis prior to the MLI changes coming into effect.
Use of a pre-ruling mechanism
Given the lingering uncertainty associated with the possible application of the PPT to transactions involving PE investors, cross-border investment by such investors may be adversely affected.
Indeed, such investors may often choose not to proceed with an investment based upon the mere hope that the relevant tax authorities will subsequently agree that treaty benefits apply under the circumstances.
In that regard, the OECD could consider extending its recommendations on Action 14 (“Making dispute resolution mechanisms more effective”) to its Action 6 minimum standards. This could be done, for example, through the use of a pre-ruling mechanism that would allow PE investors (or others) to determine, on an expedited basis and in advance of an investment, whether treaty benefits will apply to a particular investment.
Comments on the discussion draft should be sent to the OECD by February 3, 2017. Osler intends to convey our concerns, including those noted above.
For further insight on the OECD’s 2017 discussion draft, you can read the full Osler Update here.
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