By Francesca Amaddeo, Researcher, Tax Law Competence Centre (SUPSI), Manno, Switzerland
On 4 June, the Platform for Collaboration on Tax, a joint initiative of the IMF, OECD, UN, and World Bank Group (WBG), released its new toolkit concerning the taxation of offshore indirect transfers.
Indeed, as developing countries must cushion COVID-19’s impact on their domestic resources, this new guidance on the development of a tax regime applicable to offshore indirect transfers is very timely.
The new toolkit sets out a series of international tax issues that must be addressed and examined by governments to get the most successful solution for indirect transfers.
From the India Vodafone case to new tax treaties’ blueprint
Most remember the famous Vodafone case. Briefly, in 2007, Vodafone decided to expand its footprint in the Indian mobile phone market by purchasing Hutchison Essar for approximately USD 11 billion.
Vodafone’s tax planning was based on a simple trick: its subsidiary exchanged cash for shares with a similar holding company for Hutchison Essar, in a far away tax haven, the Cayman Islands. As the transaction took place entirely offshore, outside India, between non-resident companies, it escaped India taxation.
The case had, and is still having, significant consequences on judgments, rulings, and mutual agreement procedures. Indeed, even if the tax planning is allowed in this case, as in similar cases, such as Petrotech Peruana and Zain, it is clear that
the exploitation of offshore indirect transfers is a target of government efforts to curtail tax avoidance.
Recently, partially due to the COVID-19 pandemic, the international tax community has begun to understand that such strategies, especially those carried forward by MNEs, can result in base erosion and profit shifting.
The Platform for Collaboration on Tax determined it necessary to intervene to help countries (especially developing ones) enforce both domestic tax law and tax treaties with proper provisions able to fight offshore indirect transfers’ consequences.
Taxing capital gains deriving from such schemes, which are widespread around the world, requires well-structured rules addressing definitions, criteria for attribution of taxing rights, proper national provisions, eventual changes to double taxation conventions (and their relationship with OECD multilateral convention) in both OECD and UN model, while also ensuring core principles of ability to pay and efficiency.
In general, offshore indirect transfers are defined as the sale of an entity owning an asset located in one country by a resident of another.
More specifically, offshore transfers are transfers in which the transferor is resident for tax purposes in a different country from that in which the asset in question is located, and the transferor does not have a permanent establishment in the country in which the same asset is located.
But what about the definition of the asset? The toolkit notes that offshore indirect transfers concern immovable property. Despite the general definition adopted by most jurisdictions, which encompasses real property in the form of land and buildings, the Platform for Collaboration on Tax considers it suitable to also include also mineral, petroleum, and other natural resources.
In addition, rights (such as those embodied in licenses) to explore, develop, and exploit natural resources or public goods (e.g. electric, gas or other utilities; telecommunications and broadcast spectrum and networks), as well as information relating to those rights, should be included.
Immovability is a keystone since it assures a series of advantages in allocating taxing rights: it facilitates the collection of taxes and, moreover, seems to reflect the location in its value.
The toolkit stresses the relevance of the definition within domestic law since, without this basis, it is not possible to correctly apply tax treaties and international tax provisions to immovable property. Moreover, even if provided by tax treaties, without this local law definition, it is not possible to exercise taxing powers.
Offshore indirect transfers: allocation of taxing powers between equity and efficiency
Given these premises, the main issue arising from offshore indirect transfers whether the country in which the underlying asset is located should tax gains realized on such transfers, as is the case for direct transfers.
Indeed, the assumed disparity of tax treatment of direct versus indirect transfers raises questions of fairness between jurisdictions and whether assets are used in the most productive ways, the toolkit observes.
Regarding the first point, it is well-known that there is a lack of fairness between nations regarding the allocation of taxing powers.
It is possible to consider the country in which an asset is located as entitled to tax gains associated with the sale of an asset located there, but it is also accepted that countries have the right to tax returns to foreign investors in the form of dividends from a domestic source. As a consequence, it would also be possible to allocate to a state the right to tax foreign investors on capital gains associated with a domestic source.
Moreover, under the so-called benefit theory, as applied to corporate tax, an assets’ immovability suggests that taxes are in the nature of payments for public services provided by the government to help maintain the value of the local economy. In line with this thinking, the toolkit asserts that there seems to be a strong case for a presumptive primacy of source country taxing rights for gains on immovable assets, defined as sources of location-specific rents.
From the perspective of efficiency, the toolkit notes that taxing offshore indirect transfers can prevent the distortion of investors’ decisions. To reach such a goal, tax neutrality must be granted: the same rules must apply both to direct and indirect offshore transfers. However, such an evaluation should not ignore cross-borders tax planning.
The variables in play lead to different approaches. Nevertheless, the analysis suggests that it is appropriate that countries have the right to tax capital gains associated with transfers of immovable assets located there, regardless of whether the transferor is resident or has a taxable presence there.
In addition, the toolkit notes that domestic choices to not tax such gains may be considered unilateral measures, feeding tax uncertainty.
How tax treaties envisage offshore indirect transfers
Tax treaties based on the OECD or UN models typically assign either exclusive taxing rights to the residence state or a primary taxing right to the State where the asset is located, with an appropriate relief mechanism in the resident State to eliminate double taxation.
While under both models, direct transfers of immovable property, under art. 13,§1, may be taxed by the State where the property is located, gains on indirect transfers are dealt with article 13,§4, which uses the same wording in the two models.
This basic rule provides:
“Gains derived by a resident of a Contracting State from the alienation of shares or comparable interests, such as interests in a partnership or trust, may be taxed in the other Contracting State if, at any time during the 365 days preceding the alienation, these shares or comparable interests derived more than 50 percent of their value directly or indirectly from immovable property, as defined in Article 6, situated in that other State”.
As such, the primary right to tax is allocated to the country where the immovable property is located, regardless of the residence of the company (or other entity) owning that property.
The UN model also adds paragraph (§5), where the reach of offshore taxation is extended beyond the immovable property. This provision is applicable only to offshore direct ownership of entities and so not suitable as a provision to ensure the source taxation of gains on indirect transfers.
The toolkit also notes that tax treaties may be amended by the OECD multilateral convention, also known as MLI.
Indeed, the MLI modifies existing tax treaties. In particular, if there is no provision equivalent to article 13, §4, thanks to the enforcement of article 9, §4 of the MLI, tax treaty provisions will allow the jurisdiction in which immovable property is situated to tax capital gains realized by a resident of the treaty partner jurisdiction from the alienation of shares of companies that derive more than 50 percent of their value from such property.
When countries already have a provision in their tax treaties on taxation of capital gains realized from the alienation of shares, the MLI offers two options: adding a time criteria (365 days) as reference for determining whether the shares derive their value principally from immovable property, or extending the type of interests covered.
The MLI follows the general direction of the international community, especially, in fighting tx treaty abuse as a tool for tax evasion and tax avoidance.
The toolkit’s two models
In an offshore indirect transfer, nothing changes from a legal perspective. No capital gain is directly realized from the transfer in the country where the asset is located.
The structure beyond is based on the changing mechanism related to stock or a comparable interest in an entity that holds the asset either directly or indirectly: the stock or interest is held and transferred in another country, either in the country of residency of the seller or in a third country.
Here again, as often occurs, substance prevails over form.
In the toolkit, two models are identified as common structures used by jurisdictions to stop the exploitation of such practices.
Model 1 imposes taxation on a deemed direct sale by a resident. This model seeks to tax the local entity that directly owns the asset, by treating that entity as disposing of and reacquiring, its assets for their market value where a change of control occurs.
This model takes into consideration the fact that a capital gain has been realized through the indirect transfer, triggered by a change of control. The relevant taxpayer under this model is not the seller entity, which effectively disposes of the shares, but rather the entity that actually owns the assets from which the relevant shares derive their value.
Model 1 needs to be supported by a deemed disposal and a reacquisition rule for the assets from which the shares disposed of derive their value.
Model 2, proposes taxation of the non-resident seller of the relevant shares or comparable interests via a non-resident assessing rule.
Such a model must be supported directly or implicitly by a source of income rule, which provides that gain is sourced in the country where the value of the interest disposed of is derived, directly or indirectly, principally from immovable property located in that country.
A source rule relating to gains from the disposal of other assets may also be considered as including substantial shareholdings in resident companies.
A source of income rule may be further supported by a taxable asset rule dealing with such matters as whether taxation only applies to the disposal of substantial interests to exclude from the scope of tax changes in ownership of portfolio investments.
Both models have pros and cons, but Model 2 seems to be adopted by more countries.
Conclusions (or starting points)?
In sum, this brief analysis notes the necessity to shape international taxation on issues which, even though not new, are becoming more and more important.
Adoption of proper domestic legislation, especially legislation that provides a clear definition of immovable property, is needed successfully apply tax treaty provisions to offshore indirect transfers, even if countries sign the MLI and opt into article 9, §4.
This toolkit is not binding but represents a good starting point to combat tax countries’ loss of tax revenue, exacerbated by the recent pandemic.
Developing countries need some guidelines to reach uniform rules, which are the only way to avoid tax uncertainty and, as a consequence, tax disparity.
Once again, tax avoidance tests international taxation law. Will it overcome the challenge?
Francesca Amaddeo
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