3 minute read 27 May 2019
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How treaties eased double taxation impact on cross-border operations


EY Global

Multidisciplinary professional services organization

3 minute read 27 May 2019

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The principal purpose test is the most pronounced restriction of treaties through the OECD multilateral instrument.

For a large part of the Western world, the first week of January and especially 6 January, a day called Epiphany in the English language, is associated with the story of the three kings and the burning of Christmas trees. It’s reminiscent of how large corporate legal entity structures are sometimes jokingly referred to as Christmas trees.

These corporate trees have developed over the years as corporations expand into new products and services and into new jurisdictions. And for many reasons — such as liability protection, local requirements for doing business, etc. — it has been common for groups to form new legal entities for new business ventures.

The expansion of the forest (to continue the metaphor) was supported by a proliferation of tax treaties in recent decades, creating a tax framework to mitigate the adverse impact of double taxation on cross-border operations and facilitating the build of global value chain infrastructures. In some cases, it became a tax treaty network where some jurisdictions negotiated access to more favorable source country/residence country tax rates compared with other jurisdictions. And it’s fair to acknowledge that some multinational corporations at that time considered such potential treaty benefits as a factor when deciding on their platforms for foreign investments.

Claiming treaty benefits

The Organisation for Economic Co-operation and Development (OECD) has been trying to confirm that treaty benefits are claimed legitimately through the anti-base erosion and profit shifting (BEPS) framework. In response, governments are beginning to implement recommendations to restrict access to treaties through the so-called multilateral instrument (MLI).

The MLI is an instrument signed by an increasing number of jurisdictions that amends the treaties between these jurisdictions upon ratification by the countries. This ratification is likely to happen in 2018 for many and in 2019 for most participating jurisdictions.

The most pronounced restriction of treaties is the so-called principal purpose test (PPT), which essentially excludes an entity from treaty access if it is reasonable to conclude that obtaining access to the treaty was one of the principal purposes for establishing the transaction with that entity.

Such a conclusion is inherently subjective and raises a few questions:

  • Are we testing for intent or for substance?
  • And when exactly do we test? In the year that the arrangement is put in place or in the year the taxpayer is looking for treaty benefits?

The bottom line

The bottom line is that it is not clear and likely a combination of all of these elements. Furthermore, different jurisdictions may take different perspectives (although some jurisdictions may find these perspectives limited by local or regional rules, for instance in the European Union, where the European Court of Justice has restricted the application of anti-avoidance to cases that are “wholly artificial”). So it is not an exaggeration to say that the PPT test puts the onus for robust documentation addressing all possible angles largely on the taxpayer.

The introduction of the PPT happens at a critical crossroad of tax reform in various jurisdictions, including the US and Japan, and implementation of the anti-tax avoidance directives in the EU. It also comes as additional provisions of the MLI are rolled out and the world prepares for the effects of Brexit.

So, what is a multinational enterprise to do?

Just as businesses work to comply with new OECD guidelines for transfer pricing documentation, they should also rethink possible consolidation of people functions in fewer entities. And in a fashion it urges taxpayers to choose direction and execute the necessary reorganizations now, because post-PPT reorganizations may not enjoy the same levels of treaty protection they have today.

In other words, it’s time to take the ornaments and lights off the tree and trim some of the branches. It should come as no epiphany to realize that in the new environment, a smaller tax footprint that is more closely aligned with business activity is more prudent.

This article was originally published in Tax Insights on 19 Mar 2018.


In recent decades, an increasing number of tax treaties created a framework to mitigate the adverse impact of double taxation on cross-border operations and facilitate creation of global value chain infrastructures. 

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EY Global

Multidisciplinary professional services organization