Understanding Treaty Shopping

The world is increasingly becoming 1 large country. Borders are shrinking and commerce is growing. However, despite the increasing trend of cross-border business, a significant factor remains that each country and its economy is unique.


Countries are blessed with certain resources that another country would have in shortage, leading to certain economic advantages or disadvantages. Businesses ideally set up their business in a particular State with the intention of capitalising on their economic, demographic or commercial benefits, to do business. These economic barometers play a crucial role in defining the tax systems and tax rates of a particular State. This is also the reason why tax rates are different from one country to another.


What is Treaty Shopping

“Treaty shopping” generally refers to a situation where a person, who is resident in one country (say the “home” country) and who earns income or capital gains from another country (say the “source” country), is able to benefit from a tax treaty between the source country and yet another country (say the “third” country).  Once the third-country resident investor has found such a country, income from the Home State may be channelled through a corporation organized under the laws of that country. The withholding tax rate on passive income under a tax treaty is usually less than the statutory rate applicable to residents of non-treaty countries, in many cases exempting the income from taxation.


The residents who indulge in Treaty Shopping take the benefits of the different tax system in a particular State. This situation often arises often where a person is resident in the home country but the home country does not have a tax treaty with the source country. It also happens when incomes of a specific nature are treated different in different States. Therefore, the roots of the Treaty shopping are in the inconsistencies among international tax regimes. As long as there exist dissimilarities of tax systems, it can lead to distortion of incomes and investments.


The term “treaty shopping” is thought to have originated in the United States. The analogy was drawn with the term “forum shopping”, which described the situation in US civil procedure whereby a litigant tried to “shop” between jurisdictions in which he expected a more favourable decision to be rendered. David Rosenbloom, who served as International Tax Counsel in the US Treasury Department during 1977-198 1, described the phenomenon as “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”. In other words, a person “shops” into an otherwise unavailable treaty through complicated structures; hence the term “treaty shopping”.


The term ‘Treaty Shopping’ has never featured in OECD and UN Model Treaties and their commentaries, but there has been a significant emphasis in eliminating treaty shopping through other measures. For example, references to the “problem commonly referred to as treaty-shopping” are made for the first time in the OECD Commentary on Art. 1, when discussing Limitation-of-Benefits (LOB) provisions and how these provisions are meant “to address the issue in a comprehensive way”. A description of treaty shopping is given indirectly and in very general terms. It is stated that LOB provisions are there to address treaty shopping. Then it is stated that LOB provisions are “aimed at preventing persons who are not residents of either Contracting States from accessing the benefits of a Convention through the use of an entity that would otherwise qualify as a resident of one of these States”.


If one looks at the quasi-definitions of treaty shopping, what one notes is that the term “treaty shopping”, as used, may encompass a broad spectrum of structures, ranging from the purely abusive and artificial ones to others with more substance. However, are all these instances of improper use of tax treaties? The OECD Commentary seems to perpetuate this confusion. The descriptions given in Paras. 9 and 20 of the OECD Commentary to Art. 1 would seem to catch general forms of treaty shopping; i.e. treaty shopping without tax haven or conduit connotations. However, the examples given in Para. 11 of the Commentary would seem to catch treaty shopping of a more specific and abusive nature; i.e. treaty shopping through conduits and/or base companies.


Does Treaty Shopping Begin where Tax Avoidance ends?

Tax avoidance is defined as the arrangement of one’s financial affairs to minimize tax liability within the ambit of law. Tax evasion on the other hand is defined to as the illegal non-payment or under payment of tax. Now the question arises, can tax avoidance be distinguished from tax evasion?


There is no imaginary line that distinguishes one from another. As the difference cannot be codified, these matters are evaluated by a competent authority based on the facts and circumstances of each case. This brings us to a very important question. Is Treaty Shopping tax avoidance or is it tax evasion? And it is when we raise this question that the already undiscernible line becomes even more blurred. What is it about treaty shopping that makes it an instance of the former rather than the latter? Why is it assumed that all forms of treaty shopping, irrespective of their degree of artificiality, constitute tax avoidance?


The term “treaty shopping”, applied generically, may encompass a variety of entities and forms of business. It will encompass legitimate businesses conducted with economic substance in a secondary state, as much as an intermediary company established as a conduit to capitalise on tax haven benefits. However, this is only one end of the spectrum. There is also the other end, where the intermediary company is a company with some substance, conducting its own trading activities, not controlled by the parent company and liable to some tax in the country of residence. It should always be remembered that an arrangement may be imbued with some economic substance that is not immediately apparent to the tax authorities. Therefore, it is clear that not all treaty shopping structures can be classified as one that is artificial or devoid of any economic substance. This is a discussion that is represented in India through the highly publicized Vodafone case. In Vodafone India Services Pvt Ltd. vs Union of India, the Appellant(Vodafone) had decided to enter into the India market to expand its global footprint, by buying Hutchison Essar. The company purchased shares of Hutchison Essar Cayman Island (which is a tax haven), which held Essar India’s shares. Therefore, in effect there was no transfer of Hutch India’s shares. Therefore, the sale of shares did not attract any capital gains tax in India. The Supreme Court ultimately decided that the entire transaction was within the four corners of law and hence not tax evasion.


Therefore, we can draw a conclusion from the recent high profile Vodafone case that the Supreme Court has recognised that this is a case of Treaty Shopping but the same does not amount to tax evasion; it is merely tax planning. The same was upheld in the Andhra Pradesh High Court in the case of Sanofi Pasteur Holdings SA.


Which State Has the Right to Tax?

While States strongly feel that Treaty Shopping is illegal and is a form of tax evasion, treaty shopping is, arguably, an instrument of international tax planning. But, what is it about this kind of tax planning that makes it objectionable? A number of arguments have been advanced in the international tax community. It has been argued that treaty shopping is an instance of tax avoidance and as such improper and contrary to the purposes of tax treaties. Secondly, it has also been argued that treaty shopping breaches the reciprocity of a treaty and alters the balance of concessions attained therein between the two contracting states. When a third-country resident “shops” into a treaty, then the treaty concessions are extended to a resident, whose state has not participated in this arrangement and may not reciprocate with corresponding benefits (e.g. exchange of information). The usual quid pro quo of the treaty is therefore compromised and the process subverted.


The Economic Allegiance Theory was first proposed by Georg Van Schnaz. The Theory is largely considered the bedrock for International Tax Theory and Administration. Van Schnaz argued that the resident (company or individual) owes significant responsibility and allegiance to the geographical State he does business in. The home state of the business provides resources, infrastructure, protection and domicile; due to the above reasons, they Resident ought to compensate the State through his/her allegiance to the State.


Furthermore, it is often claimed that treaty shopping creates a disincentive for countries to negotiate tax treaties. The general life of a tax treaty is a decade or more, due to the significantly long process that it is, from negotiation to finalisation. If third countries can get the benefits of reduced taxation for their residents without conferring reciprocal benefits to non-resident investors, then there is no need to enter into a tax treaty, especially if there are concerns that the tax treaty might be imbalanced. This may put countries which comply with their duties of fiscal co-operation arising through tax treaties (e.g. exchange of information), at a competitive disadvantage internationally. Furthermore, lack of fiscal co-operation enhances opportunities for international tax evasion.


Double Taxation Avoidance:

The bedrock of taxation is the principle of Source and Residence. States normally follow residence taxation or source taxation or a mix of both. Disputes arise when residents of a State deal with one and another. While one State would follow Source Taxation, the other would follow Residence based taxation and this leads to double taxation. Double taxation exists in 2 forms:

  • Juridical Double Taxation: Where the same income is taxed twice in the hands of the same tax payer in two different States
  • Economic Double Taxation: The same source of income is taxed twice but in the hands of difference payers. Eg: Profits of the company are taxed and later the dividend income is taxed in the hands of the shareholder

The aim of International Taxation is to mitigate Juridical Double Taxation to the extent possible. However, economic taxation is normally considered to be acceptable.


As detailed above, the most common form of double taxation is juridical double taxation and this happens due to existence of two different tax systems in either State. The dispute in claim over taxation is normally settled through Double Tax Avoidance Treaties that are entered into by the States. The Treaty, usually based on the OECD or UN Models, consists of 32 Articles detailing the treatment of income and taxation of incomes of various types, collection and enforcement of taxes.


The Double Taxation Avoidance Agreements(DTAAs) play a significant role in mitigating double taxation. While this is so, DTAAs are bilateral in nature; which means they are entered into between 2 countries taking cognizance of the economic and tax conditions and systems prevailing in either state and the expectant impact of the same on the treaty. Hence, each Treaty is very specific to either State; but does not consider a 3rd State, unless it is multilateral in nature. The very bilateral nature of DTAAs lends itself in presenting opportunities to derive tax advantages by a resident of a 3rd State operating with another DTAA (with either State) or no DTAA at all.


How to Mitigate Tax Avoidance – Limitation of Benefits:

With the increasing trend of entities using the DTAAs to their benefit, to avoid taxes as detailed above, the nature and scope of DTAAs has been made wider. While originally envisaged for avoid double taxation, one of the critical roles played by DTAAs today is avoidance of double NON-Taxation.


The Limitation of Benefits Article was originally introduced by the US, in the US Model Treaty, and every DTAA negotiated by the US includes this article. The importance of the Limitation of Benefits, or LOB, lies in its expansive nature. The Article is an anti-abuse rule which empowers the Revenue Authorities of the USA to deny the treaty benefits to a resident that is merely a conduit to obtain benefits of the treaty.


This Article is however, not present in the OECD or UN Model Treaty. Hence, countries which adopted these Model Treaties would have to voluntarily include the same, which isn’t done commonly. This lack of LOB clauses presented legal challenges in bringing to tax transactions which are in the nature of avoidance of tax but are still within the 4 corners of the law. This trend has been increasingly over time which has led to BEPS Committee formulating an action plan to address Treaty Abuse.


Action Plan 6 of the BEPS does exactly that. The Action Plan to Prevent Treaty Abuse is targeted at the strategy of establishing companies in States with desirable tax treaties that are often qualified as “letterboxes” “shell companies” or “conduits” because these companies exist on paper but have no or hardly any substance in reality. The Action Plan, though not binding unless adopted, proposes that States should first include in their title and preamble of the DTAA, a clear statement that the States that enter into a tax treaty intend to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping. Second, countries will implement this common intention by including in their treaties: requires

  • A combination of a “limitation-on-benefits” rule (LOB, which is a specific anti-abuse rule) and of a “principal purpose test” rule (PPT, a general anti-abuse rule);
  • The inclusion of the PPT rule, or
  • The inclusion of the LOB rule supplemented by a mechanism that deals with conduit arrangements, such as a restricted PPT rule applicable to conduit financing arrangements in which an entity otherwise entitled to treaty benefits acts as a conduit for payments to third-country investors


Therefore, the Limitation of Benefits article acts as a tool that enables the revenue authorities to look beyond the façade of an entity and look into the substance and not merely the form of the entity. Much like Corporate Law, Limitation of Benefits provides the law-maker a device to lift the corporate veil of the entity and look into the purpose, objects and history of the entity in question. LOB will be the single most powerful rule that can be used by revenue authorities to reduce treaty abuse through conduits.


Should Treaty Shopping Be Allowed:

Treaty Shopping presumes that there is an overall economic and revenue loss to the affected States. It could be argued that when treaty shopping increases economic activity, the overall economic gain might exceed source-country tax losses. This begs the question. When does treaty shopping increase economic activity and when does it not? Does it depend on whether the source country is a developing country? For example, in Union of India v. Azadi Bachao Andolan, the Supreme Court refused to imply an anti-treaty-shopping clause in the India-Mauritius tax treaty.


In the judgment, the Supreme Court emphasized that in developing countries, treaty shopping was often regarded as a tax incentive to attract scarce foreign capital or technology. “Developing countries need foreign investments, and the treaty shopping opportunities can be an additional factor to attract them”. Countries had to take a holistic view. “The developing countries allow treaty shopping to encourage capital and technology inflows, which developed countries are keen to provide to them. The loss of tax revenues could be insignificant compared to the other non-tax benefits to their economy. Many of them do not appear to be too concerned unless the revenue losses are significant compared to the other tax and non-tax benefits from the treaty, or the treaty shopping leads to other tax abuses.” Treaty shopping may be a necessary evil, tolerated in a developing economy, in the interest of long-term development.


Another important element to consider in the elimination of treaty shopping, is the purpose of DTAAs itself. The ultimate objective of avoiding double taxation or double non-taxation itself is neutralising the differences in global tax rates. The goals of a universal tax rate can be considered a pipe dream. As explained earlier, the tax rates of any country are linked to its economic condition and prevailing market situation. Therefore, as resources of the world are unevenly distributed, it is almost impossible that one can expect the tax rates between 3 countries to be the same, let alone across all countries in the world. Absent a truly neutral tax system, it is difficult to assess any distortions caused by treaty shopping. In fact, it could be argued that the inherent non-neutralities of tax systems create an incentive to treaty shop. In other words, the very existence of treaties itself lends itself to Treaty Shopping. Treaty shopping is perhaps a self-help way of lessening or removing fiscal impediments to international business imposed by the inadequate relief of international double taxation and the incomplete nature of the treaty network.


Therefore, we can establish that inadequate definitions and theoretical objections which are detached from reality.



The arguments for Treaty Shopping from an objective and legal point of view point to the direction that supports the revenue, that Treaty Shopping is abusive in nature and lends itself to cheating the revenue of its dues. However, as seen above, the rationale that double taxation weakens countries ability to tax income by encouraging shifting income from domestic to cross-border countries maybe right, however it fails to taken into consideration the economic benefits accruing to the Residence State. Therefore, Treaty Shopping while from the perspective of the Source State is abusive in nature, for a Residence State (most likely a developing country) has significant economic benefits.


Further, considering the ultimate goal of tax neutrality is a pipe dream and is impossible to achieve, the existence of globally different tax regimes will stay, as will Bilateral Treaties, Treaty Shopping looks like a phenomenon that is set to stay.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s