On September 16, the OECD released its first Base Erosion and Profit Shifting (BEPS) recommendations to the OECD and G20 countries to combat tax avoidance by multinational enterprises (MNEs). The Explanatory Statement and related release included the first set of reports and recommendations to address seven of the action items in the BEPS plan, first announced in 2013. This bulletin focuses on the potential impact of one of the recommendations on private equity investments, hedge funds and managed asset structures.
Key goals to the BEPS project include the following:
- re-aligning taxation with economic activities and value creation;
- neutralizing hybrid mismatches;
- combating treaty shopping and other forms of treaty abuse;
- avoiding abusive use of transfer pricing rules in the key area of intangibles; and
- introducing country-by-country reporting to increase the information available to governments regarding the global allocation of profits, economic activity and taxation of MNEs.
Overall, the BEPS project is likely to have a significant impact on international business over the coming years. In particular, in combating treaty shopping, the proposals may impose additional tax and compliance burdens on private equity investments, hedge funds and managed asset structures.
Action 6 of the BEPS project aims at developing a model tax treaty provision to avoid treaty abuse. Canada recently delayed the implementation of its treaty shopping proposals from the 2013 Budget in favour of participating in the BEPS proposals. Thus, we anticipate that Canada will likely follow these proposals in formulating its own action plan.
The Explanatory Statement released today states that all countries have agreed that anti-treaty abuse provisions should be included in tax treaties. Accordingly, Action 6 states that its intention is to ensure that tax treaties contain sufficient safeguards to prevent treaty abuse and, in particular, treaty shopping. Tempering this broad intention, the Explanatory Statement states that:
It is also recognised that the work on treaty abuse may impact existing business structures and may reveal a need for improvements of existing policies in order not to hamper investments, trade and economic growth. For example, policy considerations will be addressed to make sure that these rules do not unduly impact collective investment vehicles (CIVs) and non-CIVs funds in cases where countries do not intend to deprive them of treaty benefits.
Action 6 specifies that further work will be necessary regarding the implementation of the minimum standard as it relates to CIVs and non-CIV funds. The proposals include model language for a limitation on benefits (LOB) provision, which includes a reference to CIVs, which are yet to be defined.
Many CIVs, including private equity funds, hedge funds and mutual funds, rely on entities located in tax-neutral jurisdictions to avoid an incidence of double taxation that would arise where residents of multiple jurisdictions are all investing through a single co-investment model.
The intention of such structures is to minimize the incremental tax that would be paid as a result of using a common legal structure in a single jurisdiction (such as a partnership, limited partnership, trust, corporation or co-ownership). In addition, many domestically tax-exempt entities including pension funds seek to invest through CIVs where it may be impractical for them to be investing directly into a foreign country. Such investors to not want to become subject to unnecessary additional taxation imposed by the collective nature of the investment compared to what may have been realized on a direct investment. It should be noted that under current rules, not every country provides the same benefits to investments by tax-exempt entities of other countries.
Action 6 recognizes that an LOB provision may not be appropriate for CIVs. The commentary suggests that the relief available will depend on how the treaty otherwise deals with CIVs (for example, how the domestic law taxes the entities including in the case of partnerships, and how partnerships with partners resident in a particular jurisdiction are taxed). Action 6 referred to certain features of CIVs as being potentially problematic—for example:
- the interests in the CIV are not publicly-traded (even though these interests are widely distributed);
- these interests are held by residents of third States;
- the distributions made by the CIV are deductible payments; and
- the CIV is used for investment purposes rather than for the “active conduct of a business”.
Action 6 encourages member states to consider the economic characteristics of the different types of CIVs used in their state, including the potential for treaty shopping. Member states may conclude that the tax treatment of CIVs does not pose a treaty shopping concern, and therefore decide to grant CIVs a specific entitlement to treaty benefits while at the same time exempting them from the LOB provision. Alternatively, member states may wish to tax such CIVs by granting treaty benefits only to the extent that beneficial interests are owned by eligible beneficiaries.
The implementation of Action 6 is likely to have a significant impact on the operational and reporting complexity of CIVs and their beneficiaries. We expect that treaty eligibility will be highly dependent upon tracing beneficial entitlements to investors (including having to keep records to do that). Moreover, funds may need to have appropriate terms that permit unequal sharing of any tax burden that arises from the proposals. Funds may want to consider changes to their constating documents and to their investment structures as these rules develop. The final report is due in September 2015 and interested parties will have the opportunity in the coming months to influence the policy implementation of these rules as they relate to CIVs.
To discuss these issues, please contact the author(s).
This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
For permission to republish this or any other publication, contact Janelle Weed.
© 2021 by Torys LLP.
All rights reserved.