Tax Treaty Series

ITQ T-

109

November 19, 2021

Question

XCo, a company resident in X, owns 100% of the shares in X Sub, another company resident in X.

X Sub owns 100% of the shares in YCo, a company resident in Y. YCo operates a very profitable business in Y, but it owns very little real estate in Y.

X Sub is a pure holding company, which was established by XCo to hold the shares in YCo – those shares in YCo were acquired by X Sub from third parties many years ago. X Sub has no other assets, and it has no employees or business premises.

XCo now sells 100% of the shares in X Sub to a third party purchaser, and derives a significant profit on the sale.

The X/Y treaty is identical to the 2011 UN model treaty. The MLI does not apply to the X/Y treaty.

The Y domestic tax law contains a GAAR provision. Applying that GAAR, the Y tax authorities disregard X Sub's existence (on the basis that it lacks substance), and treats XCo as owning and selling the shares in YCo – which causes XCo to derive a taxable capital gain under Y tax law.

Under the Y law, treaties have superior force over domestic law (including GAAR).

Does the X/Y treaty allow the Y tax authorities to levy tax on XCo in regard to the taxable capital gain which (they say) XCo derives?

Answer

Art. 13

If the actual facts are respected (i.e., X Sub, not XCo, owns and sells the shares in YCo), none of Art. 13(1)-(5) would apply. Thus, Art. 13(6) would provide XCo with an exemption from Y tax.

If, however, XCo is treated as the owner and seller of the shares in YCo, Art. 13(5) would allow Y to tax XCo on the gain it derives.

GAAR / Treaty abuse

As treaties have superior force over Y domestic law (including GAAR), it might be thought that the Y tax authorities would not be permitted to apply GAAR to change the facts, by disregarding X Sub's existence.

However, the 2011 UN Comm. on Art. 1 would allow that to occur if the use of X Sub is considered to be an "abuse" of the treaty: see paras. 20-27, and 38-39. At paras. 25 & 27, the Comm. states that 2 elements must be present for transactions or arrangements to be found to be an abuse of the treaty: (1) a main purpose (determined objectively, based on all relevant facts and circumstances) for entering into the transactions or arrangements was to secure a more favourable tax outcome; and (2) obtaining that more favourable treatment would be contrary to the object and purpose of the relevant provisions. [Yes, this is very similar to the PPT!]

Applying those 2 elements to this case:

Element (1): The fact that X Sub lacks substance is suggestive that this structure was put in place to allow Art. 13(6) to apply on eventual sale. However, it is possible that the use of X Sub could be explained for non-tax reasons – e.g., (a) to enable a sale of YCo without requiring approval from Y regulatory authorities; and/or (b) to protect XCo from non-tax legal liabilities in Y. Such possible reasons would need to be investigated, to determine whether they are credible or not.

Element (2): The scope of the "second limb" in the PPT is very difficult to identify. However, if the result in element (1) is that a main purpose of the use of X Sub was to allow Art. 13(6) to apply on eventual sale, it is likely that that would be considered to be contrary to the object and purpose of the relevant provisions.

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