Tax Treaty and General Anti-Avoidance Rules Override (Published in Westlaw Asia Law Review Article Citation: [2020] LR 389)

2020
Article
Tax Treaty and General Anti-Avoidance Rules Override

Dr Benjamin Poh
2020

Citation: [2020] LR 389
Tax Treaty and General Anti-Avoidance Rules Override

Abstract

This article analyses tax treaty-making power, its legal effect and interpretation challenge facing the court, in relation to tax treaty override and its relationship with the domestic anti-abuse tax rules. The author discusses why it is conceptually difficult to resolve tax treaty abuse with the approaches advocated by the Organisation for Economic Co-operation and Development ( “ OECD ”) Commentary without a coherent and harmonised constitutional and legal system in different countries. Lastly, the author cites the Indian Supreme Court’s views on tax treaty abuses, with the author’s opinions on the aspects of tax reforms that the Malaysian government should focus on, in response to the recent OECD Base Erosion and Profit Shifting (“BEPS”) project.

Introduction

A country may override its tax treaty obligations in response to tax treaty abuse, by passing new tax legislations or creative judicial interpretation, to close whatever tax loopholes found in its tax treaty. However, tax treaty override by a contracting state may create adverse consequences to taxpayers of the other contracting state, and destabilise international trade and investment, even though the main objective of the override is to preserve revenue of a country. Despite the adverse consequences, countries such as the UK, Australia, Canada and India, have increasingly used their statutory general anti-avoidance rules (“GAAR”) or specific anti-avoidance rules (“ SAAR ”) to override tax treaty provisions when conflicts arise between the anti-avoidance rules and the provisions of tax treaty. In Part I, the author will analyse the tax treaty-making power in Malaysia and its legal effect under the Income Tax Act, 1967 ( “ITA 1967 ”). In Part II, the author will discuss the interaction of domestic tax laws and tax treaty in Malaysia, and in some of the civil and common law countries. In Part III, the author will discuss some case precedents on tax treaty override in the UK and Australia. In Part IV, the *390 author will discuss briefly, the interaction between GAAR and tax treaty in different countries, and the OECD’s views on conflicts between GAAR and tax treaty provisions. In conclusion, the author cites the Indian Supreme Court ’s view on tax treaty abuses and provides his views on aspects of tax reforms that the Malaysian government should focus on, in response to the recent OECD BEPS project.

Part I: Tax treaty law-making power

Article 74(1) of the Malaysian Federal Constitution (“Constitution”) provides Parliament with the power to: (a) make treaties, agreements and conventions with other countries and all matters which bring the Federation into relations with any other country; (b) implement treaties, agreements and conventions with other countries. Article 76(1) of the Constitution requires Parliament to enact legislation to give legal effect to the international treaties and law signed with other states or countries. Nevertheless, Parliament does not negotiate and conclude treaties. Instead, the power of negotiating and concluding treaties rests with the federal government of Malaysia.

There is no specific provision in the Constitution to empower the federal government of Malaysia to enter into treaties with another state or country. Conventionally, it is the federal government of Malaysia that executes and signs international treaties with the other states to bind the country to its international treaty obligations under international law. As a common law country, Malaysia ’s practice of international treaties and law making is similar to that of the UK’s practice. For the UK, the treaty-making power is the prerogative power of the Crown, i.e. the Executive. In Blackburn v Attorney General ,¹ Lord Denning MR said, “ The treaty making power rests … in the Crown; that is, Her Majesty acting on the advice of her Minister. When her Ministers negotiate and sign a treaty … they act on behalf of the country as a whole. They exercise the prerogative of the Crown” .

In Malaysia, the legal effects of a tax treaty are governed by s 132 of the ITA 1967 on double taxation agreements (“DTA”), s 132A of the ITA 1967 on tax information exchange agreements (“TIEA”), and s 132B of the ITA 1967 on mutual administrative assistance arrangements ( “ MAAA ”). Section 132 on DTA is reproduced as follows:

132. Double taxation arrangements.

Part II: Interaction of domestic tax law and tax treaty

A treaty is based on the consent of the parties to it, is binding, and must be executed in good faith. The concept known as pacta sunt servanda (“agreements must be kept”) is arguably the oldest principle of international law as envisaged by Article 26 of the Vienna Convention on the Law of Treaties (“VCLT”). In the context of tax treaties, this principle of international law is legally recognised and implemented in Malaysia through s 132(1)(b) of the ITA 1967, “… those arrangements shall have effect in relation to tax or other taxes of every kind under any written law notwithstanding anything in any written law ”. This establishes the supremacy of tax treaties over domestic tax legislations.

In the UK, under s 6 of the Taxation (International and Other Provisions) Act 2010 (“TIPOA”), tax treaties have enjoyed similar supremacy over domestic tax legislations and the provisions of tax treaties shall take effect “ despite anything in any Enactment ”. In Australia, tax treaties concluded with other states are recognised under the International Tax Agreements Act 1953 (“ITAA 1953”) and according to paragraph 2 of s 4 of the ITAA 1953, tax treaties take precedence over domestic tax laws if any conflicts were to arise. Similarly, in Singapore, under s 49 of the Income Tax Act 1948, double taxation arrangements shall have effect “ notwithstanding anything in any written law”. However, in the USA, treaty law is of equal status to domestic legislation, and in the event of conflict, the “later-in-time” legislation is binding.² In civil law countries in Europe, international treaties or laws are always given priority over domestic laws. In France, Article 55 of the French Constitution provides that a treaty has priority over general laws upon its proclamation. The Japanese civil system which borrows heavily from the French tradition, also gives a treaty priority over its domestic law. Article 5 of the Swiss Constitution provides that international law has priority over domestic law.³

The supremacy of tax treaties over domestic tax legislations in the event of conflicts is well recognised in most of the common law and civil law countries, especially if the tax treaty was signed and dated after the tax legislations. However, tax treaty law is similar to any other piece of law and can be overridden, if Parliament were to pass a new tax legislation with a clear intention to override the existing tax treaty provisions, whether the tax *392 legislation was passed before or after the tax treaty provisions. In Part III, the author will discuss two case precedents in the UK and Australia, in which the courts were of the view that tax treaty override is necessary to protect the country’s revenue laws from gross abuse.

Part III: Tax treaty override

Treaty override is against the principle of “ pacta sunt servanda ” incorporated in the Vienna Convention under Article 27 which states that “ a party may not invoke the provisions of its internal law as justification for its failure to perform a treaty ”. The ramifications of treaty override could be serious, as the fundamental rights of private residents in any of the contracting states are likely to be violated without proper remedies, even though the DTA has a Mutual Agreement Procedure (“MAP”) to resolve treaty violation issues.

However, courts are more willing to invoke treaty override when it comes to the issue of specific treaty abuse by way of statutory interpretation. In IRC v Collco Dealings Ltd ,⁴ a UK case concerning the DTA between the UK and Ireland in the year 1962 on dividend stripping abuse, where specific domestic anti-tax avoidance legislation had been passed in the year 1955 to prevent similar abuse, the issue was whether this specific anti-avoidance tax legislation passed in the year 1955 can override the provisions in the DTA signed in the year 1962 Lord Viscount Simonds adopted the view in Maxwell on the Interpretation of Statutes⁵ and said, “ But if the Statute is unambiguous, its provisions must be followed, even if they are contrary to international law ”, and his Lordship continued, “… neither comity nor rule of international law can be invoked to prevent a sovereign state from taking what steps it think fit to protect its own revenue law from gross abuse or to save its own citizens from unjust discrimination in favour of foreigners. To demand that the plain words of the statute should be disregarded in order to do that very thing is an extravagance to which this House will not, I hope, give here ”.

Lord Reed however, took a different ground and said:

There is by no means so strong a presumption against Parliament having done that. Although the infringement of a treaty may cause loss to individuals, the only person properly entitled to complain of such infringement is the other party to the treaty. No doubt if that other party is aggrieved, the infringement is a breach of the comity of nations and there is presumption that Parliament did not intend to act contrary to the comity of nations, but I do not think that there is necessarily a presumption that every infringement of a treaty is a breach of the comity of nations. After a treaty has been made, circumstances may alter and it may be reasonable to take unilateral action in the expectation that the other party to the treaty will not object. Indeed, the other party may have been consulted and have raised no objection.

*393 The UK Parliament had on numerous occasions, unilaterally overridden its tax treaties’ obligations by amending its tax statutes. Such instances include s 59(1) of the Income and Corporation Taxes Act 1988 on exclusion of the UK residents from benefiting from provisions of article 7 of the OECD Model Convention; s 808B alters the meaning of “special relationship” not supported by tax treaties; s 812 on withdrawing rights to obtain repayment of tax credits under tax treaties; s 858 on dis-apply treaties on income and capital gains of the UK resident partner.⁶

In Lamesa Holding BV v Commissioner of Taxation ,⁷ an Australian case concerning profits that were generated by Lamesa Holdings BV, a non resident company based in the Netherlands, on the sale of shares in Australian Resources Ltd ( “ ARL “), ARL held all the shares of another Australian company, Australian Resources Mining Pty Limited, which in turn held all the shares in a Queensland company, Arimco Resources and Mining Company Limited. A subsidiary of Arimco, Arimco Mining Pty Limited, owned some gold mining leases in New South Wales. The full Federal Court held that the Australian government could not invoke Article 13 of the Australia/Netherlands Double Taxation Agreement to tax a capital gain made through the indirect alienation of real property that was held by a non-resident through a chain of companies. Dissatisfied with the court’s decision, the Australian government later enacted s 3A (Alienation of real property through interposed entities) under the International Tax Agreement Act 1953 to override the existing Australia/Netherlands tax treaty provisions, to allow the government to look through every level of companies, to tax capital gains on disposal of shares in a real property company.

Notwithstanding the above, the OECD was of the view that frequent tax treaty override due to tax treaty abuse will erode confidence of international tax treaty network with adverse consequences on international trade and investment:

The committee has considered the arguments that might be put forward to defend the use of overriding legislation and recognised that in a number of cases the legitimacy of the objective pursued, in particular where they aim at counteracting abuse of conventions is well founded but the Committee remains strongly opposed to overriding legislation. Member countries have so far refrained from taking retaliatory measures (which all agree would not be conducive to better understanding in the international tax field) against overriding legislation but the Committee noted that there is growing dissatisfaction with the continued use of such legislation which could erode confidence in the international tax treaty network as a whole.

*394 Instead of unilaterally overriding a tax treaty which has adverse consequences on their people and businesses, the governments of the contracting states should renegotiate the existing tax treaty with new tax avoidance clauses inserted, or resort to MAP and subsequently to tax treaty arbitration if no resolution is found. The governments should also extend a concession period to their taxpayers who had settled or planned their arrangements according to the tax treaty provisions between the states.

Part IV: GAAR versus tax treaty

The court is more likely to invoke treaty override if tax treaty is misused by taxpayers to achieve certain tax advantages via treaty shopping. In addition, a country can enact a statutory GAAR to override tax treaty provisions, in the event of conflicts. According to an Ernst & Young⁸ 2013 survey, out of 24 countries, approximately half allow their statutory GAAR to override existing tax treaties, either by overriding the treaty unilaterally or by agreeing in the treaty to allow the application of domestic GAAR. Countries which allow statutory GAAR to override tax treaty provisions include the UK, Australia, India, France, Germany, Sweden and Switzerland. Furthermore, countries around the world have started to include tax avoidance clauses to preserve the application of their domestic GAAR in tax treaties. Following are examples of 2011 to 2012 tax treaties containing specific reference to the application of domestic anti-avoidance rules:⁹

2011 – Barbados* – Czech Republic tax treaty
2011 – Ethiopia – Egypt tax treaty
2011 – United Arab Emirates – Estonia tax treaty
2011 – India – Ethiopia tax treaty
2011 – Cyprus – Germany tax treaty
2011 – Hungary – Germany tax treaty
2011 – Mauritius – Germany tax treaty
2011 – Spain – Germany tax treaty
2011 – Turkey – Germany tax treaty
2011 – Taiwan – Germany tax treaty
2011 – Malta – Hong Kong tax treaty
2011 – Portugal – Hong Kong tax treaty
*395 2011 – Spain – Hong Kong tax treaty
2011 – Switzerland – Hong Kong tax treaty
2011 – Estonia – India tax treaty
2011 – Tanzania – India tax treaty
2011 – Malta – Israel tax treaty
2011 – Spain – Singapore tax treaty
2012 – Colombia* – Czech Republic tax treaty
2012 – Ireland – Germany tax treaty
2012 – The Netherlands – Germany tax treaty
2012 – Czech Republic – Hong Kong tax treaty
2012 – Jersey – Hong Kong tax treaty

In addition to preserving the application of domestic GAAR, these treaties contain a general treaty anti-avoidance rule. However, certain countries like Malaysia, Singapore, New Zealand do not have a GAAR override provision incorporated into some of their tax treaties or domestic tax legislations. This could present interpretation challenges to their courts on how to reconcile the scope of GAAR and the tax treaties, so as to keep to its international treaty obligations and at the same time to preserve national revenue from being eroded due to tax treaty abuse. For this, the author refers to the OECD Model Convention Commentary ( “ Commentary ”) on Article 1, paragraph 9.1 on the relationship between tax treaty abuse and GAAR, which raises two fundamental questions:

(1) Whether the benefits of tax conventions must be granted when transactions that constitute an abuse of the provisions of these conventions are entered into; and

(2) Whether there are specific provisions and jurisprudential rules of the domestic law of a contracting state that are intended to prevent tax abuse conflict with tax conventions.

Two conceptual approaches are advocated by OECD to resolve these two fundamental questions. The first approach is found in paragraph 9.2 which states that the answer to the first question above is based on the answer to the second question. The Commentary states that ultimately it is the contracting state that exercises its taxing power based on domestic tax laws, as restricted by treaty law, after analysing the facts of each case giving rise to tax liability. Since these anti-avoidance rules are not addressed in tax treaty, any abuse of tax treaty could also be characterised as an abuse of domestic tax laws. *396 Therefore, the Commentary noted in paragraph 22.1, as a general rule, there will be no conflict between the domestic tax rules and the tax treaty. In paragraph 9.3, the Commentary goes on to state the second approach: abuse of tax treaty is opposed to abuse of domestic tax law, by proper interpretation of the tax treaty with its object and purpose in mind, the abusive transaction can be disregarded if the transaction was entered with the view to obtaining unintended benefits under the tax treaty provisions. In paragraph 9.5, the Commentary provides a guiding principle on the issue of tax treaty abuse: “ The benefits of a double taxation convention should not be available where a main purpose (“main purpose test ”) for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions”.

In other words, if a country does not have clear tax treaty provisions to prevent treaty abuse or a clear statutory GAAR to override tax treaty abuse, then it has two resolutions to resolve tax treaty abuse:

(1) If the tax treaty did not have a tax avoidance provision to prevent treaty abuse, then the court may refer to the domestic GAAR to see whether the facts of each case giving rise to tax liability, allow the taxpayers to obtain the tax advantages from utilising the tax treaty. If the answer is yes, then treaty benefits should be granted to the taxpayers, otherwise it is considered as an abuse of domestic GAAR; or
(2) The court may resort to tax treaty interpretation without referring to the domestic GAAR. By proper interpretation of the tax treaty with its object and purpose in mind, the abusive transaction can be disregarded if the transaction was entered with the view to obtaining unintended benefits under the tax treaty provisions.

The first resolution is based on the assumption that the domestic GAAR is consistent with the Commentary’s guiding principle – the main purpose test. In Singapore, domestic GAAR can be found in s 33 of the Income Tax Act 1948 which provides for the main purpose test in s 33(3)(b). In New Zealand, domestic GAAR can be found in subpart BG of the Income Tax Act, 2007 which provides “ … tax avoidance or effect is not merely incidental ”, in other words, the tax avoidance is the main purpose. However, in Malaysia, domestic GAAR under s 140(1) of the ITA 1967 does not clearly provide for the main purpose test, though the section makes it clear that “ any transaction has direct or indirect effect of … ” and that could mean that Parliament had intended that any transaction implemented mainly for tax purposes, may be *397 considered as tax avoidance under s140. Having said that, the GAAR cases¹⁰ decided in Malaysia, have adopted the “main purpose test” to assess any tax avoidance plan in practice.

The assumption for the second resolution is that by resorting to the object and purpose of tax treaty provisions, the court may discern whether the use of tax treaty to obtain tax advantages was abusive. This assumption may be unrealistic given that certain legal terms used in tax treaties and the Commentary still could not achieve consensus amongst OECD countries today. For instance, the term “beneficial ownership” used in tax treaties is found nowhere in the civil law system, whereas in the common law system, one may think it is equivalent to equitable ownership under trust law, but this may not be entirely correct, otherwise trustees will not be given treaty protection by the Commentaries, when they received passive income such as dividend or interest with favourable withholding tax rates. This flawed assumption has led to a number of high-profile cases being litigated on the concept of “beneficial ownership ”, such as Indofood International Finance Ltd v JP Morgan Chase Bank NA London ,¹¹ Canada v Prévost Car Inc¹² and Velcro Canada Inc v Canada.¹³ In addition, knowing the object and purpose of tax treaty provisions are almost impossible in practice, as most of the treaty negotiation processes are performed behind closed doors without public consultation and announcement. Conclusion Tax treaty abuse is not acceptable to some developed countries with significant loss of revenues through BEPS strategies employed by multinational enterprises, especially during the times of financial crisis. Nevertheless, not every country is concerned about BEPS, especially the developing countries. The India Supreme Court’s views in Union of India v Azadi Bachao Andolan¹⁴ which concerns the India-Mauritius tax treaty abuse, is interesting for developing countries to take note:

Overall, countries need to take, and do 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 other non-tax benefits to their economy. Many of them do not appear too much concerned unless the *398 revenue losses are significant compared to other tax and non-tax benefits from the treaty, or the shopping leads to other tax abuse.
…
There are many principles in fiscal economy which, though at first blush might appear to be civil, are tolerated in a developing economy, in the interest of long-term development. Deficit financing, for example, is one; treaty shopping, in our view, is another. Despite the sound and fury of the respondents over the so called “abuse” of “ treaty shopping”, perhaps, it may have been intended at the time when the Indo-Mauritius DTAC was entered into. Whether it should continue, and, if so, for how long, is a matter which is best left to the discretion of the executive as it is dependent upon several economic and political considerations. This court cannot judge the legality of treaty shopping merely because one section of thought considers it improper. A holistic view has to be taken to adjudge what is perhaps regarded in contemporary thinking as a necessary evil in a developing economy.

The author believes that the Malaysian government should take a holistic approach to its international tax policy according to its economic, social and political needs. First, it should review its existing tax treaties signed with its trading partners, to assess whether the object and purpose of these treaties are still in line with its key industries and international trade and investment requirements. The Malaysian government should formulate its tax treaty policy and negotiation model, instead of just copying the Model Convention proposed by the OECD or the United Nations. Countries like Australia, Singapore and the US have taken a holistic approach to their tax treaty policy and negotiation models. Secondly, the Malaysian government should review its existing GAAR, to assess whether the GAAR is in line with the international trade and investment environment. The government should clarify the circumstances when GAAR may be invoked and provide a safe harbour for certain legitimate tax planning. A similar approach has been taken by countries like the UK¹⁵ and India,¹⁶ which recently enacted their statutory GAAR and appointed an independent GAAR Advisory Panel working along with the Revenue to monitor the invocation of GAAR. Lastly, the government should review the interaction of GAAR and tax treaty provisions, to assess whether it is in line with its domestic circumstances, trading partners’ tax provisions and international tax laws. This is to minimise the adverse consequences of tax treaty override and to prevent significant loss of the country’s revenue as a result of deliberate tax treaty abuse.

*389 Tax Treaty and General Anti-Avoidance Rules Override

*. Advocate and Solicitor, High Court of Malaya, specialising in tax and commercial litigation and private wealth advisory. He is a Chartered Accountant of Singapore and Malaysia, CFA Charterholder, RICS Chartered Surveyor and Fellow of Chartered Tax Institute Malaysia. He holds a PhD in Tax Law from Washington School of Law, MBA (with Merit) degree from Manchester University and LLB (Hons) from London University. The author can be contacted at pcslegal.group@gmail.com. The above article has been revised and was initially published by the Chartered Tax Institute of Malaysia in its flagship magazine, Tax Guardian Vol 8/No. 3/2015/Q3 Issue.

1. [1971] All ER 1380.
2. Ibid, para [45].
3. Sung-Soo Han, “The Harmonization of Tax Treaties and Domestic Law” (2011) 7(2) Brigham Young University International Law and Management Review 44.
4. [1961] 39 TC 509.
5. 10th edn (Sweet & Maxwell, 1953), pp 143 and 149.
6. Padmore v IRC [1987] STC 36.
7. [1999] FCA 612.
8. Ernst & Young, GAAR Rising: Mapping Tax Enforcement’s Evolution (February 2013), p 19.
9. Ibid.
10. Newton v Commissioner of Taxation [1958] AC 450, LD Timber v Director General of Inland Revenue 1978 1 MLJ 203, SBP Sdn Bhd v Director General of Inland Revenue (1988) 1 MSTC 2,053, Syarikat Ibraco-Peremba Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri [2017] AMTC 69; [2014] 1 LNS 605, CA.
11. EWCA, March 22, 2006.
12. FCA/CAF, February 26, 2009.
13. Tax CC/CCI, February 24, 2012.
14. (2003) 263 ITR 607, SC (India).
15. Ernst & Young, GAAR Rising: Mapping Tax Enforcement’s Evolution (February 2013), p 83.
16. Ibid, at p 51.