International Tax Structuring for Holding Activities

10.1. Introduction
The use of holding companies for tax structuring purposes is a widely used technique
for MNEs to achieve one of their main goals, namely the minimization of their global tax
burden. Holding companies are set up for the main purpose of owning shares in other
companies and other types of assets such as debt and IP rights. The use of holding
companies is usually combined with other techniques facilitating financing and IP
activities.
There may be good business reasons for the interposition of a holding company for some
companies that are not tax related. However, many companies are using shell
companies for the mere purpose of optimizing their effective tax rate. The grey area in
between will cater to many different business models. There are notorious office
buildings which host up to a couple of thousand companies on paper, which are quite
obviously letter box companies or shell companies that do not even have employees.'
These extreme cases seem to be evidence of an unregulated past. In recent years, tax
authorities have increasingly challenged corporate structures based on different reasons,
all of which are somewhat related to the notion of sub-stance.
This chapter will first highlight the general characteristics of holding companies (section
10.2.), before considering commonly used tax planning strategies that involve the use
of holding companies (section 10.3.), Section 10.4. is dedicated to an analysis of different
substance requirements under domestic law and tax treaties which may impose limits to
such structuring
activities. Section 10.5. analyses selected measures included
in the BPS Action Plan which may impose further
limitations on -structuring with holding companies.

102. Genera' characteristics of holding companies

In its classic sense, a holding company is an entity
established with the primary business purpose of holding
investments in domestic or foreign subsidiaries. These
investments are usually the main if not the sole - assets of
a typical holding company, and its main activities are
generally limited to managing, controlling and financing
of these investments.' A holding structure combines the
advantages of economies of scale with those resulting
from structuring the organization as decentralized units.4
the decision as to whether to insert a holding company
does not have to be exclusively tax driven. The main
business reason for using holding companies is the
centralization of diverse participations in one single
company in order to facilitate their management and to
ensure better business results. This leads to a
decentralization of the management structure, which
generates many desired effects, such as:
synergy effects due to the higher power of supply and demand;

access to new capital sources;

 higher transparency of the company structure;
increased flexibility and neutrality compared with a parent company
with regard to its subsidiaries; and
reduction of control costs.'
A major legal incentive for using holding companies is the liability limita-
tion and the separation of risks.6 Further reasons include the use of holding::ii
companies as an acquisition vehicle and as an organizational form for
ventures.
10.2.1. Legal forms
As the notion of "holding company" does not refer to a
particular legal form, different types of vehicles can be
chosen to carry out the functions of a holding company.
The most suitable form will depend on the circumstances
of each individual situation and the particular aims
pursued. The individual choice will be influenced by
various factors such as the capital structure of a group:
finance and liability considerations; accounting; auditing;
and tax law considerations at the level of both the
company and the shareholders.

Corporate entities, such as stock companies and limited liability companies,

are most commonly used as holding companies. Generally, these types of
entities offer the advantage of a limited liability for the shareholders. in
addition, compared to partnerships, such entities have the advantage that
they are less likely to be affected by changes in the shareholder structure,
and therefore guarantee more stability. A decisive difference compared to
partnerships is that corporate. Entities generally are able to benefit from tax
treaties, provided that they are resident in one of the contracting states,
while partnerships usually do not qualify for tax treaty benefits.

Partnerships, however, may be more beneficial in circumstances where plan-

ning structures involve the use of different taxation and classification of
partnerships in international tax law. The fact that partnerships are treated
differently by countries, as either fiscally transparent or opaque, provides the
basis for various tax structuring opportunities involving hybrid entities)
Thus, depending on the particular circumstances, especially if different
planning strategies are combined, the use of a partnership as the holding company
may be more suitable than the use of a corporate entity.

A PE can also function as a holding company, provided that the participa-

tions bed by the PE can be properly attributed to it. For this purpose, the
participations must be actively managed and controlled by the personnel
of the PE. A factual and functional analysis of the PE must show that cor-
responding significant people functions are carried out at the PE level. The
benefit of using a PE as a holding company basically results in the conver-
.

sion of dividend income (normally subject to withholding tax) into business

profits (usually not subject to withholding tax)."
10.2.2. Types

There are different ways in which holding companies can be used. Holding
companies can be classified with regard to their main purpose, depending
on their task and functions, or according to their position within a group of
companies. Here, the term "management holding company" is often used.
A management holding company would be referred to if a company were in
charge of all strategic decisions and to some extent also of the operating
decisions. Such a holding company would actively coordinate the business
of the whole group of companies and define the overall strategy of it.'2

Another type is the finance holding company, which refers to a holding

company that is mainly used to provide financial services to all members of
the group. Compared to a management holding company, a finance holding
company is not involved in strategic decisions for the group, but will be in
charge of the group's cash management. A finance holding company will
usually be in the position to achieve more beneficial conditions for funding
or credit activities compared to a single company in a group.'3

Further classifications that are commonly used are country holding com-
panies and regional-holding companies. White a single country holding
company would be used to collect all income derived by group subsidiaries
situated in the same country, a regional holding company would fulfill this
purpose on a wider level for an entire region or continent. Furthermore,
holding companies are often interposed between the ultimate parent com-
pany and other regional or specific holding companies in order to perform
certain managerial functions, for which the term "intermediate holding
company" is often used.'''

10.3. Planning strategies and key criteria for holding

locations
The establishment of a holding company creates an additional level of
taxation; this inherently involves the risk of double taxation. Due to the fact that
groups of companies are not taxed as a single entity, an additional entity
such as a holding company might incur additional corporate income tax
and withholding taxes. Within a group, this can lead to cascade effects that
minimize the total amount of after-tax profit. For that reason, it must be the
prime goal of international tax structuring with holding companies to avoid-;
any incremental costs due to additional corporate income or withholding:
taxes. On the other band, the establishment of an additional company, i.e.
an intermediary holding, provides the general opportunity to purposefully
allocate i and expenses to different levels of the whale group."

There are two main strategies for using a holding company for tax structur-
ing activities. One is the use as a vehicle to repatriate profits to the parent
company by rerouting income, transforming income or temporarily defer-
ring income. The other strategy concentrates on the allocation of income
and expenses within a group of companies.' Depending on the direction of
the income transfer, a top-down or a bottom-up approach can be applied.
The latter refers to the transfer of income to a higher tier in the group, pos-
sibly by way of cross-border group relief. The transfer of income to a lower
tier under a top-down approach can be achieved by realizing capital gains
or losses, depreciation of participations or the transfer of expenses incurred
in connection with the acquisition of participations.

10.3, I Repatriation strategies

Within repatriation strategies, a holding company serves as an
additional entity that generates income, effectively creating
an additional level of taxation, Therefore, for these
strategies to be successful, and a holding company must be
established in a county where the company's income is taxed
only at a low level, or is even exempt from taxation and any
additional withholding tax levied on the income is less than
if the income were to be repatriated directly to the parent
company.
Re-routing of income
One alternative under repatriation strategies is to reroute the flow of in-
come, or to prolong the route, via an intermediary holding company. Here, a
main planning tool is to reduce the withholding tax on the income by either
 making use of applicable tax treaties or the EIJ Directives.2 This technique
is also referred to as treaty shopping or directive shopping.
Mete A A Co

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For example A Co, resident in Country A, has a wholly-owned subsidiary, C

Co in Country C. Assume that Country C levies a withholding tax of 25%
on dividends and that there is no tax treaty between Country A and Country
C. However, there are tax treaties between Countries A and B and between
Countries B and C, which provide for a reduced withholding tax of 5% on
qualified participations of at least 10%. Compared to the withholding tax
burden of 2.5% if the dividends were to be paid directly from subsidiary C
Co to A Co, the tax burden could be reduced by rerouting the dividends via
a holding company established in Country B. The same principle applies
if there were to be tax treaties between all three countries involved, but
rerouting the income via Country B would be still more beneficial if the tax
treaty between Countries A and C were to provide for less favorable terms.

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Although holding companies are mainly user for business and legal reasons,
tax considerations have a major impact on the decision as to whether or not
a holding company is established in a particular country. Used in connection
with national and international tax regimes, holding company's main task
is to ease a functional tax detriment that is caused by the civil concept of
groups of companies. Groups of companies consist of legally independent
companies which are independently subject to taxation. This is not consis-
tent with the business perspective, which regards a group of companies as a
single economic unit. However, the legal fiction of independence leads to
the result that the sum of the taxes of all group companies added together
is higher than the taxes the group as a whole would pay. The reason for this
difference is the multiple recognition of the same economic circumstances.
A holding company can be used as a tool minimize or even eliminate this
detriment.

Tax reasons for using holding companies include the exemption from tax on
dividends received; the exemption on capital gains realized on the sale of
participations; a reduction of withholding taxes on dividend.; interest and
royalty payments; the use of tax treaties effective financing of participa-
tions; and the pooling of profits and losses.

A typical holding structure can be illustrated as follows:

ParentCo

Sub Co 'I Sub Co 2 Sat Co

Hoki Reck:nal Firience

HoldCo i-baltiCo
1
Op Co 1 Op Co 2 OpCo3 Op Co 4
Another example is the use of the EU Directives, e.g. the EU Parent-
Subsidiary Directive (2011/96), which provides for a 0% withholding tax
for qualifying distributions between companies within the EU. Assume
company, A Co, resident in a non-EU country, which wholly owns B
resident in EU Member State 1: C Co, resident in EU Member State 2; and D
Co, resident in EU Member State 3. For profit
distributions to country A, any domestic withholding tax
could be reduced under the applicable tax
treaties. However, A Co could benefit from interposing a regional holding
company, E Co, in EU Member State 4, which has a more beneficial tax
treaty with Country A compared to the other EU Member States mentioned
above, providing for a reduced withholding tax rate of 5%.

Transformarion of income
Another alternative under repatriation strategies is the transformation of
income when repatriating it to the ultimate parent company. Basically, the
income received by the holding company is transformed into a different
type of income before it is finally repatriated. A typical example for the
transformation of income in this context is the granting of loans, A loan
can be granted either by the ultimate parent company to an interposed hold-
ing company or by the latter to an operating subsidiary_ This planning tool
makes use of differences between national tax systems, to reduce withhold-
ing taxes or to shift income to low-tax jurisdictions.

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10.3.2. Allocation strategies

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intended to be an additional entity to reroute income, but is rather meant to
originally generate the income, Depending on the direction of the income
transfer, a bottom-up or top-down approach is applied.

Bottom-tip approach
In practice, holding companies are often used to bundle different economic
activities for tax purposes for example to set off profits of one group entity against
losses of other group entities, By doing so, the effective tax burden of the
group companies involved can be reduced and the cash flow of the whole entire
of companies can he improved

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For example P Co. resident in Country I'', owns all of the shares in two sub-
sidiaries, namely Si Co resident in Country 5 and 52 Co resident in Country
X. While S1 Co is very profitable and has a significant amount of retained
earnings available, S2 Co is in a loss making situation. In order to optimize
the overall situation for the group, P Co could transfer its shareholding in
Si Co to 52 Co in return for newly issued shares. After the transaction is
carried out, S1 Co distributes a dividend to 52 Co, By doing so, the profits of
the profitable subsidiary are allocated to the level of the new "holding com-
pany here, 52 Co where the profits can be utilized more tax efficiently
either by being set off against losses or by using the profits at another level
of the group by way of granting a loan to another group member.
Allocating profits from the top unit of a group structure to a lower tier
holding company can result in tax advantages if the location of the hold-
ing company offers significant advantages regarding the taxation of profits
compared to the location of the ultimate parent. In this regard, the rules on
the taxation of capital gains or a current value depreciation of participations
are of particular importance.
For example P Co, resident in Country P, has four subsidiaries that are resi-
dent in four different countries. Assuming that in financially difficult times,
the subsidiaries are in a loss making situation and the laws of Country P do
not provide for the possibility of a current value depreciation of participa-
tions, P Co could consider interposing a wholly-owned holding company in
Country X, which in turn would hold the participations in the four subsidiar-
ies. Provided that the laws of Country X allow for current value depreciation
of participations, the overall benefits for the group would be significant. In
addition, if the financial situation of the subsidiaries is not likely to improve
in future, the rules on the taxation of capital gains may become relevant.
Depending on the domestic laws of Country X, it could be more beneficial
for the overall group if the interposed holding company were to sell the
participations instead of P Co selling the participations directly.

101.3. Key criteria for holding company locations

In order for all these strategies to be efficient, the right choice of a suit-
able holding company location is essential. A suitable holding company
circumstances of each specific case. There is likely no country that would
provide all the desired features of an ideal holding company location, but
due to the ongoing competition between countries in order to attract foreign
investment, there should be an ideal location for each individual situation,

In addition to tax-related criteria that influence the location of a holding

company, there is a variety of non-tax factors that influence the choice of
location for a holding company. Such factors include the political stability
of the foreign country; the presence of exchange controls or import quotas;
restrictions on foreign investment; the risk of property expropriation; the
availability of low-cost labour, the status of infrastructure; the presence of
stable banking facilities; and the general attitude towards foreigners within
the country in question.

10.4. Limits on tax structuring with holding companies

One of the most popular tax structuring techniques related to holding

companies is treaty shopping. In order to minimize the withholding tax
burden on profit distributions, distributions may be rerouted via an inter-
posed holding company situated in a country that has EL more beneficial tax
treaty, thereby resulting in lower withholding tax rates compared to the
situation where profits would be distributed directly to the ultimate recipi-
ent. Such holding companies often lack substance in the form of offices and
employees; as their main purpose is usually only to obtain treaty benefits.
From a taxpayer perspective, substance is not required in order to fulfill this
function and to achieve the desired effect.

Since the OECD presented its BEPS Action Plan," the importance of the
topic of substance has significantly increased. The ultimate goal of the
BEPS initiative is to prevent the granting of tax treaty benefits in the case
of international corporate structures which are set up only to enjoy the ben-
eficial terms of applicable tax treaties, In order to achieve this, the BEPS
initiative addresses a broad range of subjects, including anti-abuse measures
under domestic law and under tax treaties. Most of the suggested measures
relate, in one way or another, to the level of genuine economic activity of a
corporate structure or in other words to the notion of substance.
It is difficult to come up with a clear definition of the notion of substance. It is
easier to consider it as a threshold for the exclusion of non -acceptable cases, for
example in those instances where pure letter box companies are used to obtain tax
benefits. In any case, it is far from clear what conditions are actually required to
ascertain substance. It may depend on the business activity or purpose in question.
Considering the specific case of holding companies, th eir main business activity is
the holding of participations. In this regard, it is questionable as to what de gree of
substance is correspond ingly required.
Although the notion of substance is often used with reference to "economic"
substance, there is also a more formal approach to substance, also referred to as
"legal" substance. The latter refers to formal substance requirements in the form of
objective criteria or pre-determined thresholds which must be met in order to
comply with, and to benefit from, tax laws. Economic substance relates more to the
actual activity of a company and its effective role within an international operating
group of companies.
Domestic law and tax treaties provide for rules that require both forms of
substance in different ways. The notion of substance itself is defined in neither the
OECD Model (nor the UN Model) nor actual tax treaties. Nonetheless, the concept
of substance plays a role in the application of tax treaties: in terms of residence of
a company under article 4 of the OECD Model, in terms of the recipient of passive
income in the context of articles 10, 11 and 12 of the OECD Model, whe re the
beneficial owner may ben efit from reduced withholding tax rates or where tax
treaties contain either general or specific anti -abuse rules. When it comes to the
determination of residence under domestic law, economic substance may play a
role when determining the place of effectiv e management of a company. However,
if countries require merely for a company to be incorporated under domestic law in
order to be treated as a resident, it is an expression of a rather formal substance
requirement.
More insights are offered belo w into different substance requirements under
domestic law and tax treaties which are relevant in a holding company con -text.
Particular focus will be on (i) the substance requirements under domes -tic law as
imposed by general anti-abuse rules (GAARs) and transfer pricing rules, which both
relate more to economic substance and (ii) substance requirements under tax
treaties imposed by the requirements on residence and beneficial ownership which
relate more to legal substance.
In order to protect their tax ba ses, many countries provide for
GAARs, in the form of either a statutory provision or a judicially
developed anti-avoidance rule. While these rules differ, to some
extent, from country to country, there is a common element to
them, which can best be described as a substance-over-form
approach. The common element required for the ap plication of
GAARs appears to be a transaction or a set of transactions that is
solely or predominantly aimed at tax avoidance, and these
transactions violate the object and the p urpose of applicable tax
laws. The application of GAARs usually results in disregarding
the transactions as purported by the taxpayer and entails the
substitution of the valid legal construct by different facts that give
rise to the tax liability which would otherwise have been avoided
because of the structure chosen by the taxpayer.
An example for such regulations is the GAAR in Germany,
contained in section 42 of the General Tax Code
(Abgabenordnung, AO).The GAAR is applicable if an
inappropriate legal structure is chosen that leads to a tax
advantage for which the taxpayer cannot provide significant non -
tax reasons. A legal structure is considered inappropriate if the
taxpayer or a third party generates a tax benefit that is not
intended by the law. However, section 42 does not define the term
"inappropriate". Based on the jurisprudence of the German
Federal Tax Court (Bundesfinanzhof), a structure is considered
inappropriate if two unrelated and reasonable parties would not
have chosen that structure to a chieve a specific business goal. The
burden of proof lies with the tax authorities. Nonetheless, the
taxpayer has the right to rebut the presumption of abuse and to
demonstrate that the overall structure chosen is bas ed on relevant
non-tax reasons. The fact that a particular legal construction is
chosen because it has tax advantages does not render it subject to
the application of section 42 if there is a reasonable business
purpose.
However, the concept of unnatural or inappropriate transactions
and similar doctrines must be balanced against the basic principle
that the taxpayer should be free to organize its affairs in the way
it chooses, and that no one is obliged to choose the transactions
that lead to higher taxes rather than M alternative routes. It is this
area of conflict that renders the application of domestic GAARs
rather inefficient. To achieve this balance, most GAARs also seem
to require some sort of subjective element of intent to avoid taxes,
which is often expressed by a lack of business purp ose or
economic substance of the transaction in questions.

With regard to holding companies, GAARs might be applicable

only in extreme cases, where there are no reasonable business
purposes for the establishment of such companies and these
companies do not pursue any active business activities by
themselves. Based on the jurisprudence of the German Federal
Tax Court with regard to the German GAAR, reason -able business
purposes may be present if the interposed company is the top unit
of an international group, if a company is established in order to
acquire substantial participations in the country of estab lishment
or in third countries; or if the interposed company is taking over
substantial financing functions towards other subsidiaries or
grants guarantees in respect of subsidiaries.

In sum, as long as there is a certain level of economic substance

present at the level of an intermediary company which can be
expressed through certain decision-making powers, the
assumption of economic risk, trade on its own account or
management functions, GAARs will usually not apply.

10.4.2. Transfer pricing

The notion of substance in particular economic substance
plays a critical role with regard to transfer pricing rules. Under
the OECD Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations" (the OECD Guidelines),
which serve as a model for the domestic transfer pricing rules of
many countries, a lack of substance may result in a
recharacterization of a transaction by a tax administra tion. This is
often referred to as the substance-over-form principle, the purpose
of which is to prevent an inaccurate determination of the pro fits in
a particular country. The general principle is set out in paragraph
1.64 of the OECD Guidelines. Tax administrations should
generally recognize transactions carried out by associated
enterprises and the transfer pricing structures chosen by them,
unless an exceptional case is at hand. This is in line with the
general principle that enterprises are free to choose the structure
of their transactions. However, paragraph 1.65 of the OECD
Guidelines describes two scenarios under which tax
administrations have the right to disregard the transfer pricing
structure chosen by enterprises a nd to substitute it with a structure
they consider to be the actual structure that exists between the
parties.
The first scenario relates to situations where the economic
substance of a transaction differs from its form. In those c ases, tax
authorities may disregard the parties' characterization of a
transaction and recharacterize it in accordance with its substance.
The second scenario relates to situations where, even though the
form and substance of a transaction are the same, arrangements
are made in relation to the transaction which differs from those
which would have been made by independent enterprises behaving
in a commercially rational manner, and the actual structure
practically impedes tax authorities from determining a n
appropriate transfer prices.

In light of the above, the similarities to domestic GAARs are

obvious. Under such rules, tax authorities are entitled also to
disregard structures chosen by taxpayers who are considered
inappropriate in respect of the underlying transaction's aim or to
recharacterize transactions. As a result of the recharacterization of
a transaction or the disregarding of a structure tax benefits may be
withdrawn or not granted and tax laws applied accord ing to the
interpretation of circumstances by the tax authoriti es. Similarly,
tax authorities may proceed likewise under transfer pricing rules
if the sub-stance of a transaction or a structure does not match its
legal form. However, the application of the OECD Guidelines
does not require a taxpayer to carry out its a ctivities in accordance
with a genuine business purpose. Even if a structure lacks a
business purpose or is predominantly motivated by achieving tax
savings, the transaction may be acknowledged by tax authorities if
the structure is supported by sufficient substance. Any intention
of the taxpayer to save or avoid taxes by choosing a
particular transfer pricing structure is not relevant for the
purpose of transfer pricing rules, while it is usually a
condition for the application of GAARs.

Even though the notion of economic substance is crucial

to applying transfer pricing rules, substance or any
equivalent concept is rarely referred to and not defined in
the OECD Guidelines. However, paragraph 1.48 of the
OCED Guidelines sets out the main principle that the
purported allocation of risk must be consistent with the
economic substance of the transaction. In this regard, the
conduct of the parties should generally be taken as the
best evidence concerning the true allocation of risk.

The key element in determining the arm's length's price

for transactions between associated parties is a functional
analysis, which serves to identify and compare the
economically significant activities and responsibilities
undertaken, assets used and risks assumed by the parties
to a transaction. The starting point is the identification of
the functions carried out by the parties. When
considering functions, one must also take into account
any assets used and risks assumed in relation to these
functions. In order to judge whether the risk allocation is
consistent with the economic substance of a transaction,
not only are the contractual terms relevant, but it must
be considered whether the conduct of the associated
enterprises conforms to the contractual allocation of
risks, whether the allocation of risks in the controlled
transaction is at arm's length and what the consequences
of the risk allocation are". From this, it appears that the
allocation of risk depends on the functions carried out by
the involved parties.

The OECD Guidelines do not contain much guidance on

the substance requirements related to functions
performed by an enterprise. Instead the emphasis is on
the true allocation of risks, which indicates that the
substance requirements that must be considered under
the OECD Guidelines are related to "economic"
substance. The OECD Guidelines suggest two tests to
consider whether risk-related substance requirements are
met. Under the first test, the level of control that a
company has over a risk is analyzed, while under the
second test the financial capacity of a company to
support a risk is examined.'" Regarding the first test, the
OECD Guidelines note that the notion of "control" should
be understood as the capacity to make decisions to take
on the risk, as well as decisions as to whether and how to
manage the risk. This implies that the OECD Guidelines
require the company to have people either employees
or directors who have the authority to and effectively
perform control functions over risks. In addition to the
obviously required formal authority to take decisions in
relation to risks, the persons formally taking such
decisions would have to possess the intellectual capacity
to make those decisions (i.e. they would also have to
possess the necessary technical skills and competencies).
Thus, in particular where the activities of the holding
company focus on financing or the management of IP, the
director and employees of the company must be able to
carry out both the formal and intellectual part of the
decision-making relating to the holding activities.

10.4.3. Residence

The concept of residence is a substance requirement that

is relevant under both domestic laws and tax treaties.
Article 4(1) of the OECD Model defines the term "resident
of a Contracting State", as any person which, under the
laws of that country, is liable to tax therein. The provision
thus refers to the concept of residence adopted in the
domestic laws of contracting states? Generally, domestic
laws impose a comprehensive tax liability based on a
taxpayer's attachment to the country concerned?
Nonetheless, tax treaties are not concerned with the
domestic laws of the contracting states providing
conditions under which a taxpayer should be treated as
resident and thus being fully liable to tax. Treaties
normally do not lay down standards which the domestic
law provisions on residence must fulfill in order to claim
tax treaty benefits.
In order to determine the residence of a company,
domestic law criteria generally relate to two alternative
factors, namely the legal seat of a company (i.e. the place
where the company is incorporated) and the place where
the company is effectively managed. Most countries use
both criteria alternatively, while some countries require
that either of the two criteria be fulfilled in order for a
company to be considered resident. In countries that do
not provide for a definition of the residence of companies
in their tax laws (such as the Netherlands and Norway), a
company is normally considered to be resident if it is
incorporated under the laws of the particular country.
Thus, countries generally consider a rather formal nexus,
such as the formal act of incorporating a company, to be
sufficient for determining residence and subsequently
imposing a comprehensive tax liability on the worldwide
income of a company. From the outset, the idea of
economic substance does not appear to be of any
relevance at all.
However, in connection with the tie-breaker rule under
article 4(3) of the OECD Model, the notion of economic
substance indirectly becomes more important. Under this
provision, if a company is resident in both contracting
states, it will be deemed to be resident only in the state in
which its place of effective management is situated. Thus,
tax authorities may challenge the residence of a company
and subsequently deny tax treaty benefits to such
company, based on the argument that the company is
effectively managed and controlled from another
country, i.e. the place of effective management of the
company is not situated in the country of incorporation.

The place of effective management criterion is closely

related to the subject of substance. The notion is not
defined in tax treaties, and the Commentary on the OECD
Model also does not provide substantial help in defining
it. Paragraph 24 of the Commentary on Article 4 merely
notes that the place of effective management is the place
where key management and commercial decisions that
are necessary for the conduct of the entity's business as a
whole are, in substance, taken. In this regard, it is crucial
to take into account all the facts and circumstances of a
particular case. Furthermore, until 2008, a previous
version of the Commentary on the OECD Model included
a reference to the place where the company's board
meetings take place. However, this reference was
deleted, as it was perceived to give undue priority to the
place where a company's board meetings are held. In
case of the application of the tie-breaker rule, a letterbox
company incorporated under the laws of a country,
without any further substance, could have difficulties in
claiming that its effective place of management is in the
country where it is incorporated. Substance requirements
considered in such cases are usually related to the
following factors:
-where are the company's board meetings held;
-do the company's directors possess the necessary skills
to carry out their functions;
-where is the company's supervisory board located (in
cases of a two-board structure);
-where are other decision-making employees located:
-where are the company's bank accounts, bookkeeping
and annual accounts located;
-where are the company's offices located: and
-where are the shareholders meetings held.

These elements of substance are usually not codified in a

country's legislation, but rather are derived from the case
law of domestic courts or guidelines issued by the tax
authorities. Nonetheless, it appears that, in recent years,
tax authorities have stepped up their efforts to tackle
artificial arrangements based on a lack of residence, i.e.
based on a lack of substance.
Some countries have introduced enhanced substance
elements. The Netherlands, a commonly used holding
company location, is a prominent example. From 2014,
holding companies resident in the Netherlands must
satisfy certain requirements in order to demonstrate
significant presence in the Netherlands. For holding
companies, it is required, among other things, that at
least half of the statutory board members with decision-
making authority must reside in the Netherlands; that
these board members possess the required knowledge to
execute their tasks; that board decisions are taken in the
Netherlands; that the most significant bank accounts and
accounting records are held in the Netherlands; and that
qualified staff to execute and register the company's
activities are present." However, these substance
requirements need not be met for residence purposes,
but solely for purposes of applying for an advance tax
ruling.

CONTINUAR DESDE AQUI

As long as countries continue to rely on the incorporation
of a company as a sufficient requirement for tax
residence purposes and fail to impose further substance
requirements evidencing a significant nexus of a company
to a particular country, the residence criterion would
(without more) not set a strict limit on the form of a
potential economic substance requirement for tax
structuring activities involving holding companies.
Instead, it would be a rather limited formal substance
obligation.

10.4.4. Beneficial ownership requirement

Another aspect that may constitute a limit to planning

activities involving the use of holding companies is the
application of the "beneficial owner-ship" requirement.
Commonly, countries provide for a withholding tax on
outbound payments of dividends, interest and royalties.
Depending on avail-able relief from such withholding
taxes under an applicable tax treaty or the EU Directives
with respect to the country of the payer and the country
of the recipient, taxpayers may consider interposing a
(holding) company in a third country so as to result in
reducing the amount of withholding tax levied in the
country of the payer. The reduction of withholding taxes
is a crucial element of tax structuring activities with
holding companies, but in order to achieve the beneficial
effect, the interposed company must qualify as the
beneficial owner of the income. If the interposed
company only constitutes a mere conduit company, tax
authorities may challenge the structure based on a lack of
substance, as the receiving interposed company will not
be considered the beneficial owner of the income.
The notion of "beneficial owner" has been subject to
significant work by the OECD in recent years?' The
concept of "beneficial owner" was introduced in the 1977
edition of the OECD Model in order to deal with simple
treaty shopping situations where income is paid to an
intermediary resident of a tax treaty country who is not
treated as the owner of that income for tax purposes
(such as an agent or nominee). In 2003, new paragraphs
were added to the Commentary on Articles 10, 11 and 12
of the OECD Model, intended to clarify the meaning of
"beneficial owner" in some conduit situations. Finally, in
an attempt to provide further clarity, more amendments
to the Commentary on the OECD Model were added in
July 2014.72
The concept of "beneficial owner" is generally not defined
in tax treaties. Technically, in the absence of a tax treaty
definition, the term must either be interpreted with
recourse to domestic law based on article 3(2) of the
OECD Model or an autonomous interpretation must be
applied. Whether that autonomous interpretation is a
contextual interpretation that -other-wise requires", or a
plain international tax meaning, has been subject to
academic debate." However, at the OECD level this
debate has been ended as expressed by the 2014 update
of the Commentary on articles 10, II and 12 of the OECD
Model.
The notion of "beneficial owner" found in articles 10, 11
and 12 of the OECD Model was not only subject to
academic debate, but has also given rise to different
interpretation by courts and tax administrations in over
the years. In recent years, tax authorities have
increasingly denied relief from withholding taxes on
passive income or the application of reduced withholding
tax rates under tax treaties, arguing that a recipient of
passive income would actually not be the beneficial
owner as required under articles 10, I I and 12 of the
OECD Model.'4 This has led to a variety of court decisions,
one of the most prominent of which is the Indofood
International Finance Limited v. JPMorgan Chase Bank
(2006) case," which is said to have been the trigger for
the OECD's recent work on clarifying the meaning of the
term "beneficial owner". In the Indofood decision, the
Court attempted to identify an international meaning of
the term, compared to a definition under the domestic
laws of the countries involved. The case law on the
subject of beneficial owner is not uniform. It indicates
that some courts have taken a rather narrow approach
regarding the scope of the concept, merely excluding
conduit companies acting as agents or nominees,76 while
other courts have taken a broader approach - potentially
inspired by the 2003 changes to the Commentary on the
OECD Model - considering the beneficial ownership
concept as a sort of anti-abuse provision."

Given the risk of double taxation and non-taxation arising

from these different interpretations, the OECD worked on
proposals aimed at clarifying the interpretation that
should be given to the concept of beneficial owner in the
context of the OECD Model. In July 2014, the
Commentary on Articles 10, 11 and 12 of the OECD Model
was updated, clarifying that the concept of beneficial
owner must be given an autonomous meaning,
independent from any technical meaning under domestic
law.78
Another significant amendment to the Commentary on
the OECD Model relates to the clarification of examples
where a recipient of passive income cannot normally be
regarded as the beneficial owner because of its very
narrow powers in relation to the income in question
which render such person a mere fiduciary or
administrator acting on account of the interested
parties?' The amended Commentary provides that, in
such cases, the recipient can-not be considered the
beneficial owner because the recipient's right to use and
enjoy the income is constrained by a contractual or legal
obligation to pass on the payment received to another
person. It further notes that such an obligation will
normally derive from relevant legal documents, but can
also be found to exist on the basis of facts and
circumstances indicating that, in substance, the recipient
clearly does not have the right to use and enjoy the
income received unconstrained by a contractual or legal
obligation to pass on the payment received to another
person. These amendments reflect the criteria developed
by Canadian courts in the Prevost" and Velcro 62 cases. In
these decisions, the judges found that, in order to answer
the question as to whether the recipient of income is the
"beneficial owner" of that income, it must be considered
whether the recipient receives the income for the
recipient's own use and enjoyment and assumes the risk
and control over the income received by the recipient.
These amendments are particularly relevant in the case of
holding companies. They clearly limit the scope of the
application of the beneficial ownership requirement to
extreme cases involving pure conduit structures. By
providing this guidance in the Commentary, the OECD
introduces a measure of certainty to the question. This is
underscored by the new paragraph 12.5. of the
Commentary on Article 10 of the OECD Model (2014),
which asserts that there are many other means of
addressing conduit companies and, more generally,
treaty-shopping situations. These means include specific
and-abuse provisions in treaties, GAARs and substance-
over-form or economic substance approaches. The
concept of beneficial owner deals with some forms of tax
avoidance, specifically those involving the interposition of
a recipient that is obliged to pass on the income received
to someone else. However, it does not deal with other
cases of treaty shopping, and cannot be considered to be
restricting other approaches to address such cases in any
way.
With the 2014 update of the Commentary on the OECD
Model, the OECD definitely achieved its proclaimed aim
to provide more clarity with regard to the interpretation
and application of the beneficial ownership requirement.
However, under the intended meaning of the term as it is
now provided in the Commentary, the beneficial
ownership requirement does not set a strict limit in the
form of a potential economic substance requirement on
tax structuring activities involving holding companies.
Instead, it is rather limited to the form of a mere formal
substance requirement. One may wonder whether the
result of the process on clarifying the interpretation of
the term would have been the same if it would have
taken place after 2012 during the course of the BEPS
initiative.

10.4.5. Interim conclusion

In light of the above, one can say that substance

requirements under both domestic law and tax treaties
have the potential to pose a limit on tax structuring
activities involving holding companies. However, given
the way these requirements are currently imposed by
most jurisdictions, none of these requirements sets a
strict limit on tax structuring activities.

10.5. Potential impact of the BEPS Action Plan

While the discussion above considered current limitations

on tax structuring activities involving holding companies,
it is equally essential to examine the possible impact of
future limitations that jurisdictions might adopt within
the course of the OECD's BEPS initiative. The OECD Action
Plan on Base Erosion and Profit Shifting, released on 19
July 2013, contains 15 actions." Depending on the specific
business functions for which a holding company is used in
a specific structure (e.g. mere holding of participations,
financing activities or 1P management), a variety of
actions under the BEPS Action Plan may have a severe
impact on such structures. In particular, Action 3 on
strengthening CFC rules" and Action 6 on preventing
treaty abuse are of general importance to tax structuring
activities involving the use of holding companies,
regardless of the actual business function of the holding
company. The discussion below will focus solely on the
potential impact of the final report on Action 6," which
notes at the outset that treaty abuse is one of the most
significant sources of BEPS concerns.

10.5.1. Action 6: Prevent treaty abuse

After a first public discussion draft was released on 14

March 2014," the OECD published the final report on
Action 6 on preventing the granting of treaty benefits in
inappropriate circumstances, including treaty shopping
situations. With regard to treaty shopping situations, the
report recommends a three-pronged approach to be used
to address treaty shopping arrangements. Most notably,
the report recommends that countries include in their tax
treaties a specific anti-abuse rule based on the limitation-
on-benefits provisions included in tax treaties concluded
by the United States and a few other countries (limitation
on benefits rule)."
In order to address other forms of tax treaty abuse,
including treaty shopping situations that would not be
covered by the limitation on benefits rule (such as certain
conduit financing arrangements), it is further
recommended that tax treaties include a more general
anti-abuse rule based on the principal purpose of the
transactions or arrangements (the principal purpose test).
In addition, tax treaties should, in their title and
preamble, include a statement that the contracting
states, when entering into a tax treaty, intend to avoid
creating opportunities for non-taxation or reduced
taxation through tax evasion or avoidance, including
through treaty shopping arrangements." These suggested
changes to the OECD Model reflect the overall agreement
that the OCED Model must include a minimum level of
protection against tax treaty abuse. The final report on
Action 6 thus contains a proposal for an additional article
on the entitlement to treaty benefits to be included in tax
treaties?' The proposed article X contains a limitation on
benefits rule in paragraphs 1 through 6 and a principal-
purpose test in paragraph 7. The Report further provides
for a proposed addition to the Commentary on the OECD
Model on these two rules under article X.

10.5.2. Limitation on benefits rules in tax treaties

One of the recommendations is to include in tax treaties a

specific anti-abuse rule, based on the limitation on
benefits provisions included in tax treaties concluded by
the United States. Such a rule would address a larger
number of treaty shopping situations based on the legal
nature, ownership in, and general activities of residents of
a contracting state.
A limitation on benefits rule does not relate to the
purpose or intention of a taxpayer, but provides for a
series of objective tests which must be met by a taxpayer
in order to qualify for tax treaty benefits. This is to ensure
that a tax treaty between two countries cannot be
misused by residents of a third country by interposing a
mere conduit company in one of the contracting states in
order to gain access to that tax treaty and benefit from it.
In such a scenario, the interposed company would
generally be entitled to benefits as a resident of a
contracting state, subject to conditions set out in the
respective tax treaty, unless the tax treaty contains a
limitation on benefits rule. The rationale behind such a
rule is that a taxpayer which satisfies any of the tests has
a sufficiently strong nexus to the other contracting state,
which makes the taxpayer eligible for tax treaty benefits,
even in the absence of a proper business connection and
regardless of the purpose of a specific transaction.
A limitation on benefits rule basically restricts the general
rule that a tax treaty is applicable to residents of a
contracting state, by providing that only "qualified
persons" are entitled to tax treaty benefits, provided that
any other conditions specified in the underlying tax treaty
for obtaining the desired benefits are met.94 While this
general principle is set out in article X(1) of the proposed
limitation on benefits rule, article X(2) defines "qualified
persons" by listing a series of attributes of a resident of a
contracting state. any one of which suffices to render
such resident a "qualified person" so as to be entitled to
all the benefits of the tax treaty. The further structure of
the limitation on benefits rule is as follows: Article X(3)
sets forth the "active trade or business test", under which
a person may be granted benefits with regard to certain
types of income regardless of whether the person is a
qualified person. Article X(4) provides a so-called
"derivative benefits" test under which certain categories
of income may qualify for benefits. Article X(5) provides
that benefits may also be granted if the competent
authority of the country from which the benefits are
claimed determines that it is appropriate to grant
benefits in that case. Finally, article X(6) defines the terms
used specifically in article X(2) through (5).

10.5.2.1. Publicly-traded companies test

With regard to holding companies, the test under

proposed article X(2) (c) is of particular relevance in order
for holding companies to be considered "qualified
persons". This provision contains the so-called publicly-
traded companies test and applies to two categories of
companies, namely publicly traded companies and
subsidiaries of publicly traded companies. Accordingly, a
company resident in a contracting state is entitled to all
the benefits of the tax treaty under article X(2)(cXi)" if (i)
the principal class of its shares, and any disproportionate
class of shares, is regularly traded on one or more
recognized stock exchanges and (ii) the company satisfies
at least one of the following additional tests - the
company's principal class of shares is primarily traded on
a recognized stock exchange located in a contracting state
of which the company is a resident; or the company's
primary place of management and control is in its country
of residence.
Article X(2)(c)(ii)98 relates to subsidiaries of publicly-
traded companies. Pursuant to the provision, a company
resident in a contracting state is en-titled to all the
benefits of the tax treaty under article X(2)(cXii) if five or
fewer publicly traded companies described in article
X(2)(c)(i) are the direct or indirect owners of at least 50%
of the aggregate vote and value of the company's shares
(and at least 50% of any disproportionate class of shares).
If the publicly-traded companies are indirect owners,
however, each of the intermediate companies must be a
resident of one of the contracting states.
Thus, for example, a company resident in Country A. all
the shares of which are owned by another company
resident in Country A, would qualify for benefits under a
tax treaty between Countries A and 8 if the principal class
of shares of the parent company is regularly and primarily
traded on a qualifying stock exchange. However, a
subsidiary would not qualify for benefits under article
X(2)(cXii) if the publicly-traded parent company were a
resident of Country C, for example, and not a resident of
the two contracting states, Countries A and B.
Furthermore, if a parent company resident in Country A
indirectly owned a company through a chain of
subsidiaries, each such subsidiary in the chain, as an
intermediate owner, would have to be a resident of
Country A or B in order for the subsidiary resident in
Country A to meet the test in clause (ii)1'.
In particular, the requirements for subsidiaries to meet
the test set out in article X(2)(c)(ii) result in the denial of
tax treaty benefits in common structures as shown below,
where regional holding companies are involved.
StateA
Al CO
qv), pedo;
YON twAvy
A2 Co
PDX
State S
Mold CO
TOON parAtimoon
Statee
CCo
OF
Country C would deny tax treaty benefits under the tax
treaty between Country A and Country C for the
dividends paid from C Co, to A2 Co, as the regional
holding company interposed between A2 Co resident in
Country A and Al Co also resident in Country A, is not
resident in one of the contracting states, but rather
resident in Country B.

10.5.2.2. Ownership/base erosion test

Article X(2)(e) provides for an additional method to

qualify for tax treaty benefits that applies to any form of
legal entity that is a resident of a contracting state. The
test under this provision, the so-called ownership and
base erosion test, is a two-part test. Both prongs of the
test must be satisfied in order for the resident to be
entitled to tax treaty benefits under article X(2) (e). The
test is a strict rule solely concerned with the ownership
structure and the ratio between deductible payments
made to residents of third countries and the gross income
of the paying entity!'"
The ownership prong of the test, under article
X(2)(e)(i),102 requires that 50% or more of each class of
shares or other beneficial interests in the person be
owned, directly or indirectly, on at least half the days of
the per-son's taxable year, by persons which are residents
of the contracting state of which that person is a resident
and which are themselves entitled to tax treaty benefits
under certain parts of article X(2). However, in the case of
indirect owners, each of the intermediate owners must
be a resident of that contracting state.
The base erosion prong of article X(2)(e)(i.e. is satisfied
with regard to a person if less than 50% of the person's
gross income for the taxable year, as determined under
the tax law in the person's country of residence, is paid or
accrued, directly or indirectly, to persons which are not
residents of either contracting state entitled to treaty
benefits under article X(2), in the form of payments
deductible for tax purposes in the person's state of
residence.
The rationale for this two-part test is that, as treaty
benefits can be indirectly enjoyed not only by equity
holders of an entity, but also by that entity's various
classes of obliges (such as lenders, licensors, service
providers, insurers and reinsurers), it is not enough, in
order to prevent such benefits from flowing substantially
to third-country residents, merely to require substantial
ownership of the entity by treaty country residents or
their equivalent. It is also necessary to require that the
entity's deductible payments be made in substantial part
to such treaty country residents or their equivalents'05.
For example a third-country resident could lend funds to
a company resident in Country A (A Co), to be on-loaned
to a company resident in Country B (B Co). The interest
income of A Co would be exempt from withholding tax in
Country B under the interest article of the tax treaty
between Countries A and B. While A Co would be subject
to corporate income tax in Country A, its taxable income
could be reduced to nearly zero by the deductible interest
paid to the third-country resident. If, under a tax treaty
between Country A and the third country, that interest is
exempt from withholding tax in Country A, the treaty
benefit under the treaty between Countries A and B. with
regard to the interest income from Country B, will have
flowed to the third-country resident.
Even though article X(2Xe) sets out strict requirements in
order to qualify for treaty benefits, such a strict test
always provides room for tax structur-ing opportunities
and to create structures to conform with the
requirements. However, currently existing structures
particularly those involving inter-national joint ventures
may need to be restructured, as many common
structures may fail to meet this test.
PublIcirtradad PUBlokroadoct Limited Llalaft Company/
StateA Company I State B Company &Ms C 3314% SA%
3333% IOW Join Venture Company State B
MY%
Stale C
For example assume a joint venture by three parent
companies (two of which are publicly-traded companies)
and one limited liability company, each a resident of a
different country (Countries A, B and C). The joint venture
company is resident in Country B and receives dividends
from an operating subsidiary in Country C, while it pays
interest (80% of its income) on equal loans granted by the
participating companies. In such a case, the joint venture
company could not benefit from the tax treaty between
Country B and Country C, as one parent company is not a
resident of either Country B or C, but of Country A and
more than 50% of the joint venture company's income
(213 of 80%= 53.33%) is paid to recipients which are not
publicly-traded companies the principal class of shares of
which is primarily traded on a stock exchange located in
Country B.

10.5.2.3. Active business test

Article X(3) sets forth an alternative test under which a
resident of a contracting state may receive tax treaty
benefits with respect to certain items of income that are
connected to an active business conducted in its country
of residence. A resident of a contracting state may qualify
for benefits under article X(3) whether or not it also
qualifies under article X(2).
Article X(3)(a) sets forth the general rule that a resident of
a contracting state engaged in the active conduct of a
business in that jurisdiction may obtain the benefits of
the tax treaty with regard to an item of income, profit or
gain derived from the other contracting state. However,
the item of in-come, profit or gain must be derived in
connection with or incidental to, that business's'.
The term "business" is not defined in the proposed new
article X. Pursuant to article 3(2) of the OECD Model,
countries will ascribe to this term the meaning that it has
under their domestic laws. However, the business of
making or managing investments for the resident's own
account will be considered to be a business only when
part of the banking, insurance or securities activities are
conducted by a bank, an insurance company or a
registered securities dealer. Such activities conducted by
a person other than a bank, insurance company or
registered securities dealer will not be considered to be
the conduct of a business, nor would they be considered
to be the conduct of a business if conducted by a bank,
insurance company or registered securities dealer but not
as part of the company's banking, insurance or dealer
business.
Due to this restriction, a pure holding company is not
likely to benefit from the active business test, unless the
company is also involved in other business activities.

10.5.2.4. Derivative benefits test

Article X (4) sets forth a derivative benefits test that is

potentially applicable to all treaty benefits, although the
test is applied to individual items of income. In general, a
derivative benefits test entitles the resident of a
contracting state to tax treaty benefits if the owner of the
resident company would have been entitled to the same
benefit had the income in question flowed directly to that
owner. To qualify under this paragraph, the company
must meet an ownership test and a base erosion test.
Article X (4)(a) sets forth the ownership test. Under this
test, seven or fewer equivalent beneficiaries must own
shares representing (i) at least 95% of the aggregate
voting power and value of the company and (ii) at least
50% of any disproportionate class of shares. Ownership
may be direct or indirect)" The term "equivalent
beneficiary" is defined in the new article X (6)(f). In simple
terms, a person may be an equivalent beneficiary because
it is en-titled to equivalent benefits under a tax treaty
between the source country and the country in which the
person is a resident."2
Article X (4) (b) sets forth the base erosion test. A
company meets this base erosion test if less than 50% of
its gross income, as determined under the tax law in the
company's state of residence, for the taxable period is
paid or accrued, directly or indirectly, to a person or
persons which are not equivalent beneficiaries in the
form of payments deductible for tax purposes in the
company's country of residence."' This test is the same as
the base erosion test in article X (2)(e)(ii), except that the
test in article X(4) (b) focuses on base eroding payments
to persons which are not equivalent beneficiaries".
The rationale behind the derivative benefits clause is that
treaty shopping usually does not arise where the benefits
under a given tax treaty would be available had the payer
transferred the income directly to the ultimate recipient.
Denying tax treaty benefits to equivalent beneficiaries
would be especially problematic within the European
Union. A derivative benefits clause as included in the US
Model is commonly considered incompatible with EU
law."' Therefore, tax treaties signed by the EU Member
States with the United States include an adapted version
of a derivative benefits clause, expanding the scope of the
equivalent beneficiaries to residents of EU/EEA Member
States." 6 EU Member States willing to follow the OECD
recommendations included in the final report on Action 6
will have to take this into account.
Although a derivative benefits clause is intended to ease
the overall restrictive effect of a limitation on benefits
rule, the way the suggested clause in article Xis worded,
such effect does not appear. By requiring that any inter-
mediary company also be an equivalent beneficiary, the
derivative benefits clause is rather overly restrictive in its
effect.
In essence, the suggested limitation on benefits rule
provides for severe limitations on structuring activities
with holding companies. However, the tests set out in the
rule are clear and objective, and therefore carefully
planned structures involving holding companies will still
be effective even if limitation on benefits rules were to be
added to existing tax treaties. It is rather doubtful as to
whether tax authorities around the globe would be able
to deal effectively with the corresponding increase of
administrative burden in the course of the comprehensive
introduction and subsequent application of limitation on
benefits rules.

10.5.3. Principal-purpose test under tax treaties

In contrast to the first recommendation to introduce a

limitation on benefits provision into the OECD Model,
focusing on objective tests regarding the entitlement to
tax treaty benefits, the second recommendation to
introduce a principal-purpose test focuses on subjective
elements such as the intention of a taxpayer. This
principal-purpose test will be placed in a paragraph 7 of a
new article on entitlement to benefits following the
limitation on benefits rule in paragraphs 1 to 6 of that
new article.
The provision of article X(7) has the effect of denying a
benefit under a tax treaty where one of the principal
purposes of an arrangement or trans-action that has been
entered into, is to obtain a benefit under the tax treaty.
However, where this is the case, the last part of the
paragraph allows the person to which the benefit would
otherwise be denied the possibility of establishing that
obtaining the benefit in these circumstances would be in
accordance with the object and purpose of the relevant
provisions of a tax treaty."' Flowerer, the proposed article
X(7) particularly notes that the application of the
principal-purpose test may result in the denial of tax
treaty benefits, even though the application of the
limitation on benefits rule would not be an obstacle to
granting tax treaty benefits in a particular case.
The principal-purpose test, in principle, reflects the
already existing guidance in paragraphs 9.5 and 22 to 22.2
of the Commentary on Article I of the OECD Mcxlel."9 The
reference to paragraph 9.5 is significant in this regard, as
that paragraph provides that it should not be lightly
assumed that a taxpayer is entering into a type of abusive
transaction. The guiding principle should be that the
benefits of a tax treaty should not be available where (i) a
main purpose for entering into a certain transaction or
arrangement was to secure a more favourable tax
position and (ii) obtaining that more favourable
treatment in these circumstances would be contrary to
the object and purpose of the relevant provision.
Paragraphs 22 to 22.2 relate to the issue that domestic
anti-abuse provisions in the form of substance-over-form
rules, economic substance rules and GAARs aiming at
combating tax treaty abuse in particular the use of
base companies are not in conflict with tax treaties and
may be applied to cases involving tax treaties. However,
paragraph 22.2 specifically notes that countries should
carefully observe their obligations under tax treaties as
long as there is no clear evidence that treaties are being
abused.
More light is shed on the intended role and use of the
principal-purpose test by the proposed amendments to
the Commentary on the OECD Model included in the final
report on Action 6. Paragraph 14 of the suggested
Commentary contains examples illustrating the
application of the principal-purpose test. However, the
four examples used for this purpose show rather clear cut
cases of two scenarios that describe obvious conduit
arrangements, and two scenarios of bona fide
arrangemerus.123 Also, the part dealing with the
meaning of "arrangement and transaction" refers to
rather obvious cases of treaty shopping arrangements. It
notes that the term encompasses arrangements
concerning the establishment, acquisition or maintenance
of a person which derives income, including the
classification of that person as a resident of one of the
contracting states, and includes steps that persons may
take themselves in order to establish residence. An
example of an "arrangement" is seen where steps are
taken to ensure that meetings of the board of directors of
a company are held in a different country in order to
claim that the company has changed its residence.'23
Thus, there is an indication that the principal-purpose test
is aimed at artificial arrangements that lack any
underlying legitimate business justification, or in other
words without any underlying economic substance.
This is further underscored by paragraph 15 of the
suggested Commentary on Article X, which goes even a
bit further and invites those countries that may not be
able to accept the principal-purpose test in its suggested
wording included in the new article X(7), to add an
alternative article X(7) in order to address treaty shopping
strategies generally referred to as conduit arrangements.
Such countries could include a paragraph providing for a
denial of tax treaty benefits in general or of certain tax
treaty provisions, in respect of any income obtained
under or as part of a conduit arrangement. The
alternative paragraph should further include a definition
of a conduit arrangement, for which also an example is
suggested. According to the given example, the term
"conduit arrangement" means a transaction or series of
transactions:
-which is structured in such a way that a resident of a
contracting state entitled to the benefits of this tax treaty
receives an item of income arising in the other
contracting state, but that resident pays, directly or in-
directly. all or substantially all of that income to one or
more persons which are not residents of either
contracting state and which, if they were to receive that
item of income directly from the other contracting state,
would not be entitled under a tax treaty between the
state in which those persons are resident and the
contracting state in which the income arises, or
otherwise, to benefits with regard to that item of income
which are equivalent to, or more favourable than, those
available under this tax treaty to a resident of a
contracting state; and
-which has as one of its principal purposes obtaining such
increased benefits as are available under this tax treaty.'"
Despite the proposed amendments to the Commentary
on the OECD Model regarding the application of the
principal-purpose test, the introduction of a principal-
purpose test somewhat contradicts the aspiration for
more legal certainty, which would be better achieved by a
set of objective rules as included in a limitation on
benefits rule. Considering that the tax treatment of a
transaction is always a crucial component of any business
transaction, it will be difficult in practice to determine
whether the tax treatment of a trans-action must be also
considered one of the principal purposes of transaction. A
principal-purpose test is likely to create difficulties and
uncertainties for legitimate business transaction,
particularly for transactions which would comply with the
limitation on benefits rule. Countries that nevertheless
wish to introduce an additional test should consider
introducing a "sole" purpose test instead, which would be
more preferable in the light of legal certainty.
In essence, the suggested principal-purpose test does not
add another thresh-old in the form of a substance
requirement to tax treaties, but rather reflects what is
already expressed under domestic GAARs. The addition of
a principal-purpose test to tax treaties, therefore, will be
particularly relevant for countries which take the position
that their domestic anti-avoidance rules - including GAARs
- would not be applicable to cases involving tax treaties
which do not include a particular reference to domestic
anti-avoidance rules, allowing for the application of such
rules. Nonetheless, the combination of a limitation on
benefits rule and a principal-purpose test is a
combination which is rarely found in any existing tax
treaty. A limitation on benefits rule, in general, is already
considered a very restrictive measure, difficult to
reconcile with the objective and purpose of tax treaties to
promote exchanges of goods and services, and the
movement of capital and persons. Thus, it appears
somewhat surprising that the OECD recommends such a
holistic approach, suggesting that a principal-purpose test
is needed to supplement the limitation on benefits rule.

10.6. Conclusion

This chapter has considered commonly used tax

structuring strategies involving the use of holding
companies and potential limitations on these structuring
activities in the form of various substance-related
requirements under domestic laws and tax treaties. In
addition, the possible impact of future limitations that
countries might adopt within the course of the OECD's
BEPS initiative, was analyzed. In particular, the OECD
recommendations to countries to introduce a limitation
on benefits rule as well as a principal-purpose test in their
tax treaties were considered.
Thus far, under the currently existing requirements under
domestic laws and tax treaties, which relate to the notion
of substance, in the form of either economic substance or
legal substance, there are no strict limits on tax
structuring activities involving holding companies.
Notably, as long as countries continue to rely on
incorporation of a company as sufficient for residence
purposes, without imposing further substance
requirements evidencing a significant presence of a
company, the residence requirement does not set a strict
limit in the form of an economic substance requirement
on tax structuring activities. Instead, it is rather limited to
the form of a mere formal substance requirement. It
remains rather easy to interpose holding companies in
structures in order to optimize the repatriation of income
to the ultimate parent company of a group and to limit
the overall tax burden of a group.
While the impact of domestic GAARs has always been
somewhat limited in view of structuring activities
involving holding companies, the recent amendments to
the Commentary on Articles 10, II and 12 of the OECD
Model, providing a clarification of the meaning of
"beneficial owner" in conduit situations, have eased the
situation of holding companies even more. The
uncertainty of previous years regarding the interpretation
of the meaning of "beneficial owner" partly caused by
tax authorities that challenged structures around the
globe and partly caused by conflicting case law has
potentially vanished with the 2014 update of the
Commentary.
The introduction of a limitation on benefits rule and/or a
principal-purpose test to tax treaties may provide for
severe limitations on planning activities with holding
companies. However, in particular, the tests set out in the
limitation on benefits rule are clear and objective, and
therefore carefully planned structures involving holding
companies will still be effective even if limitation on
benefits rules are ultimately added to existing tax
treaties. In addition, it is not likely that the introduction of
a principal-purpose test would add another threshold in
the form of a substance requirement to tax treaties. It
would rather reflect what is already expressed under
domestic GAARs. However, the introduction of a
principal-purpose test would create a significant level of
uncertainty for transactions involving the use of tax
treaties, as the test under such rule is very subjective and
rather vague com-pared to the tests under a limitation on
benefits rule. As a principal-purpose test does not
adequately differentiate between genuine business
transactions and tax avoidance transactions, there is a
risk that genuine transactions could also be challenged by
tax authorities.
Still, in the course of the OECD's BEPS initiative, countries
may intro-duce recommended amendments to their
domestic laws and tax treaties, and focus more on the
overall level of genuine economic activity of a corporate
structure. As a result, substance requirements may
become more important in the future, in particular for
source countries that have the perception that profits are
being shifted improperly out of their jurisdictions.
However, even if countries were to take corresponding
actions, increased substance requirements would not
bring an end to tax structuring activities with holding
companies, but could rather make such activities more
expensive for MNEs.