Tax treaties play a central role in preventing double taxation and fostering economic cooperation between jurisdictions.
However, some multinational enterprises (MNEs) exploit these treaties through a strategy known as treaty shopping which involves the manipulation of tax treaties by routing income through intermediate jurisdictions forming a “triangular operating structure” comprising the source jurisdiction, the residence jurisdiction, and a conduit jurisdiction with extensive treaty networks.
This article examines the dark side of tax treaties, exploring how treaty shopping works, the mechanisms MNEs use to exploit treaties, and global efforts to curb the abuse led by the Organisation for Economic Co-operation and Development (OECD).
Understanding the tax treaty network
Tax treaties are bilateral agreements between countries designed to allocate taxing rights over cross-border income. They serve to eliminate double taxation; address tax evasion and avoidance; provide a framework for settling tax disputes; and provide a stable tax environment to foreign investors.
MNEs use treaty shopping as a tax planning strategy to take advantage of favourable tax treaties between jurisdictions. This strategy typically involves three key players namely a jurisdiction where the ultimate parent or beneficial owner is resident often a low or zero tax jurisdiction; a jurisdiction where the income is generated; and a conduit or intermediate jurisdiction with extensive and favourable tax treaty networks.
How MNEs exploit the triangular model
This triangular model allows MNEs to reduce or eliminate withholding taxes on dividends, interest, royalties, or capital gains through one or more intermediate jurisdictions with beneficial tax treaties but without real economic activity.
Treaty shopping is generally facilitated through the following mechanisms:
Conduit companies that are established in jurisdictions with extensive treaty networks to act as intermediaries.
Letterbox companies that exist only on paper, with a registered address but no real economic activity, substance or employees in the country where they are incorporated. They are often used solely to claim treaty benefits.
Back-to-back loans: An enterprise in a high tax jurisdiction lends funds to an associated enterprise through a third country with a favourable tax treaty, allowing for reduced withholding tax on interest.
Circular flow of funds: MNEs may structure transactions so that funds seemingly circulate through jurisdictions, masking their origin and ultimate beneficiary, solely to leverage treaty provisions.
Hybrid mismatches that are treated differently for tax purposes in different jurisdictions to exploit gaps in treaties and avoid taxation altogether.
Combatting treaty shopping
Treaty shopping, although often legal in form, is viewed as abusive in substance. Many jurisdictions and international organisations have developed multiple strategies to counteract it. The OECD’s Base Erosion and Profit Shifting (BEPS) Action 6 recommends that tax treaties must include: the principal purpose test that denies treaty benefits if one of the main purposes of any arrangement is to secure tax benefits; and limitation on benefits clauses that allow only enterprises that meet specific conditions to benefit from treaties, often based on ownership, business activity, and substance.
The OECD also developed the multilateral instrument which allows countries to swiftly update their existing tax treaties without renegotiating each treaty.
Conclusion
Tax treaties are designed to foster cooperation, not exploitation; and to eliminate double taxation, not promote double non-taxation. Yet, the dark side of these arrangements has become a significant driver of global tax avoidance. MNEs that use aggressive treaty planning may remain technically compliant with the law, but they violate its spirit and erode public trust.
As international tax reform efforts gather pace, developing countries must not be left behind. A careful balance is needed: encouraging investment while ensuring that the tax benefits granted under treaties are only enjoyed by enterprises that are genuinely entitled to them.
Only then can tax treaties fulfil their original purpose of promoting trade and investment.
*Vilipo Muchina Munthali is the managing consultant at Swift Resources, an international tax and transfer pricing consulting firm Feedback: vilipo@swiftmalawi.com
