The Impact of the OECD Multilateral Instrument on Real Estate Funds
Real Estate Tax Alert
On 24 November 2016, the Organisation for Economic Cooperation and Development (OECD) released the widely anticipated text of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI). An explanatory statement that accompanied the release provides for clarification of the approach taken by the OECD and how each article is intended to affect the treaties covered by the MLI. In this Real Estate Tax Alert, we address two key measures that are included in the MLI provisions on treaty abuse. Both measures could have a negative impact on the taxation of real estate funds.
The MLI is designed to swiftly implement tax treaty related measures arising from the OECD BEPS project. The MLI provisions on treaty abuse address the concerns that double tax treaties could grant treaty benefits in unintended circumstances, i.e. treaty abuse. According to the OECD, this treaty abuse can originate from all tax benefits provided by a treaty source state, e.g. exemptions, withholding tax reductions, deferrals and refunds. The MLI includes a number of minimum standards as regards treaty abuse (Action 6), which are mandatory for jurisdictions signing up to the MLI. Reference is made to the final text of the MLI: ‘Final Text of Multilateral Instrument Released’.
The MLI states that signatory jurisdictions must choose between the following three alternatives to prevent treaty abuse:
- a principal purpose test (PPT);
- a simplified limitation on benefits (LOB) rule supplemented with a PPT; or,
- a detailed LOB rule supplemented by a mechanism to deal with conduit arrangements.
The PPT aims to deny treaty benefits to the extent that obtaining a benefit was one of the principal purposes of any arrangement or transaction. The simplified LOB approach on the other hand provides specific tests to be met by a treaty resident in order to claim treaty benefits. These – shortly put – include ownership by qualified persons, ownership by listed companies and a trade or business test. For the detailed LOB rule no text is included in the MLI since substantial bilateral customization is likely to be required.
On 28 October 2016, the Dutch government announced that it is their intention to opt for the PPT as much as possible, as this alternative is supported by most jurisdictions and will likely become the new international standard. According to the Dutch government it is also the only measure that can avoid overkill as well as underkill. A counterargument to this statement would of course be that the PPT is an open norm, which leads to less legal certainty than an LOB rule.
The MLI does not contain further guidance on treaty access to CIVs and non-CIVs, which would have been a welcome clarification for fund and asset managers. Neither does the MLI address the recommendations of the European Commission (EC) released in January 2016. This recommendation stated that the MLI PPT should be aligned with the case law of the EU Court of Justice as regards the abuse of law doctrine. As such, the EC recommends that EU Member States should allow for an escape from the PPT if an arrangement or transaction ‘reflects a genuine economic activity’, even if one of the main purposes was to obtain a treaty benefit.
The ‘genuine economic activity’ escape is not included in the final text of the MLI nor is it addressed in the explanatory notes. This escape and interpretation of the PPT is – at least in intra-EU relations – of course highly relevant in relation to holding and financing companies included in real estate fund structures.
Real estate entity clause
The MLI also allows signatory jurisdictions to opt for a new real estate entity clause, which – compared to the text of article 13(4) of the OECD Model Convention – basically contains the introduction of a testing period (365 days) and an expansion of the interests covered (interests comparable to shares):
“Gains derived by a resident of a Contracting State from the alienation of shares or comparable interests, such as interests in a partnership or trust, may be taxed in the other Contracting State if, at any time during the 365 days preceding the alienation, these shares or comparable interests derived more than 50 per cent of their value directly or indirectly from immovable property, as defined in Article 6, situated in that other State.”
The wording ‘comparable interests’ included in the model outcome of the Final Report on Action 6 (above) has been replaced in the MLI with ‘other rights of participation in an entity’. Signatory jurisdictions can opt to apply the clause in full, but they can also opt out or only include the testing period or the expansion of interests. Until recently it has been Dutch tax treaty policy not to include real estate company clauses. However, on 28 October 2016 the Dutch government announced that they will from now on strive to include this clause in Dutch tax treaties.
It is still too early to predict what the exact impact of the minimum standard and real estate company measures of the MLI will be on existing tax treaties. The simple reasons for this are the multitude of options given to the signatory jurisdictions and the subsequent unclarity on the choices to be made by individual countries, as well as the uncertainty surrounding the interpretation of the PPT and possible implementations of LOB rules.
A significant group of jurisdictions are expected to sign the MLI on 5 June 2017. The MLI subsequently needs to be ratified by at least five jurisdictions before the MLI enters into force. The MLI will not actually change existing tax treaties, but will co-exist besides the existing treaties. Effectively, the MLI will only impact treaties if both treaty partners have ratified the MLI and both treaty partners make the same choices regarding the different options, e.g. both treaty partners opt for the introduction of a PPT. If the countries do not make the same choice, the tax treaty remains unchanged and, if changes are desired anyway, the countries involved need to re-negotiate their tax treaty regarding the specific option to be included in their respective tax treaty. The first situations covered by the MLI are likely to become effective on 1 January 2018 at the earliest.