On 1 August 2011 HM Treasury quietly published a document setting out their plans to add an additional layer of anti avoidance provisions in respect of ‘treaty shopping’.

One of my previous senior colleagues often used the phrase ‘treaty shopping’ with me on projects and initially I needed to look up what he was banging on about. It turns out that it was nothing more than creating a tax efficient bridge between two jurisdictions.

Let’s suppose that a company in Country A wants to pay interest on a loan to a company in Country B. There is no double tax treaty between the two countries in question and so withholding tax (WHT) of say 25% might be due, which is undesirable. To avoid the imposition of this WHT, the company decides to insert a new company in between the two existing companies in Country C. Country C has a double tax treaty with both country A and B, and so there is no WHT on the payment of interest from A to C and then C to B. Miraculous !

Very clever, but the tax authorities caught up with this. Generally double tax treaties require that in order for a resident to get the benefit of a reduced WHT rate they need to be paying the money to a party who is the ‘beneficial owner’. If instead that person (C) just passes on the income to a third person, (B), then they are not the beneficial owner and arrangements are in place prior to receipt for the majority of the income to be passed on. No risk is taken on by C, and it has no real right to enjoy the income being received. This concept was tested in the so called Indofoods case in the UK, and some level of protection for the UK Exchequer was confirmed.

Notwithstanding the beneficial ownership provisions the US introduced a much more onerous regime called ‘Limitation on benefits’ or LoBs. LoB provisions are written into each US double tax treaty and vary from treaty to treaty. They are much more formulaic and include a ‘base erosion test’ which means that if the US resident company pays an amount to an entity in another country and that entity passes on more than 50% of its income as an above the line tax deductible adjustment to a third person in another jurisdiction then the payment will not benefit from the WHT rates set out in the double tax treaty.

All pretty conclusive you might think?! Well it appears that HM Treasury feel that companies are still side stepping the beneficial ownership rules in order to treaty shop. In some cases UK tax treaties do not include a beneficial ownership provision, and the tax treaties in question won’t be updated for years due to the time taken to deal with such matters. For that reason HM Treasury proposed to add a layer of anti avoidance legislation which essentially provides a motive test for ‘arrangements’ which lead to a WHT benefit. ‘Arrangements’ is one of those strange words which tax advisers come across regularly and have to decide why they are taking a particular route – is it mainly for tax purposes or can we demonstrate a bona fide commercial purpose?

This motive test was clearly an attempt by HM Treasury to frighten taxpayers and rattle the old Exchequer sabre. The mere suggestion that a structure might not benefit from WHT reductions if it even smelt minutely of tax planning might well have been enough to frighten many companies away from what previously there would have been no hesitation in adopting as a plan.

The provisions were loose and not focused on any particular planning – just a naughty motive. This would leave the taxpayer in limbo – is he within the rules or not? One might assume that whilst HM Treasury continues to discuss the merits of a GAAR (general anti avoidance regulation) such loose unspecific pieces of legislation are exactly what are considered needed by Government to allow the counteraction of over zealous aggressive tax planning.

But here’s the funny thing, on Friday 9 September HM Treasury pulled the proposals. Their decision was based on the fact that the consultation process had thrown up too many examples where such a rule would have an unintended effect and create an unacceptable level of uncertainty for businesses.

Now whilst this is something of a surprise (normally you don’t see such definitive consultation proposals withdrawn), the really interesting thing is the significance this has for the GAAR mentioned above. If HMT cannot reconcile some of these business uncertainty issues on a fairly specific area of tax law, then how on earth are they going to deal with it when / if it introduces a GAAR? That’s a big issue and one that I will come back to in due course.