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  • Marnix Meijer

The Effects of the Principal Purpose Test on Tax Treaties

Updated: May 8

A new general anti-tax avoidance measure was introduced in the world of tax treaties in 2019 as a part of the Multi-Lateral Instrument and the OECD-Model tax convention. This anti-tax avoidance measure, the Principal Purpose Test (PPT), was implemented following the Base Erosion and Profit Shifting-project of the OECD and its Inclusive Framework under the motto: ‘taxation where value is created’. (1) With this goal in mind the measure tries to prevent the use of ‘shell entities’, the use of: entities with little to no substance, created solely for the purpose of securing a more favorable tax treatment through tax treaties. In this longread a short explanation of the PPT-measure is given. The longread then shows the potential effects of the PPT when applicable, followed by a short conclusion.

The PPT can be found in section 9 of article 29 of the OECD-Model Tax Convention of 2017. (2) Though text of the article cannot be found in every tax convention, the PPT could still apply following the statements of applicability of the MLI itself by the countries party to the relevant tax convention. Should both countries state that the MLI is applicable on the treaty then the PPT should also be applicable.

As the name suggests the PPT is an anti-tax avoidance measure centered around looking at the purposes of the structure or arrangement for which a tax treaty benefit is claimed. Exclusively evaluating a legal arrangement exclusively is not enough. It requires an objective analysis of all relevant facts and circumstances. Based on this objective analysis must then be concluded that it would be reasonable to say that one of the main purposes of a legal arrangement or structure is to claim a tax treaty benefit. It does not have to be the main purpose, only one of the main purposes although it should not easily be concluded. Though the tax reduction could give a strong suspicion of the motive to claim tax benefits, the PPT also looks at the commercial reasoning behind the structures and arrangement. Before applying the PPT, the tax authority should also evaluate the commercial reasons for the structure. This also gives the relevant entities the chance to defend the structure and prove the commercial considerations for the use of the entity. When however, there is almost no other reasonable explanation possible for the use of the entity other than claiming a tax treaty benefit, the tax avoidance motive could be concluded.

The PPT ‘looks through’ the structure and compares the tax rate with and without the entity claiming the tax treaty benefits. Whenever a considerable tax rate reduction is apparent, the commercial rationale of the company or legal arrangement must be tested. Should the suspicion still exist after both tests, the relevant tax administrations could invoke the PPT and deny the tax treaty benefit and tax the payments without tax treaty restrictions.

An example of a PPT evaluation can be depicted as follows:







In the picture above a structure is illustrated in which the PPT could play a role. In the example a Natural Person is using a company in country B resulting in an overall rate of 0 percent, contrary to a tax rate of 15 percent when a direct payment would be made from company C to the Natural Person. The use of the shell company in country B in this structure consequently results in a tax rate deduction of 15 percent. The reduction could therefore raise the suspicion of tax avoidance and the applicability of the PPT by the tax authority. The tax authority would have a strong case when invoking the PPT and claiming it would be reasonable to conclude that at least one of the reasons for the use of the shell is to claim tax benefits, as this example uses a shell company with little to no commercial rationale. The tax authority could then deny the relevant tax treaty rate deduction and tax the income regularly at the regular rate of 15 percent rate.


As explained above, the PPT consists of an objective analysis of all facts and circumstances. When it would be reasonable to conclude that one of the main objectives of the structure of arrangement is to gain a more favorable tax treatment and there is no commercial reasoning explaining the structure or arrangement, the claimed tax treaty benefit could be denied by the relevant tax administrations. Consequently, it is important to always check the tax effects of the structure or arrangement before its set-up or execution.


Links to sources:

1. Members of the OECD/G20 Inclusive Framework on BEPS

2. Model Tax Convention on Income and on Capital: Condensed Version 2017 | READ online (oecd-ilibrary.org)


#dividend #Withholdingtax #Antiabuserules #taxplanning



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