In this age of globalization, international trade and transactions continue to increase, and the role of tax treaties appears more significant today than ever before. In this context, the question whether domestic anti-abuse rules can be applied to counter abuse of tax treaties is highly relevant. This essay is attempting to examine this problem from an Indonesian perspective.
Other terms are ‘improper use of the convention’ and ‘treaty shopping’. The term of ‘improper use of the convention’ tends to be more polite, not sarcastic and not judging, so Directorate General of Taxes/DGT (Indonesian competent authority) prefers this term. The meaning is a condition where a person (legal body or individual) who has no right to get benefit of treaty, but uses other person for getting benefit unavailable directly (IBFD International Tax Glossary, 2005).
Indonesia is still regarded as capital importing countries or source country. Source country will always attempt to impose tax on income derived from that country. According to Indonesian income law (UU PPh), business profit derived by non-resident will be levied tax with progressive tariff as permanent establishment (PE) or levied tax 20% as non-PE according to article 26. Passive income derived by non-resident will be levied tax 20% as prescribed in article 26 of UU PPh. So, they shall be taxed.
Many theories argue about benefits of tax treaty, from double tax avoidance till anti tax evasion. Otherwise, in source country’s eyes tax treaty is not more than a distributive rule restricting tax right of source country. Tax treaty seems to reduce tax revenue of undeveloped or developing country as source country.
Indonesia has concluded tax treaty with 58 countries. Those treaties certainly provide tax reduction or exemption for income derived by non resident in Indonesia. For examples : no PE no tax right for business profit (article 7), exclusive right of domicile country on international traffic shipping and aircraft profit (article 8), 0-15% tariff for passive income (article 10, 11, 12).
A few treaty partners have applied domestic rules conducive to treaty abuse. Those are Seychelles, Malaysia (Labuan), Netherland, Singapore. Batam differs from them because the facility is only for value added tax, not for income tax. Those conducive domestic rules are: Facility for incorporating legal body conducive for paper-box company, ring-fencing policy, inbound income tax exemption, outbound income tax exemption. These countries are regarded as tax haven countries. According international taxation expert’s opinion, one of tax haven country type is Treaty haven country, a treaty partner country which has good treaty network and applies low tax tariff on passive income. Commonly, this country will be used as intermediary state to benefit tax treaty facilities.
These domestic rules are often exploited by a few Indonesian corporations by incorporating special purpose vehicles (SPV) in order to get inward fund, or foreign corporation incorporates SPV in treaty partner country to perform business in Indonesia and thus makes use of benefit of tax treaty.
COD and Beneficial Owner
DGT as Indonesian competent authority has attempted to take measures in order to prevent treaty abuse. Some domestic anti-abuse rules have been released. Formerly SE-03/1996 was released to stipulate certificate of domicile (COD) for benefiting of tax treaty facilities. Then SE-04/PJ.34/2005 was released to define ‘beneficial owner’ as the real owner of passive incomes. SE-03/PJ.03/08 was released to prescribe beneficial owner, which had no significant changes.
Setting beneficial owner label and certificate of domicile (COD) as the requirements for benefiting tax treaty facilities could not afford to prevent treaty abuse. The problem was still the same, how to find out the beneficial ownership. COD required didn’t give useful information to determine whether the income recipient is beneficial owner or not. COD only informed us resident status. Other problems were there were many various forms of COD and sometimes COD itself was written with various languages. Those made the income payer as withholding agent confused.
The definition of beneficial owner was also criticized by OECD, criteria were not clear and tending to judge forms of corporation as non beneficial owner (not characteristics as substance). It was such a suspicious critic, a sincere one or an unwillingness of developed countries to limitation on benefit stipulated in domestic rule.
Beneficial owner as the keyword to prevent treaty abuse is ruled in article 26 of UU No. 36/2008 (UU PPh). It mentions that domicile country of non-resident is state where beneficial owner resides. Learning from the past and problems in practice, recently DGT releases PER-61/PJ/2009 ruling procedure to apply tax treaty and PER-62/PJ/2009 ruling treaty abuse prevention. Both will come into force on 1st January 2010.
PER-62/2009 attempts to deliver beneficial ownership and treaty abuse comprehension. Not only does it state the definition clearly but also beneficial owner criteria and treaty abuse characteristics. This regulation prescribes that if income recipient isn’t beneficial owner or doesn’t satisfy criteria of non treaty abuse, the income payer as withholding agent won’t be allowed to use tax treaty tariff. PER-61/2009 is a measure taken by DGT in order to make sure that income recipient is beneficial owner. How? by improving form of COD. This regulation introduces COD ‘DGT1’ more complicated but more informative. Sometime we have to sacrifice simplicity to gain more information.
COD Endorsed By Competent Authority
COD DGT1 is more informative because it consists of resident status and beneficial ownership identification filled by non-resident. As prescribed in domestic rules, requirements for benefiting tax treaty are resident of treaty partner and beneficial owner of income (cumulative conditions).
Once this rule was released, it prescribed that beneficial ownership identification in COD DGT1 had to be filled by income recipient and endorsed by competent authority where non-resident resides. Questionnaire answered by recipient and endorsed by competent authority will be deliberated by withholding agent to determine the beneficial ownership.
It’s such a revolutionary rule released by DGT. Not only was COD DGT1 a resident status certification from competent authority as usual but also beneficial ownership information endorsed by competent authority.
If this former COD DGT1 ran well, treaty abuse might be prevented and we could say: ‘SPV regime has been over in Indonesia’. However in practice, this COD invited many challenges to apply. Income payer as Indonesia withholding agent complained that it’s not easy to have COD endorsed by few competent authorities.
Unwillingness of competent authority to endorse former COD DGT1 should be a big question mark. There are a few reasons why competent authority seems unlikely to endorse former COD DGT1.
Firstly, Examining and endorsing COD seem to be additional administrative burdens for competent authority. Competent authority needs time to examine information given in COD and bear responsibility for what they’ve endorsed. Endorsing information means responsibility for the truth of information.
Secondly, they question the acceptability of treaty to this procedure. They say this procedure has not been prescribed in tax treaty and there is no mutual agreement procedure arranged yet. This argument is not completely right. COD DGT1 is a form containing information about income recipient and income derived. So, COD DGT1 is not more than information given by competent authority. It’s a kind of exchange of information.
As we know, article 26 of tax treaty about exchange of information has prescribed that the competent authorities of the Contracting States shall exchange such information as is necessary for the prevention of evasion of such taxes. Although it’s still debatable whether treaty abuse is a kind of tax avoidance or tax evasion, at least goodwill of treaty partner is expected here. It’s suggested that this article be revised to make clear the purpose of treaty itself to prevent treaty abuse. Enhancing the level of cooperation is expected a lot by concluding Exchange of Information Agreement with several treaty partners suspected as treaty haven country.
Thirdly, it can be the most reasonable one, it’s their effort to shelter their resident to conduct abusive transaction. As mentioned before, it’s indicated that a few treaty partner countries act as treaty haven country to invite investors to enter their countries for economic purpose. As a consequence, it’s reasonable that a competent authority seems unwilling to declare the truth about its resident.
Tax treaty itself is unlikely to agree to treaty abuse. Article 1 paragraph 7 OECD MTC commentary of improper use of the convention mentions that ‘the principal purpose of double taxation convention is to promote exchanges of goods and services, and the movement of capital and persons. It’s also a purpose of tax conventions to prevent tax avoidance and evasion‘. Passive income articles of tax treaty also prescribe beneficial owner as the party which has a right to benefit reduced tariff.
The fundamental principle of treaty law, pacta sunt servanda, is set out in article 26 of the Vienna convention, which provides, “Every treaty in force is binding upon the parties to it and must be performed by them in good faith.” In light of the principle that states must execute a treaty in good faith, it is legitimate to doubt that the residents of those states are entitled to abuse the treaty in question.
Based on argumentations above, there should be no reason for competent authority to be unlikely to endorse COD DGT1. Mutual understanding on the purpose of tax treaty to prevent abusive transaction is expected here. Indonesia as source country has right not to apply treaty benefit for non beneficial owner based on treaty itself.
In order to make this regulation applies effectively DGT revises COD DG1 by omitting competent authority endorsement on beneficial owner information. It’s such a significant revision. Omitting competent authority endorsement means lacking of competent authority’s responsibility for information provided by income recipient. Now beneficial ownership information in COD DGT1 is neither more than an attachment of COD nor regarded as part of COD itself, because COD shall come from competent authority, not from taxpayer.
It looks like a backward step taken by DGT. But it will be a backward step for moving forward a hundred steps if DGT can afford to make use of this income recipient’s information to find abusive transaction then ask competent authority for confirming this suspicious information (not all information, only suspicious ones), regarding as exchange of information prescribed in article 26 of DTA.
Treaty Abuse in Business Activity
Passive income is about fund. Fund is easily located or moved by the owner in order to minimize tax burden. This is what makes tax authority concern and think that the owner (beneficial owner) puts his fund first in treaty partner country before investing his fund to source country, in order to make use of treaty facilities. So as mentioned in article 10, 11, 12 of tax treaty or article 26 (1a) of UU PPh, the domicile country is the state where beneficial owner resides.
Active income (business activity) is about business activity. The corporation who owns business profit is the corporation who performs activity. Like beneficial owner of passive income, the corporation can be located formally to treaty partner country before carrying on business in source country, in order to benefit treaty facilities. By registering a corporation in notary office, a corporation has been incorporated there. So, it’s easy to incorporate a corporation legally. As we know, offshore company is easily incorporated in a few countries promoting themselves as offshore corporation countries, such as British Virginia Island, Seychelles, Panama, and Mauritius. A few of them have concluded tax treaty with Indonesia. These countries are regarded as tax haven countries.
The concept or context of COD DGT is still on abusive transaction on interest, dividend, and royalty (passive income) known as taxable object of article 26 of UU PPh. Meanwhile, not only is abusive transaction conducted on passive income but also active income (business profit). As we know, tax treaty provides also tax exemption on international traffic shipping in article 8, and representative office as non-PE in article 5.
There is a case where an-international traffic liner shipping holds Seychelles COD, so no tax right for Indonesia as article 8 of tax treaty Indonesia-Seychelles. The correspondence coming from Singapore indicates that board directors are in Singapore. Another case is representative office holds Singapore COD. According to article 5 paragraph 4 of DTA Singapore-Indonesia, this representative office doesn’t constitute PE thus no tax right for Indonesia. But goods imported from Hongkong and documents sent indicate that effective management is in Hongkong.
As illustrated above, abusive transactions may be conducted by Permanent establishment but there are no domestic anti abuse rules prescribing strictly COD for business activity. In another hand, COD itself doesn’t solve the problem. COD can’t inform the real owner of business profit. When passive income has the key ‘beneficial owner’, business activity should have one, that is effective management.
Why effective management? Commentary on article 4 paragraph 3 of OECD MTC mentions 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 are in substance made. The place of effective management will ordinarily be the place where the most senior person or group of persons (for example aboard of directors) makes its decisions. OECD MTC also admits the place of effective management as the place where corporation resides in substance. The key word ‘place of effective management’ is used to solve dual resident problem (tie breaker rule).
Beneficial owner and effective place of management have the same characteristic: the real owner of income in substance rather than formality. Place of effective management as the key word to prevent treaty abuse conducted by PE may be still debatable. Treaty experts will argue that, different from beneficial owner, effective management as the key for anti treaty abuse hasn’t been stipulated in treaty, not including the resistance of competent authority where the corporation is incorporated legally. However, author agrees that the chances for success by the Indonesian tax authorities with respect to treaty abuse lie in the use of a domestic anti-abuse rule applicable to treaties rather than in recourse to administrative enforcement.