Question

In many instances, tax planners have established corporate vehicles in third countries to take advantage of the benefits of a treaty between the third country and the country in which the income would be earned. Explain the following concepts: Treaty shopping; The Judicial Doctrines the IRS had invoked to defend against treaty shopping abuses; The Anti-Conduit Regulations?

Answer 1

Treaty Shopping

Treaty shopping refers to the use of a treaty by persons who might not ordinarily come within its scope to avoid taxes. The objective is to reduce source taxation – typically on dividends, interest, royalties and business income not connected to a permanent establishment.

For example, A Comapny ("A") resident in the India (Home country) may Invested in Company ("B") in the China (source country). Dividends paid from "B" to "A" would be subject to a 30% withholding tax in China. There is a Treaty between China and U.K. for no tax on dividends and the same treaty is exist between india and U.K. Now If "A" Form a Company ("C") in the U.K. (the third country) and transfer the stock of ("B") China to ("C") U.K, dividends paid from B China to C U.K is Tax Free and same divident later transfer to (A) india from (C) U.K. The same be subjected to anti-treaty shopping rules.

If this approach were successful, the dividend withholding tax of 30% on dividends now reduced to Zero. In addition, because the U.K.

This Type of planning is eliminated by respective country through including specific rules in the treaty that limit the benefits under the treaty in certain circumstances. These rules are typically called “limitation on benefits” or “LOB” provisions. Other countries, are also generally rely on domestic law anti-treaty shopping provisions, rather than including the rules within the treaty itself.

Judicial Doctrines

The following judicial doctrines have been developed by the courts to analyze the economic substance of a transaction and then determine its tax consequences.

1. Substance over Form :- In applying the income tax laws, with few exceptions, the substance of the transaction, rather than its form, determines the tax consequences.

e.g Related party transactions provide fertile territory for self-dealing and the form of the transaction is often secondary to achieving a tax result. In contrast, arm’s length transactions with independent third parties are far less vulnerable to substance over form attack. Independent third parties usually express their transaction in writing and are concerned about the non-tax ramifications of the transactions; consequently, the form of the transaction usually embodies the actual substance as well.

2. Sham Transactions :-  

The sham transaction concept embodies two separate theories:

• A sham in fact — which is a fictional transaction that never actually occurred.
• A sham in substance is a transaction that actually occurred but which lacked the substance the form allegedly represented.

Transactions that are entered into solely for the purpose of obtaining tax benefits and that are without economic substance are considered shams for Federal income tax purposes and purported indebtedness associated therewith will not be recognized.

A sham transaction is a transaction that is lacking in objective economic reality and that has no economic significance beyond expected tax benefits.

In deciding whether transactions lack economic substance, we consider such factors as the lack of arm’s-length negotiations, inflated purchase prices, the structure of the financing of the transactions, and the degree of adherence to contractual terms.

3. Distribution to Shareholders and Constructive Dividends :- The courts have often found a constructive dividend when a corporation transfers money or other property, without an expectation of reimbursement, to or for the benefit of one or more of its shareholders, and the transaction is not characterized or reported as a dividend. The transfer must be made with respect to the corporation’s stock. It is not necessary that either the corporation or the shareholder intend a dividend distribution for constructive dividend treatment to result.  Actually, in almost every case, the constructive dividend was improperly characterized as a loan, business expense or consideration for the purchase of an asset.

4. Assignment of Income Doctrine :- The "assignment of income" doctrine states that income is taxed to the one who earns it — a taxpayer cannot avoid tax by assigning his income to another party or entity. Gross income derived from property must be included in the income of the person who beneficially owns it.

5. Step Transactions :- The step transaction doctrine, especially pronounced in the corporate-shareholder area, requires that interrelated steps of a transaction may be analyzed as a whole if they in substance are interdependent and focused on a particular end result

6. Business Purpose :- Courts will not recognize a transaction that lacks any business or corporate purpose, but is a mere device for dodging the taxpayer’s taxes