PART III: THE SEPARATE FEATURES OF TAX SPARING PROVISIONS
6.2 Conditions regarding the tax incentive measure
6.2.1 Introduction and considerations
Many operative tax sparing provisions stipulate special conditions in respect to the host country measure under which the tax incentive is granted. Generally, such conditions are
109 OECD Commentaries C(23)-31 paragraph 74 and UN Commentaries p. 336 paragraph 74.
designed as a reference to statutory law of the developing country, as a generally phrased condition, or both. Such conditions entail that only tax foregone under qualifying incen-tives is subject to tax sparing, and moreover effectively limit the discretion of the host State to amend or deploy tax incentives after the tax treaty is binding.
The OECD generally recommends the adoption of conditions regarding the tax incentive measure
“(…) to ensure that tax sparing is only granted for agreed concessions.”110
This appears to reflect that the basic rationale is to ensure a certain level of predictability, as to which incentives qualify and the characteristics of those measures, and the amount of credits that have to be granted for tax not actually paid. From a principal point of view, it is also a restriction on the derogation from the consideration of capital export neutrality. Non-etheless, other considerations are also relevant when assessing the appropriateness of con-ditions regarding the tax incentive measure.
6.2.1.1 The need for dynamic adaptions
The host State may have legitimate reasons to amend its tax incentive measures without the consent of the other State party. Generally,
“Investment policies should be regularly reviewed for effectiveness and relevance and adapted to changing development dynamics.”111
Changing conditions, for example newly emerging sectors needing foreign capital and satu-rated sectors where tax incentives are granted, may induce the need to change tax incentive measures. Moreover, the rationalization of tax incentive measures, i.e. improving their
110 OECD, Tax Sparing: A reconsideration (1998) p. 35.
111 UNCTAD (2012) p. 107.
pact on foreign investment whilst reducing their adverse effects, may require subsequent adjustments. Also, tax incentive measures in developing countries are often adopted on a
“trial and error” basis,112 strongly implying a practical need for subsequent revisions. Gen-erally, for these purposes, alterations on treaty level may entail an overly cumbersome process that may inhibit otherwise appropriate alterations.
6.2.1.2 Prevention of abuse
Conditions as to the tax incentive measure may also contribute to prevent abuse.113 An ex-ample of treaty abuse that may be counteracted by stipulating conditions for the tax incen-tive regime is routing schemes involving establishment of a conduit company in the host State.114 By stipulating statutory references to tax incentive measures that require profits to be derived from active business operations in the host State, or by establishing this as a separate condition under the tax sparing provision which will be addressed under section 8, such routing schemes may be prevented.
In the case of matching credit, a credit for notional tax may in principle be obtained without benefiting from host country tax incentives as the credit is fixed and not based on the tax foregone. For example: The State of source A has a tax treaty with State B. Under that trea-ty, profits attributed to a permanent establishment are exempted in A. In B, the permanent establishment is subject to very low tax, i.e. 5 percent. The profits earned by the company resident in A, from the permanent establishment, are subsequently paid as interest to a company in State C. The withholding tax on interest in State A is 8 percent. Between State A and C there is a tax sparing provision providing a credit at the fixed rate of 20 percent.
Overall, in A and B, the taxpayer pays total of 13 percent tax on the gross amount of the interest, thus obtaining a credit for notional tax of 7 percent in State C without benefiting from tax incentives in State A. Such an arrangement may be motivated by the higher level
112 Bazó (2008) p. 3.
113 Brooks (2009) paragraph IV D.
114 OECD, Tax Sparing: A reconsideration (1998) p. 29 and p. 71-72 provides an example of routing interest.
of tax between B and C, which is for example 20 percent on interest payments. If condi-tions are stipulated as to the tax incentive measure, ensuring that the income subject to tax sparing is also subject to qualifying tax incentives, such arrangements are prevented.
6.2.1.3 Overview
An important practical argument is the “oversight” provided by establishing specific condi-tions.115 It is the home State tax administration that has to determine the creditable amount.
If the computation of the credit for notional tax is based on the difference between tax that would have been payable and tax payable under the tax incentive regime, the home State tax authorities have to make a distinction between what is considered tax incentive meas-ures and what is considered ordinary tax measmeas-ures. For this operation it is expedient that the tax incentive measures are sufficiently defined. Making this distinction based on broad-ly phrased criteria could be very difficult in practice as it presupposes thorough knowledge of the host State domestic laws and of host State legislative amendments. Presumably, this is the reason why tax sparing provisions that adopt this computation method often stipulate precise conditions as to the tax incentive measure or set forth other mechanisms that ensure oversight.116 Conversely, the argument of “oversight” is generally not valid if the credit is subject to a fixed amount, as a fixed credit is generally provided, regardless of the ordinary tax liability and the tax actually paid. Consequently, many provisions that adopt this com-putation approach do not specify which tax incentive measures it applies for.117