MLI & Treaty Shopping
MLI & Treaty Shopping
The Multilateral Instrument (MLI) is the primary tool for implementing BEPS treaty-related measures across the global tax treaty network. Treaty shopping — the practice of routing transactions through intermediary jurisdictions to obtain treaty benefits not intended for the ultimate beneficiary — is addressed through anti-abuse provisions in the MLI and updated OECD Model.
MLI Overview
The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the MLI) allows countries to modify their existing bilateral tax treaties simultaneously, without renegotiating each one individually.
The MLI covers four main areas: preventing treaty abuse (Action 6), preventing artificial PE avoidance (Action 7), improving dispute resolution (Action 14), and neutralizing hybrid mismatches (Action 2). Countries select which treaties and provisions the MLI modifies through a system of notifications and reservations.
Principal Purpose Test (PPT)
Art. 7 of the MLI (reflecting Art. 29(9) of the 2017 OECD Model) introduces the Principal Purpose Test — the minimum standard for preventing treaty abuse:
A treaty benefit shall not be granted if it is reasonable to conclude that obtaining that benefit was one of the principal purposes of any arrangement or transaction, unless granting the benefit would be in accordance with the object and purpose of the relevant treaty provisions.
The PPT is a subjective test — it requires an assessment of the taxpayer's purposes and motivations. The burden falls on the tax authority to demonstrate that obtaining treaty benefits was one of the principal purposes, but the taxpayer bears the practical burden of documenting commercial rationale.
Limitation on Benefits (LOB)
The LOB is an objective, rules-based anti-abuse provision that limits treaty benefits to residents who satisfy specific qualifying conditions:
Qualified Person Test
Individuals, governments, publicly traded companies, and their subsidiaries automatically qualify. Ownership and base erosion tests apply to others.
Active Trade or Business Test
Treaty benefits for income connected with an active trade or business carried on in the residence state. The income must be derived in connection with that business.
Derivative Benefits Test
Benefits are available to entities owned by persons who would have been entitled to equivalent benefits had they received the income directly.
Discretionary Benefits
The competent authority may grant benefits to a resident who does not otherwise qualify, if the establishment and operation of the entity did not have treaty shopping as a principal purpose.
PPT vs LOB
Countries can choose to adopt the PPT alone (the minimum standard), the PPT supplemented by a simplified LOB, or a detailed LOB supplemented by an anti-conduit rule. Each approach has different implications:
PPT
Subjective, flexible, broader scope. Applies to all types of treaty benefits. Provides less certainty but catches more arrangements.
LOB
Objective, rules-based, narrower scope. Provides certainty for qualifying persons but may not catch all abuse. Often used in US treaties.
Most countries have adopted the PPT as their minimum standard. Where both PPT and LOB apply, satisfying the LOB does not prevent denial under the PPT — both tests must be passed.
Treaty Modification
The MLI modifies existing bilateral treaties through a system of covered tax agreements (CTAs). Both treaty partners must list a treaty as a CTA for the MLI to apply. The MLI provisions then operate alongside (or supersede) the existing treaty text.
Key considerations for determining how a specific bilateral treaty has been modified:
Notifications and Reservations
Each signatory files notifications specifying which treaties and provisions the MLI covers. Reservations opt out of specific articles.
Matching and Compatibility
MLI provisions only apply where both treaty partners have made compatible choices — asymmetric notifications can result in partial application.
Synthesised Texts
The OECD publishes synthesised texts showing how the MLI modifies specific treaties, combining the original treaty text with applicable MLI provisions.
Anti-Abuse in Practice
For holding structures and international arrangements, the practical implications of anti-abuse provisions are significant:
Substance Requirements
Entities must demonstrate genuine economic substance — qualified personnel, office space, real decision-making authority, and actual business activities beyond holding shares.
Commercial Rationale
Every step in a transaction structure should have a demonstrable commercial rationale independent of obtaining treaty benefits.
Documentation
Board minutes, business plans, functional analyses, and economic substance reports are essential evidence to defend against treaty abuse challenges.
Best practice
The PPT is a subjective test — documenting the commercial rationale for transaction structures is essential for treaty benefit claims.