China: The Application Of Article 9 (Capital Gains) Under The MLI To Covered Tax Agreements (Part 1)

Last Updated: 6 June 2019
Article by Alfred Chan

This paper is organized as follows:

Section I will examine the structure of the multilateral instrument (the MLI), the interaction between the operative clauses and the compatibility clauses, and the application of different types of options in the MLI including opt-out provisions, opt-in provisions and alternative provisions;

Section II will look at article 9, titled "Capital Gains from Alienation of Shares or Interest of Entities Deriving their Value Principally from Immovable Property". Specifically, it will compare the application of Article 9 to the CTAs with the application of other articles, such as the provision dealing with the purpose of a CTA and prevention of treaty abuse, to the CTAs. The comparison will highlight both the similarities and differences between opt-in provisions and alternative provisions;

Section III will use the understanding of the legal logic developed in the previous section to make a comparison between the different MLI positions some contracting jurisdictions have adopted with respect to Article 9.

In Section IV, the article ends with a conclusion that one can learn from understanding the MLI as an international convention.

Section I - The Operation of the MLI

  1. Overview of MLI structure

Articles 3 to 17 under Part II to V of the MLI provisions are substantive provisions addressing the BEPS issues. The substantive provisions have the following common structure: operative clauses, compatibility clauses, reservation clauses and notification clauses. In respect of the compatibility clause, the phrases "shall apply in place of; "shall apply to", "shall apply in the absence of" or "shall apply in place of or in the absence of" are specified to modify the application of the provisions of the CTAs nominated under Article 2(1) of the MLI (the specified phrases). An understanding of the structure of the MLI provisions is important as the phrase "shall apply", "shall not apply", and "shall apply with respect to" appear in different parts of the MLI, with different implications which we shall deal with next.

As noted, article 9 of the Multilateral Instrument (the MLI) addresses Capital Gains from Alienation of Share Deriving their Value Principally from Immovable Property. Paragraph 9(1) reads:

"Provisions of a CTA providing that gains derived by a resident of a contracting jurisdiction from the alienation of shares or other rights of participation in an entity may be taxed in the other contracting jurisdiction provided that these shares derived more than a certain part of their value from immovable property situated in that other contracting jurisdiction (or provided that more than a certain part of the property of the entity consists of such immovable property (real property)):

a) shall apply if the relevant value threshold is met at any time during the 365 days preceding the alienation; and

b) shall apply to shares or comparable interests,...".

In this instance, "Shall apply" is not related to the specified phrases under the compatibility clause. Here it means that article 9(1) directly modifies - or is directly read into - the relevant texts of the CTAs of a contracting jurisdiction. The modified texts become part of the operative clause, of which its application will be modified under the compatibility clause. In contrast, the compatibility clause will not directly modify the CTA contexts. Instead, it modifies the application of the MLI provisions to the CTAs by using the 4 phrases specified in the above-mentioned paragraph.

"Shall not apply" and "shall apply" are also used in the notification clauses (paragraph 7, Article 9), which provides:

Paragraph 9(7) provides that "Each Party that has not made the reservation described in subparagraph a) of paragraph 6 shall notify the Depositary of whether each of its CTAs contains a provision described in paragraph 1, and if so, the article and paragraph number of each such provision. Paragraph 1 shall apply with respect to a provision of a CTA only where all Contracting Jurisdictions have made a notification with respect to that provision."

  1. Compatibility clause

Paragraph 2 of Article 9 is the compatibility clauses, which deals with the interaction between itself and paragraph 9(1). Paragraph 5 of Article 9 is also the compatibility clause dealing with itself and paragraph 9(4). A compatibility clause comes into play in the following circumstances: where a contracting jurisdiction has not made any reservation (opt-out provision) for the operative clause; where a contracting jurisdiction has chosen to adopt a provision in the MLI, whether it is an opt-in or an alternative provision. Paragraph 9(2) and paragraph (5) provide that:

"9(2). The period provided in subparagraph a) of paragraph 1 shall apply in place of or in the absence [Emphasis added.] of a time period for determining whether the relevant value threshold in provisions of a Covered Tax Agreement described in paragraph 1 was met."

"9(5). Paragraph 4 shall apply in place of or in the absence of [Emphasis added.] provisions of a Covered Tax Agreement providing that gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or other rights of participation in an entity may be taxed in the other Contracting Jurisdiction provided that these shares or rights derived more than a certain part of their value from immovable property (real property) situated in that other Contracting Jurisdiction, or provided that more than a certain part of the property of the entity consists of such immovable property (real property)."

  1. Options in the MLI

Options in the MLI can be classified as opt-out provisions (reservations), opt-in provisions and alternative provisions.

(1) Opt-out provision

In some cases, the MLI allows a Party to the Convention to reserve its right to opt out of an MLI provision or part of that provision. For the MLI provisions that fall within the scope of the minimum standards as agreed in the BEPS package, a complete exclusion (an entire opt-out) is not permitted, unless:

  • the contracting jurisdictions shall endeavor to reach a mutually satisfactory solution that meets the minimum standard, as in the reservation available in article 7(15)(a) or
  • the contracting jurisdiction has already contained an equivalent provision in the existing CTA, as in the reservation available in articles 6(4) and 7(15)(b).

For other MLI provisions that do not reflect the minimum standards, full exclusion from application of the MLI provisions is explicitly provided under Article 28(1). Paragraph 1 of Article 9 is one of the examples. Another example is paragraph 5 of Article 10 (Anti-abuse Rule for Permanent Establishment Situated in Third Jurisdictions). It provides that:

5. A Party may reserve the right:

a) For the entirety of this Article not to apply to its CTAs;

b) For the entirety of this Article not to apply to its CTAs that already contain the provisions described in paragraph 4;

c) For this Article to apply only to its CTAs that already contain the provisions described in paragraph 5.

Thus, a contracting jurisdiction can reserve its right for the entirety of the Article not to apply subparagraph 5(a) to its CTAs. If a contracting jurisdiction makes a reservation under subparagraph 5(a), Article 28(9) allows the contracting jurisdiction, at any time, to withdraw it or replace it with a new reservation either under subparagraph 5(b) or 5(c), which are more limited in scope than that under subparagraph 5(a). A contracting jurisdiction can also reserve its right not to apply subparagraph 10(5)(b) on the strength of equivalent provision that already exists in its CTAs. An equivalent provision is an exception to the principle of reciprocity, under which the contracting jurisdiction is not allowed to apply the MLI provision to a subset of its CTAs.

(2) Opt-in provision

Opt-in provisions are used to supplement the application of a primary operative clause. One example for such supplementation is paragraph 3 of Article 6 (Purpose of a Covered Tax Agreement). Paragraph 1 of that article modifies all CTAs to include basic preamble language about the desire "to eliminate double taxation... without creating opportunities for non-taxation or reduced taxation." Paragraph 3 allows the possibility to include the other part of the preamble of the OECD Model Tax Convention: "Desiring to further develop their economic relationship and to enhance their co-operation in tax matters". Paragraph 3 provides that this preamble language is included only with respect to Covered Tax Agreements that do not already contain preamble language referring to a desire to develop an economic relationship or to enhance co-operation in tax matters. Also, as paragraphs 83 and 84 of the MLI's explanatory statement note, because including this portion of the preamble of the OECD Model Tax Convention is not required in order to meet a minimum standard, this paragraph is an optional provision.

The next example is paragraph 4 of Article 7 (Prevention of Treaty Abuse). Paragraph 3 of Article 7 provides that a Party that has not made the reservation for paragraph 7(1) – that is, the party has not opted out of the principal purpose test (PPT) – may also choose to apply paragraph 4 with respect to its covered tax agreements as below:

"Where a benefit under a Covered Tax Agreement is denied to a person under provisions of the Covered Tax Agreement (as it may be modified by this Convention) that deny all or part of the benefits that would otherwise be provided under the Covered Tax Agreement where the principal purpose or one of the principal purposes of any arrangement or transaction, or of any person concerned with an arrangement or transaction, was to obtain those benefits, the competent authority of the Contracting Jurisdiction that would otherwise have granted this benefit shall nevertheless treat that person as being entitled to this benefit, or to different benefits with respect to a specific item of income or capital, if such competent authority, upon request from that person and after consideration of the relevant facts and circumstances, determines that such benefits would have been granted to that person in the absence of the transaction or arrangement."

In essence, an opt-in provision is the same as a non-default option – one type of option in the alternative provision category.

(3) Alternative provision

Alternative provisions are included in the MLI to give flexibility for the contracting jurisdiction by providing a choice between various measures all leading to the same goal. From a technical perspective, there are two categories of alternative provision: alternative provisions with default option, [1] and alternative provisions without a default option.

If a contracting jurisdiction does not explicitly opt out of the default option in the Articles, the default option shall apply automatically. For example, paragraph 1 of Article 7 (Prevention of Treaty Abuse) provides for the principal purpose test as the default option. Paragraph 1 of Article 7 provides that

"Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement."

Paragraph 6 of Article 7 provides for an alternative (opt-in) provision for the contracting jurisdiction to adopt the simplified limitation of benefit provision to its CTAs, in order to supplement the application of principal purpose test, the default provision included under paragraph 1.

Article 9 (Capital Gains from Alienation of Shares or Interest of Entities Deriving their Value Principally from Immovable Property) also provides paragraph 4 as the alternative provision to paragraph 1. Paragraph 4 of Article 9 reads:

"For purposes of a Covered Tax Agreement, gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or comparable interests, such as interests in a partnership or trust, may be taxed in the other Contracting Jurisdiction if, at any time during the 365 days preceding the alienation, these shares or comparable interests derived more than 50 per cent of their value directly or indirectly from immovable property (real property) situated in that other Contracting Jurisdiction."

(4) Comparing between an opt-in and alternative provision

Both Article 7(6) and Article 9(4) are alternative provisions. However, there are differences between the two alternative provisions. Article 7 provides a default option of principal purpose test under paragraph 7(1). It suffices for a contracting jurisdiction to apply the principal purpose test (Article 7(1)) to its CTAs, without choosing to apply the simplified limitation of benefit provision (Article 7(6)) to its CTAs, which is optional and supplementary in nature. In contrast, Article 9 does not provide for a default option.

Section II – Object and purpose of Article 9

The explanatory statement provides a useful overview of article 9(1), which is closely connected to the action 6 report:

128. Paragraph 1 addresses situations in which assets are contributed to an entity shortly before the sale of shares or comparable interests (such as interests in a partnership or trust) in that entity in order to dilute the proportion of the value of the entity that is derived from immovable property, based on Article 13(4) of the OECD Model Tax Convention as revised in paragraph 44 (page 72) of the Action 6 Report.

129. The Action 6 Report provides two changes with respect to Article 13(4) of the 2014 version of the OECD Model Tax Convention: (i) to introduce a testing period for determining whether the condition on the value threshold is met; and (ii) to expand the scope of interests covered by that paragraph to include interests comparable to shares, such as interests in a partnership or trust. The provision in paragraph 1 has been divided into two subparagraphs. Subparagraph a) reflects the introduction of the testing period, and subparagraph b) reflects the expansion of the interests covered.

Instead of introducing a testing period and expanding the coverage of existing capital gains provisions to include additional type of interests, some Parties to the MLI may prefer to apply Article 13(4) of the OECD Model Tax Convention to their CTAs, rather than incorporating a testing period and expanding types of interest covered by existing capital gains provisions. Paragraph 3 of Article 9 allows such Parties to do so. Paragraph 3 also allows a Party to introduce a provision addressing gains derived from alienation of shares in entities deriving their value principally from immovable property (real property) into a CTA that does not have such a rule.

Further, Article 9(4) provides an optional provision that offers an alternative way to address a particular BEPS issue.

III. The differing MLI positions on Article 9

As of 27th September 2018, the following Signatories and Parties to the Convention have adopted their positions with respect to Article 9 as follows: [2]

Table 1. Article 9(1) Positions

Opt-in and opt-out provisions

Reservation and notification given

Contracting jurisdictions

not to apply paragraph 9(1)

Reservation made under paragraph 6(a)

The U.K. and Isle of Man

not to apply paragraph 9(1)(a)

Reservation made under paragraph 6(b)

China (provisional)

not to apply paragraph 9(1)(b), and not to opt in for paragraph 4 (the alternative provision)

List of CTAs subject to reservation for 9(1)(b) given under paragraph 6(e), and notification given under paragraph 7

Australia

The United Kingdom and Isle of Man have opted out of paragraph 1 of Article 9, meaning that in the absence of adopting the alternative provision in paragraph 4, the entire Article 9 shall not apply to the CTAs of these two contracting jurisdictions.

Australia provisionally chose to apply paragraph 9(1). The reservation made for paragraph 9(1)(b) and the notifications given for paragraph 1 have become definitive for Australia after the deposit of the Instrument of Ratification to the Depositary on 26th September 2018.

To acquire the legal relevance to the adoption of paragraph 1, Australia gave notification to the Depositary pursuant to paragraph 9(7) that paragraph 1 shall apply in place of the provision in, or in its absence be added to, all of its 42 CTAs including the tax treaties with Austria, Ireland, Japan, New Zealand, Sweden and the United Kingdom.

Out of a total of Australia's 42 CTAs, 19 of the CTAs already contain a provision that expands the scope of shares to cover comparable interest in a land-rich entity such as interest in a partnership or trust. Pursuant to Article 9(6)(e) of the MLI, Australia reserves its right not to apply paragraph 1(b) of Article 9 to these 19 CTAs including the tax treaties with Ireland, Japan, New Zealand and the United Kingdom. The 19 CTAs, as an exception to the reciprocity principle, for which reservation has been made with respect to paragraph 9(1)(b), will not be subject to modification by the compatibility clause under paragraph 2. It is also noted that both the tax treaties with Austria and Sweden do not contain the provision under paragraph 9(1)(b) including interests in partnership and trust, and do not contain a 365-day testing period in respect of paragraph 9(1)(a). Therefore, these two CTAs for which no reservation has been made under paragraph 9(6)(e), shall be subject to modification by the compatibility clause under paragraph 9(2).

IV - Concluding comment

It is important to distinguish between an opt-in provision and an alternative provision in the application of the MLI provisions including Article 9. Understanding the concept and logic in the legal texts is a pre-requisite in the interpretation and application of the relevant legal texts including Article 9, and it serves as a tool to guide us through the technicalities of the MLI.

In what follows, Part II and Part III will compare the application of the Article 9 of the MLI between selected contracting jurisdictions in order to assist readers in understanding how the opt-in, opt-out provisions (reservations), and the alternative provisions actually work in practice.

[1] See paragraph 90 of the Explanatory Statement.

[2] A Party is a contracting jurisdiction for which the Multilateral Convention is in force pursuant to Article 34.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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