“Treaty shopping” generally refers to a situation where a person, who is resident in one country (say the “home” country) and who earns income or capital gains from another country (say the “source” country), is able to benefit from a tax treaty between the source country and yet another country (say the “third” country). This situation often arises where a person is resident in the home country but the home country does not have a tax treaty with the source country.
For example, a corporation (“CayCo”) resident in the Cayman Islands (the home country) may own a corporation (“USCo”) in the U.S. (the source country). Dividends paid from USCo to CayCo would be subject to a 30% U.S. withholding tax. If CayCo were to form a corporation (“UKCo”) in the U.K. (the third country) and transfer the stock of USCo to UKCo, dividends would be paid from USCo to UKCo and, without anti-treaty shopping rules, these dividends would qualify for benefits under the U.S.-U.K. Income Tax Treaty.
If this approach were successful, the dividend withholding tax of 30% on dividends paid by USCo could be reduced to zero. In addition, because the U.K. does not impose any withholding taxes on dividends paid to non-U.K. residents, the overall tax rate of the group may decrease. However, the U.K. income tax rules would need to be reviewed to confirm that dividends from USCo to UKCo would not be subject to U.K. income taxes.
Different countries attack this problem in different ways. The U.S. generally includes in its tax treaties with other countries specific rules that limit the benefits under the treaty in certain circumstances. These rules are typically called “limitation on benefits” or “LOB” provisions. Other countries, such as Canada, generally rely on domestic law anti-treaty shopping provisions, rather than including the rules within the treaty itself.
Domestic law anti-treaty shopping rules are often implemented by providing that only “beneficial owners” of the payments are entitled to treaty benefits. For instance, in the example above, if CayCo and UKCo had invested into a Canadian corporation (“CanCo”) rather than into USCo, the Canadian anti-treaty shopping provisions may conclude that CayCo is the beneficial owner of dividends paid by CanCo. As a result, the CanCo dividend may not qualify for reduced treaty benefits under the Canadian-U.K. Treaty.
The anti-treaty shopping provisions are some of the most complex international tax rules in existence. An example of the LOB provisions can be seen in the recent amendment (in treaty terminology called a "protocol") to the U.S.-Netherlands Income Tax Treaty (see Article 7 of the Protocol).