The Boundaries and Impact of the Principal Purpose Test

Oct. 18, 2021, 7:00 AM

Countries endowed with petroleum resources pursue their economic exploitation, which if carried out successfully can provide substantial “hidden wealth” for the host country. An attractive and balanced tax system is a key factor in this economic equation.

This article focuses on the new treaty general anti-avoidance rule (GAAR), the principal purpose test (PPT), which aims at “shielding” the host country’s tax base from abusive transactions.

Generally, double tax treaties (DTTs) enable international oil companies to repatriate their profits by paying low withholding taxes or asserting a claim to crediting the host country taxation, thus reducing their overall cost bases.

However, tax base erosion defeats the principles of horizontal equity and fairness which underlie a tax system by enabling international oil companies to avoid paying their “fair share” of taxes. The new treaty GAAR purports to combat such practices and preserve the integrity of the host country’s tax system.

The PPT has been developed in the context of the base erosion and profit shifting (BEPS) project, as devised and developed by the Organization for Economic Cooperation and Development (OECD)/G-20.

In this article we will discuss the Canadian case, Alta Energy, that reached the Court of Appeals and “re-cast” this decision in view of the PPT.

Principal Purpose Test

The Evolving Path to the PPT

Specific and general anti-avoidance rules found their way into OECD commentaries and double tax treaties before 2003. The “guiding principle” as introduced in the 2003 OECD commentaries stipulates that the treaty benefits should be denied in the event “the main purpose of transactions or arrangements was to secure a favorable tax position” and by doing so it defeats “the object and purpose of the relevant provisions.”

In 2015, the OECD released 15 actions comprising the BEPS plan. Action 6 included the PPT and accorded the status of “minimum standard” under Article 7 of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI). After signing and ratifying the MLI, the PPT is transposed into existing and new treaties of the signatory states. The 2017 OECD commentaries embody the full text underpinning the PPT.

It may be suggested that the wide acceptance of the PPT and its expected uniform application by signatory states might afford this standard the character of a “principle of a customary international tax law.”

Action 6 also extended the Preamble to the 2017 OECD Model Tax Convention, by clearly stipulating that a DTT should not create opportunities for non-taxation, tax avoidance, or tax evasion, including treaty shopping.

Deconstructing the PPT and Its Main Components

The PPT purports to combat both:

  • conduit structures implemented for obtaining a tax advantage that would not have been gained otherwise, for example by interposing a “residence” company to gain access to favorable tax treaty with the situs jurisdiction; and
  • tax abusive transactions or arrangements aiming to afford tax treaty benefits.

The OECD stated that the PPT codified the aforementioned “guiding principle.” The PPT prima facie differs as follows:

  • it applies notwithstanding the other provisions of this Convention;
  • it is activated by the tax benefit constituting “one of the principal purposes” instead of “the main purpose”; and
  • treaty entitlements would be denied under the PPT unless “granting of the said benefit in the circumstances would be in accordance to the object and purpose of this Convention.”

The PPT comprises two components, the principal purpose component (subjective component), and the object and purpose component (objective component). The subjective component appears to recruit a “reasonableness” element, hence pointing to “objectification” of the subjective component.

It may be suggested that the “objective component” implies a “nexus” with the state of residence which may be established by either (i) ownership (if dispersed), or (ii) active economic conduct in the source state, or (iii) looking through to see whether the shareholder would anyway have enjoyed the said tax benefits.

In the presence of sufficient nexus, it may be posited that treaty benefits should not be denied unless the transaction hides tax abuse.

Critical Analysis of the PPT

The PPT is likely to become the flagship in the anti-tax avoidance armory.

The text of the PPT appears to “lower the bar” for abuse by only demanding that the tax benefit obtained constitute one of the principal purposes, and not the main purpose. In parallel, the “reasonableness” test, albeit demanding a careful assessment of facts and circumstances, does not require the finding of conclusive evidence.

Finally, it appears that the PPT “shifts the burden” to the taxpayer to prove the “objective element.”

However, it may be suggested that the OECD commentaries appear to confine the field of operation of the PPT by introducing a “business reality test.” In this respect, the relevant functions and risks as formulated by the OECD Transfer Pricing Guidelines may be a realistic proxy to uncover the business reality.

As an illustration, Example G outlines the setting up of a regional company, RCO, in State R which features business attributes and has a good double tax treaty network. The commentary concludes that in this case, the treaty benefits should be upheld if the company undertakes relevant key risks and functions.

It may also be said that the PPT should not dismantle “bona fide” transactions which are inextricably linked to core commercial activity.

Alta Energy

Case Summary

The Alta Energy Luxembourg SARL case reached the Canadian Federal Court of Appeal (the Court), affirming the Tax Court’s Decision and landing a blow to the Crown’s plans to use the Canadian GAAR.

The case involved the sale of the equity participation in the Canadian company Alta Energy Partners Ltd (AEP) by its direct parent company, Alta Energy Luxembourg (Alta Lux), through which Alta Lux realized substantial capital gain.

Alta Lux obtained the equity participation in AEP in the context of AEP’s ownership restructuring by effectively substituting the prior Delaware direct shareholder, thus achieving a tax efficient ownership structure of Alta Canada by presumably allowing the “tax free” sale of shares in AEP. The shareholders of Alta Lux were Alta Resources LLC and an affiliate of the Blackstone Group through a Canadian Partnership.

The holding of the shares in Alta Canada comprised the sole asset and investment of Alta Lux. The duration of the holding was around 18 months. Alta Lux was incorporated on April 19, 2012 and the same day acquired the investment in Alta Canada which it sold 18 months later, in September 2013, realizing a vast profit of $382 million.

AEP actively conducted unconventional shale oil business in the Duvernay Shale in Western Canada pursuant to acquiring the relevant licenses and leases, drilling horizontal and vertical wells between 2012 and 2013.

Main Tax Provisions Covered

  • Canadian taxation is charged on taxable Canadian property;
  • The Canadian GAAR, which is composed of (a) the existence of a tax benefit, (b) avoidance transaction, and (c) abuse of provision or tax treaty;
  • The Luxembourg–Canada treaty, provisions 1, 4 which cover the scope and residency, and 13(4) and (5), which lay down the rule according to which the source state, Canada, taxes gains emanating from disposal of shares if (a) their value derives substantially from “immovable property” in the source state, and (b) the seller has a substantial interest of at least 10%. Nevertheless, the treaty affords a carve-out to the general rule when the property is used for carrying out the business.

Court’s Judgment

The Court examined the object of the appeal. The Court implemented a “textual, contextual and purposive” interpretation analysis as enshrined in the Vienna Convention in arriving at its decision, which upheld the Tax Court’s ruling.

The Court reached its decision after ruling that the DTT did not condition the rights to the Luxembourg entity on (a) the residency of the shareholders of Alta Lux, (b) the taxation of the profit under the laws of Luxembourg, or (c) the scale of economic or commercial ties with Luxembourg.

Brief Commentary

The Court appears to endorse the principle of pacta sunt servanda, refusing to “rewrite the treaty” by uncovering a “hidden” anti-avoidance provision, either by (a) attributing operative status to the Preamble which surpasses its real use as an interpretative tool for the substantive provisions, or (b) stretching the interpretation of the treaty to breaking point.

This bring us to the question, had the PPT and the extended Preamble been applicable at the time, would the Court have reasoned differently?

Application of PPT in Alta Energy

Prima facie, the Court restrained itself and gave effect to the plain meaning of the relevant provisions of the DTT in their context and in line with their object and purpose.

We attempt below to “re-cast” the Court’s judgment in the view of the PPT and the extended Preamble.

  • If the Extended Preamble was effective

In the relevant literature there is a broad consensus between scholars for the use of the Preamble chiefly for interpretation purposes, hence denying the possibility of its functioning as a substantive/operating provision per se. In this respect its role should be to aid in the interpretation of the terms, if ambiguous, or serve as indication of a purpose or objective.

As a corollary, the Preamble should not be used to override the plain and clear meaning of words. Considering the above, the extended Preamble should not really have had an impact on the judgment in the absence of a substantive anti-avoidance provision.

  • If both PPT and the Extended Preamble were effective

We have already elaborated on the scope and operation of the PPT.

Alta Lux was set up admittedly to gain access to the favorable Luxembourg DTT hence escaping Canadian taxation on its profits in the context of a future sale of the shares in Alta Canada. Presumably selling Alta Canada was contemplated by the “investors” ab initio.

Additionally, absent Alta Lux, the investors would not have gained the said tax benefit. Further, the facts as depicted in the judgment hint that Alta Lux did not maintain real offices or employees, and presumably lacked the competence to undertake related risks or decisions and the financial capability to absorb these.

There is also no indication that Alta Lux conducted active business of servicing, managing, supporting Alta Canada in any way. Finally, it appears that Alta Canada was the only asset of Alta Lux for a short period of time.

Considering the above, the Court may have delivered a different judgment in the presence of the PPT and the extended Preamble. Such conclusion may be feasible after considering that (a) the main purpose (or if not, then one of the main purposes) for incorporating Alta Lux was ipso facto to obtain tax benefit, hence escaping taxation, and (b) allowing the tax benefit in that situation may have defeated the purpose and objective of the provisions of the DTT.


The PPT transcends the conventional anti-avoidance tax treaty tools, thus reinforcing host countries in their battle to disassemble aggressive structures and abusive arrangements that may have been contrived by multinational companies or lack genuine or commercial sense.

In this respect, the PPT safeguards the key principles underlying tax systems, such as horizontal equity and fairness, by dictating that multinational companies should pay their fair share of tax in host countries. However, its extensive and unconstrained application, extending beyond reasonable and acceptable boundaries, could impede global trade, with significant consequences.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Costas Michail is Director in charge of Tax Advisory in Cyprus law firm Scordis, Papapetrou & Co (Corporate Services) Ltd, with more than 13 years of experience in the tax profession, specializing in international and domestic tax.

The author may be contracted at c.michail@scordispapapetrou.com

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