On February 29, 2016, the Organization for Economic Co-operation and Development (OECD) published a discussion draft titled, Proposed Changes to the OECD Model Tax Convention Concerning the Treaty Residence of Pension Funds. This Discussion Draft was built on the final version of the report on Action 6 of the BEPS Action Plan (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances). The current OECD Model Tax Convention does not include specific rules for determining whether a pension fund can be deemed a resident of its state of establishment. In order to specifically address treatment of pension funds, the Discussion Draft proposes changes to: Article 3 (General Definitions), Article 4 (Residence), and the Commentary on Article 3 and Article 4 of the OECD Model Tax Treaty.
Article 3 — General Definitions
The Discussion Draft proposes adding a definition of a “recognized pension fund” to paragraph 1 of Article 3.
- The term recognized pension fund of a State means an entity or arrangement established in that State that is treated as a separate person under the taxation law of that State and:
- (i) That is constituted and operated exclusively to administer or provide retirement or similar benefits to individuals and that is regulated as such by that State or one of its political subdivisions or local authorities; or
- (ii)That is constituted and operated exclusively to invest funds for the benefit of entities or arrangements referred to in subdivision (i).
Article 4 — Residence
The Discussion Draft further proposes to replace paragraph 1 of Article 4 of the OECD Model Convention which determines whether the investor is a resident of a contracting sate, by making explicit reference to a “recognized pension fund.”
|For the purpose of the Convention, the term “resident of a Contracting State” means any person, who under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof as well as a recognized pension fund of that State. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.|
Commentary to Article 3 and 4
The Discussion Draft proposes adding paragraphs 10.3 to 10.7 to the Commentary on Article 3 expanding the definition of a “recognized pension plan” to include certain arrangements that provide pension services.
Notably the commentary makes the following reference to pensions that are operated as trust schemes.
There is considerable diversity in the legal and organizational characteristics of pension funds around the world and it is therefore necessary to adopt a broad formulation. The reference to an “arrangement” is intended to cover cases where pension benefits are provided through vehicles such as a trust, which under the relevant trust law, would not constitute an entity: the definition will apply as long as the trust or the body of trustees is treated for tax purposes, as a separate entity recognized as a separate person.
It does not matter whether the regulatory framework to which the entity or arrangement is subjected is provided in tax laws or in other legal instruments; what matters is that the entity or arrangement be recognized by law as a vehicle constituted to finance retirement benefits for individuals and be subject to conditions intended to ensure that it is sued solely for that purpose.
The commentary also provides examples of arrangements that satisfy the definition of a “recognized pension fund.”
|... an agency or instrumentality of a State set up exclusively to administer or provide retirement benefits under the social security legislation of that State. Another example would be a company or other entity that is established in a State solely for the purpose of administering or providing retirement or similar benefits to individuals and whose only assets include funds that are covered by a retirement scheme regulated by the tax laws of that State which provide that the income from that scheme is exempt from tax. The definition of recognized pension fund would apply to that company or entity regardless of whether that company or entity is person liable to tax (i.e. with respect to income not derived from the scheme) and therefore qualified as a resident of that State under the first sentence of paragraph 1 of Article 4.|
Under the current version of the U.S. Model Tax Treaty, the definition of a pension fund requires that the fund be
- (i) operated exclusively or almost exclusively:
- (a) To administer or provide pension or retirement benefits; or
- (b) To earn income from the benefit of one or more persons established in the same Contracting State that are generally exempt from income taxation in that Contracting State and that are operated exclusively or almost exclusively to administer or provide pension or retirement benefits;
The proposed definition of a “recognized pension fund” under Article 3, paragraph j),
subparagraph (ii) of the OECD Model Tax Convention includes specific reference to group trusts, which may help in alleviating some treaty accessibility issues experienced by group trusts or similar arrangements.
- (ii) That is constituted and operated exclusively to invests funds for the benefit of entities or arrangements referred to in subdivision (i)
The commentary to Article 3, further expends on the term “arrangement” to include vehicles such as trusts.
|The reference to an “arrangement” is intended to cover cases where pension benefits are provided through vehicles such as a trust, which under the relevant trust law, would not constitute an entity: the definition will apply as long as the trust or the body of trustees is treated for tax purposes, as a separate entity recognized as a separate person.|
Another potential consideration is that group trusts can include Puerto Rican pension funds.
While the US Model Tax Treaty requires the that the group trust be operated “exclusively or almost exclusively to administer or provide pension or retirement benefits,” which may be interpreted to allow participation by Puerto Rican pension funds in the group trust, the OECD Model Tax Convention does not make such reference in its definition of a “recognized pension fund.”
If adopted, the Model Tax Convention will be reflected in future bilateral tax treaties, as well as multilateral instruments that would be implemented to facilitate BEPS. It is anticipated that OECD will issue additional commentary with an intended implementation for the 2017 Model.
Many countries already agree that pension funds meet the requirements set forth in the residency articles and therefore are eligible to benefit under tax treaties. It follows that the proposals in the Discussion Draft may impact a smaller segment of countries and may create new or additional criteria to be addressed by those countries that already agree on treaty eligibility.
There is also concern that the portion of the definition of a “recognized pension fund” that states that it should be “treated as a separate person” may be too restrictive and may thereby exclude certain arrangements that are not deemed separate persons in their country of domicile, but are nevertheless granted benefits available to pensions.
|... pension funds often invest together with other pension funds pooling their assets in certain arrangements or entities, and may for various commercial, legal or regulatory reasons, invest via wholly owned entities or arrangements that are residents of the same State. Since such arrangements or entities act only as intermediaries for the investment of funds used to provide retirement benefits to individuals, it’s appropriate to treat them like pension funds that invest through them.|
The Discussion Draft builds on the final version of the OECD’s Base Erosion Profit Shifting (BEPS) Report, Action 6 (Preventing and Granting of Treaty Benefits in Inappropriate Circumstances) where it was concluded that work needs to be done so that “… pension funds should be considered to be a resident of that State in which it is constituted regardless of whether the pension fund benefits from a limited or complete exemption from taxation in that State.”
The Discussion Draft provided for a short commentary period until April 1, 2016. Comments received will be discussed by Working Party 1 at its next meeting when the Working Party will be asked to finalize the changes included in the Discussion Draft.
The proposed changes to the Model Tax Convention aim to establish a “recognized pension fund” as a resident of its country of domicile, thereby eliminating ambiguity of such pension fund or groups trust being eligible to qualify for tax treaty benefits. The proposed changes also emphasize that such is the case regardless of whether the pension fund is exempt from taxation in its state of establishment.
Potential Impact on Revenue Ruling 81-100 Group Trust
As a matter of brief background, an Internal Revenue Service (IRS) Revenue Ruling 81-100 group trust (group trust) pools retirement benefit plans that are exempt from U.S. taxation under Section 501(a) of the Internal Revenue Code (IRC). When investing in foreign markets, these group trusts oftentimes experience issues accessing tax treaty benefits. One of the main reasons being that foreign tax authorities are not assured that the underlying pension plan participants within the group trust are treaty eligible and therefore require proof in the form of documentation at the underlying participant level. This proves to be a burdensome requirement for the group trust that is difficult and oftentimes impossible to comply with.
BBH’s pension clients have experienced issues accessing treaty benefits in a variety of markets. Some examples include Japanese Investment Trust Management (ITM) Pension Funds, as well as Japanese Trust Pension Funds experiencing difficulties accessing treaty benefits in Switzerland. The Swiss Tax Authorities are requesting a complete list pensions with names and percentages held, along with a confirmation from the competent tax office that states that the listed investors are founded as pension funds in Japan. Typically, upon submission of such information, along with a Certificate of Residence (CoR) in the name of the Trust Bank, confirming that the final beneficiaries are pension funds, the Swiss Tax Authorities issue tax refunds.
The Swiss Tax Authorities have also requested additional information of group trusts that meet the Revenue Ruling 81-100 criteria. While the IRS deems group trusts that meet Revenue Ruling 81-100 criteria as opaque (non-transparent) entities for tax purposes, the Swiss Tax Authorities do not agree with this assessment and have therefore issued requests for additional information with respect to the participants in the fund, including disclosures and CoRs of the participants in the fund as proof of eligibility for DTAT benefits. For many investors, the additional requirements prove to be difficult or impossible to comply with.
Group trusts have also experienced similar treaty accessibility issues with respect to their investments in Japans, France and Germany.
Although the proposed definition of a “recognized pension fund” includes reference to group trusts, not all procedural treaty accessibility problems are addressed. Procedural problems, as referenced above, have to do with having to prove the residence of the participants in the group trust in order to satisfy Limitation of Benefits (LoB) article requirements. These would need to be addressed promptly.
The Association of Global Custodians (AGC), of which BBH is an active member, has drafted a letter in response to the Discussion Draft making additional suggestions of possible issues with the current proposals.
For more information, please contact BBH's Global Tax Team.
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