What Is an MLI and How Does It Affect Tax Treaties?

The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, known as the Multilateral Instrument (MLI), is a global agreement from the Organisation for Economic Co-operation and Development (OECD). Its function is to update the network of existing bilateral tax treaties to combat tax avoidance by multinational enterprises. Historically, amending thousands of individual tax treaties required lengthy bilateral negotiations. The MLI streamlines this by allowing jurisdictions to modify their treaties simultaneously, transposing the results of the OECD’s Base Erosion and Profit Shifting (BEPS) project into their agreements and closing loopholes without renegotiating each treaty from scratch.

The Problem the MLI Solves Base Erosion and Profit Shifting

The MLI addresses tax avoidance strategies known as Base Erosion and Profit Shifting (BEPS). Base erosion refers to actions by multinational companies to reduce their taxable income in countries where they generate value. Profit shifting is moving those profits from higher-tax jurisdictions to locations with low or no corporate taxes, exploiting gaps between different countries’ tax rules.

Common strategies include transferring intellectual property (IP) to a subsidiary in a tax haven and then paying it large, tax-deductible royalties. Another method involves a subsidiary in a low-tax jurisdiction making high-interest loans to group companies in higher-tax countries. In both cases, profits are shifted to low-tax locations while expenses are deducted in high-tax ones.

These techniques were often permissible under older bilateral tax treaties designed mainly to prevent double taxation, not the complexities of the modern digital economy. This created opportunities for BEPS, leading to corporate tax revenue losses for governments and an uneven playing field for domestic businesses.

How the MLI Modifies Existing Tax Treaties

The MLI does not replace existing tax treaties but works alongside them as an overlay. This mechanism avoids the process of bilaterally renegotiating individual treaties, allowing for a swift implementation of anti-avoidance measures. The MLI’s provisions only take effect by modifying a pre-existing agreement.

For the MLI to affect a bilateral tax treaty, it must be designated as a “Covered Tax Agreement” (CTA) by both signatory countries. When joining the MLI, a country submits a list of treaties it wishes to cover. If its treaty partner also lists that agreement, the treaty becomes a CTA; otherwise, the MLI has no effect on it.

The MLI’s functionality rests on a “matching” principle, where a specific provision only modifies a CTA if both countries have agreed to adopt it. This ensures changes are made by mutual consent. The MLI contains a variety of provisions that countries can choose from to meet their specific policy needs.

This flexibility is achieved through reservations and notifications submitted in a country’s “MLI Position” document. A country can use a “reservation” to opt out of an article or part of it. Alternatively, a country can make a “notification” to select its preferred option from several choices within an article.

Key Changes Introduced by the MLI

Preventing Treaty Abuse

An objective of the MLI is to prevent “treaty shopping,” where an enterprise routes investment through a third country to gain access to its tax treaty benefits. To combat this, the MLI introduces a “Principal Purpose Test” (PPT) as a minimum standard under Article 7.

The PPT denies treaty benefits if obtaining the benefit was a principal purpose of the arrangement. The taxpayer must demonstrate a genuine commercial rationale for their structure beyond securing a tax advantage. This forces a substance-over-form analysis to ensure benefits align with underlying economic activities.

Changes to Permanent Establishment Status

The MLI tightens the rules for what constitutes a “Permanent Establishment” (PE), the threshold for a foreign company having a taxable presence. Previously, companies could use a “commissionaire arrangement,” where a local entity facilitates sales but does not formally conclude contracts, to avoid creating a PE.

Article 12 broadens the definition of a dependent agent PE. A PE may be created if a person in a country habitually plays the principal role leading to the conclusion of contracts that are then routinely concluded without material modification by the foreign enterprise.

The MLI also targets the artificial fragmentation of business activities. Article 13 introduces an anti-fragmentation rule. This rule requires that the combined activities of closely related enterprises be considered together to determine if, as a whole, they go beyond a preparatory or auxiliary nature.

Addressing Hybrid Mismatch Arrangements

Hybrid mismatch arrangements exploit differences in the tax characterization of an entity or financial instrument between countries to achieve double non-taxation. For example, a paying company may get a tax deduction for an “interest” payment, while the receiving company treats the income as a tax-exempt “dividend.”

The MLI implements measures to neutralize these arrangements. Article 3 addresses hybrid entities, clarifying that treaty benefits are granted on income only to the extent that the income is treated as income of a resident for tax purposes by the entity’s home jurisdiction.

Improving Dispute Resolution

When tax authorities in two countries disagree on a tax treaty’s application, it can lead to double taxation. The method for resolving these conflicts is the Mutual Agreement Procedure (MAP), a government-to-government negotiation that could often drag on for years.

The MLI aims to make dispute resolution more effective by strengthening MAP provisions. It also offers an optional provision for mandatory binding arbitration. Countries opting in commit that if a MAP case is not resolved within a set timeframe, it will be submitted to an independent panel for a binding decision.

Determining the MLI’s Impact on a Specific Treaty

Determining how the MLI modifies a specific bilateral tax treaty requires a multi-step analysis. The process involves verifying the positions of both countries and understanding how their choices interact.

First, confirm that both countries have signed and ratified the MLI. Its provisions become legally effective for a country only after it completes its domestic ratification process. The dates of entry into force can differ for each country and type of tax.

Next, verify that the specific bilateral treaty is listed as a Covered Tax Agreement (CTA) by both jurisdictions. If a treaty is not on both countries’ lists, the MLI does not apply to it.

If the treaty is a CTA, analyze each country’s “MLI Position.” This document, submitted to the OECD, details the choices, reservations, and notifications made for every MLI provision and is needed to understand which articles a country has adopted.

To simplify this task, the OECD developed the MLI Matching Database. This online tool compares the MLI Positions of two selected countries. It shows which provisions “match” and will therefore modify the selected CTA.