Limitation on benefits: Overview, definition, and example
What is limitation on benefits?
A limitation on benefits (LOB) clause is a provision commonly included in international tax treaties and agreements to prevent the misuse of tax treaty benefits. It limits the availability of treaty benefits, such as reduced withholding tax rates or exemptions, to entities that meet certain qualifying criteria. These criteria typically ensure that only residents or entities with substantial ties to the contracting countries can access the tax benefits of the treaty. The goal of the LOB clause is to prevent "treaty shopping," where companies or individuals from third-party countries attempt to take advantage of favorable treaty provisions by routing their transactions through a country with a more beneficial tax treaty.
For example, an entity in a country with a favorable tax treaty might be limited in claiming the benefits of that treaty unless it meets certain requirements, such as conducting substantial business activities in that country.
Why is limitation on benefits important?
Limitation on benefits clauses are important because they help ensure that the tax benefits of a treaty are used only by legitimate residents or entities of the contracting countries. By preventing treaty shopping, LOB clauses safeguard the integrity of tax treaties and ensure that they are not exploited by parties who have no substantial connection to the countries involved. This helps preserve the intended tax benefits for eligible taxpayers and reduces the risk of tax avoidance through artificial structures or transactions.
For businesses, understanding LOB clauses is crucial for ensuring compliance with international tax rules and avoiding penalties related to improper use of tax treaty benefits.
Understanding limitation on benefits through an example
Imagine a corporation based in Country A, which has a favorable tax treaty with Country B that provides reduced withholding taxes on dividends. If a company in Country C (which has no tax treaty with Country B) wants to benefit from this reduced withholding tax rate, it might set up a subsidiary in Country A to route its dividend payments. However, the LOB clause in the tax treaty between Country A and Country B prevents such treaty shopping. The LOB clause requires that the entity in Country A must meet certain requirements, such as having a substantial business presence or significant economic activity in Country A, before it can claim the treaty benefits.
In another example, a holding company in Country A might use a treaty with Country B to reduce taxes on dividends paid to shareholders in Country C. However, the LOB clause in the treaty prevents the holding company from receiving these benefits unless it can prove it is genuinely established in Country A and meets the treaty’s criteria, such as having a certain level of local employees or operations.
An example of a limitation on benefits clause
Here’s how a limitation on benefits clause might look in a tax treaty or agreement:
“A resident of a Contracting State shall not be entitled to the benefits of this Agreement if it is determined that the primary purpose or effect of its establishment, acquisition, or maintenance was to secure benefits under this Agreement that are not available under the provisions of this Agreement to persons who do not have a substantial economic presence in the Contracting State.”
Conclusion
Limitation on benefits clauses play a crucial role in international tax treaties by ensuring that tax benefits are only available to legitimate residents or entities of the contracting countries. These clauses help prevent treaty shopping, where entities or individuals from third-party countries seek to exploit the tax advantages of a treaty without having substantial connections to the treaty’s signatories. For businesses involved in cross-border transactions, understanding and complying with LOB clauses is essential to ensure they qualify for the intended benefits and avoid unintended tax consequences or penalties.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.