What is a Multilateral Instrument (MLI)? Purpose, Provisions and Impact

The OECD's Base Erosion and Profit Shifting (BEPS) project aims to address the challenges posed by multinational corporations exploiting tax loopholes to shift profits to low or no-tax jurisdictions, leading to significant revenue losses for governments. To expedite the implementation of BEPS measures across numerous bilateral tax treaties, the Multilateral Instrument (MLI) was developed. 

The MLI enables jurisdictions to swiftly and efficiently modify their existing tax treaties by incorporating BEPS recommendations, streamlining the process, and promoting fairer international taxation.

Malaysia was actively involved in the development of the MLI, which was finalized in Paris on 24 November 2016. The country signed the MLI on 24 January 2018, and it entered into force for Malaysia on 1 June 2021.

What is Multilateral Instrument (MLI)?

The Multilateral Instrument (MLI), formally known as the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, is a tool developed under the Organization for Economic Co-operation and Development (OECD) and the G20’s Base Erosion and Profit Shifting (BEPS) project.

The MLI is not a standalone treaty but rather a tool that modifies existing bilateral tax treaties between countries. It has been designed to implement a series of tax treaty measures that update international tax rules and reduce the opportunities for tax avoidance by multinational enterprises. This approach allows countries to close loopholes and align with international tax standards without the need to negotiate each treaty separately, thus saving time and effort.

OECD and BEPS

The Organisation for Economic Co-operation and Development (OECD) is an intergovernmental organization founded in 1961, consisting of 38 member countries. It serves as a platform for its members, who are committed to democracy and a market-based economy, to collaborate on economic progress and world trade. The OECD allows member countries to compare policy experiences, address common challenges, identify best practices, and coordinate domestic and international policies.

Base Erosion and Profit Shifting (BEPS) refers to strategies employed by multinational corporations to shift profits from higher-tax jurisdictions to areas with lower or no tax rates, often with little to no economic activity. These practices reduce the taxable income or "tax base" in the higher-tax jurisdictions, resulting in lower tax revenue for those governments. While some of these tactics are illegal, most exploit gaps and mismatches in tax regulations. BEPS strategies impact the fairness and integrity of tax systems and disproportionately affect developing nations, which rely more on corporate income taxes for revenue.

Purpose of MLI

The purpose of the Multilateral Instrument (MLI) is to swiftly and efficiently implement changes to bilateral tax treaties in order to combat tax avoidance and ensure fair taxation. It aims to address tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax jurisdictions.

Here are the main objectives of the MLI:

1. Preventing Treaty Abuse: The MLI introduces measures to prevent the misuse of tax treaties, such as treaty shopping, where taxpayers attempt to take advantage of treaty benefits not intended for them.
2. Strengthening Tax Treaties: The MLI updates existing bilateral tax treaties to align them with the minimum standards and best practices developed under the BEPS project. This includes provisions like the Principal Purpose Test (PPT) to ensure treaties are not used for tax evasion or avoidance.
3. Enhancing Dispute Resolution: The MLI incorporates improved procedures for the resolution of disputes related to the application of tax treaties, including the Mutual Agreement Procedure (MAP), which allows taxpayers to seek resolution in cases where they believe a treaty has not been applied correctly.
4. Broadening the Scope of Permanent Establishment: The MLI expands the definition of a permanent establishment (PE) to counter strategies used to artificially avoid PE status, ensuring that profits are taxed where the economic activities generating them take place.
5. Reducing the Need for Bilateral Treaty Updates: By allowing multiple countries to simultaneously update their treaties through a single multilateral agreement, the MLI reduces the need for time-consuming bilateral negotiations, thus facilitating quicker implementation of BEPS measures.

Covered Tax Agreements

The Multilateral Instrument (MLI) targets "Covered Tax Agreements" (CTAs). To designate a tax agreement as a CTA, participating countries must inform the OECD about the specific bilateral income tax treaties they wish to include. Countries then select which MLI provisions to adopt for each CTA, with certain provisions being mandatory and others optional. If both parties to a bilateral tax agreement choose to designate it as a CTA, the MLI will modify the agreement accordingly. Additionally, countries can designate treaties and protocols that have been signed but are not yet in force, expecting these will become CTAs once effective.

Upon signing and ratification, each party is required to submit a list of reservations and notifications to the OECD, referred to as the "MLI position." This list specifies which MLI provisions each country accepts or rejects. The impact of the MLI on each tax treaty is determined by the mutual acceptance or reservations of the provisions by the treaty parties. Generally, if one party remains silent, it is assumed they accept the other party's list of reservations and notifications. However, certain articles require both parties to explicitly agree to additional measures.

Provisions Adopted by Malaysia on the MLI

Minimum Standard Provisions

1. Article 6: Purpose of a Covered Tax Agreement

This provision includes a statement in the preamble of the tax treaty clarifying that the treaty's intent is not to create opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including treaty-shopping arrangements.

2. Article 7: Preventing Treaty Abuse

This article introduces a general anti-abuse rule, commonly known as the Principal Purpose Test (PPT), to prevent treaty abuse. It denies treaty benefits if one of the principal purposes of a transaction is to obtain those benefits, unless doing so is in line with the treaty's objectives.

3. Article 16: Mutual Agreement Procedure (MAP)

This provision updates the MAP to resolve disputes regarding the interpretation or application of double tax agreements. It allows an aggrieved party to present their case to the competent authority of either Contracting State and sets a three-year duration for MAP applications.

Optional Provisions

1. Article 3(1): Transparent Entity

This provision allows treaty benefits for income derived through fiscally transparent entities, such as partnerships or trusts, as long as one of the countries treats the income as that of one of its residents under its domestic law.

2. Article 12: Artificial Avoidance of Permanent Establishment Status

It addresses scenarios where agents or intermediaries play a principal role in concluding business contracts on behalf of a foreign enterprise, thereby constituting a permanent establishment of that enterprise in the country.

3. Article 13: Specific Activity Exemptions

Only genuine preparatory or auxiliary activities are excluded from the definition of a permanent establishment. This provision prevents entities from fragmenting their activities to qualify for this exclusion.

4. Article 15: Definition of a Person Closely Related to an Enterprise

This article defines what constitutes a person closely related to an enterprise concerning permanent establishment articles.

5. Article 17: Corresponding Adjustments

It provides for a country to make a corresponding adjustment to the profits of a resident entity as a result of an adjustment by the other country to the profits of an associated entity, aiming to alleviate double taxation.

Treaties Modified by MLI: Malaysia

Below is a table listing the countries with which Malaysia's treaties will be modified by the MLI, based on the countries' positions as of June 2024:

The number of treaties modified by the MLI may change as more of Malaysia's tax treaty partners sign and ratify the MLI and list their treaties with Malaysia.

Impact of MLI on Bilateral Tax Treaties

The Multilateral Instrument (MLI) has a profound impact on bilateral tax treaties by modernizing and streamlining them to address contemporary challenges in international taxation. Here’s how the MLI influences these treaties:

1. Updating and Enhancing Treaties: The MLI modifies nearly 2,000 existing bilateral tax treaties without the need for renegotiation between countries. It introduces standardized measures that address issues like tax avoidance and double taxation, ensuring that treaties are aligned with the latest international tax standards.
2. Preventing Treaty Abuse: One of the primary goals of the MLI is to prevent the abuse of tax treaties. It incorporates provisions such as the Principal Purpose Test (PPT), which allows countries to deny treaty benefits if obtaining those benefits was one of the main purposes of a transaction. This helps close loopholes that companies might exploit to minimize their tax liabilities.
3. Flexibility and Customization: The MLI allows countries to choose which provisions to adopt in their bilateral treaties, providing flexibility in how each treaty is applied. This means the impact of the MLI can vary significantly from one treaty to another, depending on the choices made by the participating countries.
4. Broadening the Definition of Permanent Establishment: The MLI expands the concept of Permanent Establishment (PE) to include various forms of business activities that were previously excluded. This includes provisions to prevent the artificial avoidance of PE status through strategies like commissionaire arrangements and fragmentation of activities.
5. Improving Dispute Resolution: The MLI enhances the Mutual Agreement Procedure (MAP) in treaties to provide clearer and more efficient processes for resolving tax disputes. This helps reduce the potential for double taxation and provides a framework for countries to work together in addressing cross-border tax issues.
6. Wider Impact on International Taxation: By setting minimum standards and optional provisions, the MLI creates a more uniform approach to international taxation. This encourages transparency and cooperation among countries, reducing the likelihood of tax disputes and fostering a more stable and predictable tax environment for multinational enterprises.

Preparing Businesses for MLI

• Assess Impact on Arrangements: Businesses need to evaluate how the MLI affects their existing and new arrangements, particularly regarding the Principal Purpose Test (PPT), which targets transactions primarily aimed at obtaining tax benefits.
• Check Treaty Modifications: Identify whether their tax treaties are covered by the MLI and assess the effective dates and provisions adopted by Malaysia and its treaty partners.
• Review Cross-Border Transactions: Align the substance of arrangements with their legal form and ensure all business decisions have a genuine commercial purpose.
• Understand Anti-Fragmentation Rules: Analyse the full scope of their value chain, considering all related entities, to determine the potential creation of a Permanent Establishment (PE).
• Prepare for Agency PE Expansion: Expect increased scrutiny from tax authorities on structures like marketing and sales support companies and adapt to mitigate tax risks.
• Adapt to Increased Complexity: Recognize the heightened complexity introduced by the MLI in international taxation and stay informed on how authorities plan to implement these changes.

Conclusion

MLI represents a significant step forward in international tax cooperation, aiming to ensure that bilateral tax treaties remain relevant and effective in the face of an evolving global economy. It prompts countries and businesses to reassess their tax strategies and structures, promoting fair taxation and reducing opportunities for tax avoidance.