Sovereign Jurisdictions and the Architecture of Anti-Avoidance: A Comprehensive Analysis of the Evolution of International Tax Law

Sovereign Jurisdictions and the Architecture of Anti-Avoidance: A Comprehensive Analysis of the Evolution of International Tax Law

1. Introduction: The Juridical Nature of the Double Taxation Convention

The international tax architecture functions as a complex scaffolding constructed at the intersection of sovereign domestic law and bilateral public international law. At its core, the Double Taxation Avoidance Agreement (DTAA) represents a diplomatic compromise between two contracting states, each agreeing to self-limit their inherent sovereign power to tax in exchange for reciprocal benefits that theoretically foster cross-border trade and investment.¹ The fundamental premise of these agreements has historically been the elimination of double taxation—a scenario where the same income is taxed in the hands of the same taxpayer by two different jurisdictions.³ However, the philosophical and practical orientation of these instruments has undergone a seismic shift over the last two decades, evolving from mechanisms of pure relief to instruments of regulation against fiscal evasion.

Tax treaties balance sovereign taxing rights with the prevention of abuse by establishing a framework that allocates jurisdiction between states while simultaneously incorporating specific mechanisms to ensure these allocations are not exploited for tax avoidance. This balance is achieved through the interaction of distributive rules, anti-abuse provisions, and the coordination of domestic and international law.⁴ Fundamentally, tax treaties do not create a new power to tax; rather, they modify the existing sovereign jurisdiction of the contracting states. They act as a "stencil" placed over domestic law: where the stencil covers domestic liability, taxation is restricted or eliminated, but where there are holes, domestic liability remains.⁶

This report provides an exhaustive analysis of this evolution, examining the inherent anti-avoidance principles that existed prior to the Base Erosion and Profit Shifting (BEPS) project, the legal tension between pacta sunt servanda and domestic General Anti-Avoidance Rules (GAAR), and the seminal Indian jurisprudence—Union of India v. Azadi Bachao Andolan and Vodafone International Holdings B.V. v. Union of India—that has defined the boundaries of legitimate tax planning versus abusive treaty shopping.

1.1 The "Stencil" Theory and the Preservation of Sovereignty

The "stencil" metaphor underscores a critical legal reality: tax treaties are permissive in their relief but restrictive in their application of sovereign power. If a state does not have the domestic authority to tax a specific item of income, the treaty cannot bestow that authority. Conversely, if domestic law imposes a tax, the treaty may limit the rate or the right to exercise that imposition.

Allocations of sovereign taxing rights are not transfers of power but limitations on exercise. When a Source State agrees to cap withholding taxes on dividends, it is not granting the Residence State the power to tax; it is merely agreeing not to exercise its own plenary power beyond a certain limit.⁷ This distinction is vital for understanding the interplay between domestic anti-avoidance rules and treaty obligations. If a treaty is merely a stencil restricting domestic law, then the removal of the treaty benefit (due to abuse) simply allows the full weight of domestic law to apply once more.

2. Allocation of Sovereign Taxing Rights: The Distributive Framework

The primary method of balancing rights within the international tax system is the allocation of taxing power between the Source State (where income arises) and the Residence State (where the taxpayer resides). This allocation is achieved through "Distributive Rules," which classify income into different schedular categories and assign primary or exclusive taxing rights.

2.1 Distributive Rules and Reciprocity

The architecture of distributive rules is built upon the principle of reciprocity. To facilitate trade and investment, source states often agree to restrict their sovereign right to tax certain income. This restriction is generally based on the assumption that the income will be taxed in the Residence State.⁷

• Source State Restrictions: These are concessions made by the state where the economic activity occurs. For example, Article 10 (Dividends) and Article 11 (Interest) typically impose a cap on the withholding tax rate (e.g., 10% or 15%) that the Source State can levy. This reduction is designed to prevent the tax burden from becoming prohibitive for cross-border investors.⁸
• Residence State Obligations: In exchange for the Source State's concession, the Residence State is typically obliged to relieve double taxation. This is achieved through Article 23 of the OECD Model, which mandates either the exemption method (forgoing its right to tax foreign income entirely) or the credit method (taxing the income but granting a credit for the foreign tax paid).⁶

This bilateral bargain creates a "closed system" where the tax base is shared. However, this system relies on the integrity of the tax base in both jurisdictions. If the Residence State does not tax the income (due to a territorial system or tax exemptions), and the Source State restricts its tax based on the treaty, the result is "double non-taxation"—a phenomenon that modern treaties explicitly seek to prevent.⁴

2.2 The Saving Clause: The Ultimate Sovereign safeguard

To protect fiscal sovereignty, treaties often include a "Saving Clause" (e.g., Article 1(3) of the OECD Model 2017 or Article 1(4) of the US Model). This provision preserves a state's right to tax its own residents (and in the case of the US, its citizens) as if the treaty did not exist.⁹

The Saving Clause ensures that treaty benefits generally do not restrict a country's ability to tax its own domestic base. It prevents the anomaly where a resident of a country uses a tax treaty to avoid tax in their own country of residence. For instance, without a Saving Clause, a US citizen living in a treaty partner country might claim that the treaty prevents the US from taxing their income, despite the US's citizenship-based taxation model. The Saving Clause effectively "turns off" the treaty restrictions for the state's own residents, with specific exceptions for benefits that are intended to apply even to residents (such as relief from double taxation or non-discrimination).¹⁰

3. The Legal Concept of Pacta Sunt Servanda and Treaty Interpretation

The interpretation of tax treaties is governed by the Vienna Convention on the Law of Treaties (VCLT), 1969. The cornerstone of treaty law is the principle of pacta sunt servanda.

3.1 The Binding Nature of Obligations

Article 26 of the VCLT states: "Every treaty in force is binding upon the parties to it and must be performed in good faith".¹² This principle creates a binding obligation on the contracting states to adhere to the agreed limitations on their taxing rights. In the context of taxation, pacta sunt servanda implies that a state cannot use its domestic law to unilaterally alter the bargain struck in the treaty.

This principle is the primary defense used by taxpayers against the application of domestic General Anti-Avoidance Rules (GAARs). The argument posits that if a taxpayer meets the specific requirements of the treaty (e.g., possesses a valid Tax Residency Certificate), denying the benefits based on a domestic "substance-over-form" doctrine constitutes a breach of the international obligation to perform the treaty in good faith.¹⁴

3.2 The "No Conflict" View and the Guiding Principle

To reconcile the pacta sunt servanda obligation with the need to combat abuse, the OECD and legal scholars have developed the "No Conflict" view. This perspective asserts that domestic anti-abuse rules do not conflict with tax treaties because treaties are not intended to facilitate abuse.⁶

• The Guiding Principle (2003): The 2003 revision to the OECD Commentary on Article 1 introduced an inherent "guiding principle." It stated that the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment would be contrary to the object and purpose of the relevant provisions.¹⁵
• Interpretive Approach: This allows states to apply domestic substance-over-form doctrines or GAARs without violating international law obligations. Courts may interpret treaty provisions (e.g., the definition of "beneficial owner") in a way that aligns with domestic anti-avoidance principles, thereby preventing the treaty from becoming a shield for tax avoidance schemes.¹⁶

The "No Conflict" view essentially redefines "Good Faith" in Article 26 VCLT. It argues that claiming treaty benefits for artificial arrangements is an act of bad faith; therefore, denying those benefits is the only way to perform the treaty in good faith.¹⁶

4. Inherent Anti-Avoidance Rules Before BEPS

A critical question in the historical analysis of international tax law is whether, prior to the BEPS project, the system was devoid of anti-avoidance rules. The research indicates that inherent anti-avoidance rules existed long before the explicit codification of the Principal Purpose Test (PPT).³

4.1 Judicial Doctrines: Fraus Legis and Abuse of Rights

Civil law jurisdictions have long utilized the doctrine of fraus legis (fraud on the law) or abuse of rights to combat treaty abuse.

• Fraus Legis: Originating in Roman law and refined in jurisdictions like the Netherlands, fraus legis applies where a transaction complies with the letter of the law but violates its spirit. For fraus legis to apply, two conditions were required: (1) the subjective motive of tax avoidance, and (2) the objective violation of the purpose of the law.¹⁷
• Abuse of Rights: Common in France and international law, this principle posits that a right cannot be exercised for a purpose other than that for which it was granted. If a taxpayer establishes a conduit company in a treaty jurisdiction solely to access reduced withholding rates, they are exercising their right to incorporation and treaty access for a purpose (tax avoidance) that contradicts the treaty’s purpose (encouraging economic exchange).¹⁸

4.2 The "Sham" Doctrine and Substance Over Form

In common law jurisdictions, the "sham" doctrine served as a precursor to modern anti-avoidance rules. A sham is a transaction that is meant to deceive—documents are created to give the appearance of rights and obligations different from the actual legal rights and obligations the parties intend to create.²⁰

However, the "sham" doctrine was often limited. In the seminal Indian case of Azadi Bachao Andolan, the Supreme Court held that as long as a transaction was "genuine" (i.e., the parties actually transferred the shares and paid the money), it could not be a sham, even if it was done solely to save tax.¹ This narrow interpretation of "inherent" anti-avoidance rules necessitated the development of explicit treaty-based rules like the LOB and PPT.

5. Analysis of Indian Jurisprudence: The Battle for Certainty

India's engagement with international tax law provides one of the most intellectually rich and contentious case studies in the world. The jurisprudence highlights the conflict between "form" and "substance" and the evolution of the "sham" doctrine in the context of developing economies seeking Foreign Direct Investment (FDI).

5.1 Union of India v. Azadi Bachao Andolan (2003)

The judgment in Azadi Bachao Andolan is a landmark decision that defined the Indian approach to "Treaty Shopping" for nearly a decade.

• Context: The India-Mauritius Double Taxation Avoidance Convention (DTAC) exempted capital gains from tax in India (the Source State). Since Mauritius (the Residence State) did not tax capital gains, this created a situation of "double non-taxation." Mauritius became the primary route for Foreign Institutional Investors (FIIs) investing in the Indian stock market. The Indian Revenue attempted to deny treaty benefits to "shell" Mauritius companies, alleging treaty shopping.¹
• The Circular: To calm the markets, the Central Board of Direct Taxes (CBDT) issued Circular No. 789, declaring that a Tax Residency Certificate (TRC) issued by Mauritius was conclusive evidence of residence and beneficial ownership.
• The Judgment: The Supreme Court upheld the validity of Circular 789 and ruled in favour of the taxpayers.
  • Legitimacy of Treaty Shopping: The Court held that treaty shopping—residents of third states establishing entities in Mauritius to access the treaty—was not inherently illegal unless explicitly prohibited by the treaty (e.g., via a Limitation on Benefits clause). The Court viewed treaty shopping as a "necessary evil" tolerated by developing nations to attract capital.²
  • Interpretation of McDowell: The Court interpreted the earlier McDowell judgment narrowly, reaffirming the Duke of Westminster principle that taxpayers are entitled to arrange their affairs to reduce tax, provided the transactions are genuine and not "shams" or "colourable devices".¹
  • Form over Substance: The decision effectively codified a "form-over-substance" approach for treaty interpretation, holding that the legal form (incorporation in Mauritius + TRC) trumped economic substance.²²

5.2 Vodafone International Holdings B.V. v. Union of India (2012)

The Vodafone case represents the zenith of the "legal certainty" versus "economic substance" debate regarding indirect transfers.

• The Transaction: Vodafone International Holdings B.V. (Netherlands) acquired the single share of a Cayman Islands company (CGP) from Hutchison (Hong Kong). CGP held, through a complex chain of Mauritius subsidiaries, a 67% controlling interest in Hutchison Essar Limited (an Indian company). The transaction took place entirely outside India between two non-residents. The Indian Revenue sought to tax the capital gains, arguing that the transfer of the Cayman share was effectively an "indirect transfer" of the underlying Indian assets.²⁰
• The "Look-Through" Attempt: The Revenue argued that the Cayman company had no commercial substance and was merely a holding structure. Therefore, the Court should "look through" the corporate veil to the underlying Indian assets.
• The Judgment: The Supreme Court (3-judge bench) ruled in favour of Vodafone, rejecting the Revenue's jurisdiction.
  • The "Look-At" Principle: The Court rejected the "look-through" approach. Instead, it established the "Look-at" test: the Revenue must look at the transaction as a whole rather than dissecting it. If the structure existed for a genuine business purpose (e.g., ease of exit, global financing) and was not created solely for tax avoidance, it must be respected.²⁰
  • Corporate Veil: The Court emphasized the sanctity of the corporate veil. A subsidiary is a distinct legal entity. Holding companies in tax havens (Cayman, Mauritius) are valid legal structures in international trade. The fact that a parent company exercises shareholder influence does not make the subsidiary a "sham".²⁵
  • Section 9 Interpretation: The Court held that Section 9(1)(i) of the Income Tax Act (deeming income to accrue in India) did not cover "indirect transfers" of capital assets situated outside India. The "situs" of the share was the place of incorporation (Cayman), not the location of the underlying assets (India).²⁶
  • Reconciling Azadi: The Court clarified that Azadi Bachao Andolan was good law. It reconciled the two by stating that McDowell only prohibits "colourable devices" (shams). Since the Vodafone structure was a genuine FDI structure, it was not a sham.²⁴

Post-Script: The Indian Parliament subsequently amended the Income Tax Act retrospectively to tax indirect transfers, overturning the Vodafone verdict legislatively. This caused significant damage to India's reputation for tax certainty, leading to arbitration losses and eventually the repeal of the retrospective tax in 2021.²³

6. Mechanisms for the Prevention of Abuse: From Stencil to Filter

Historically, the focus of treaties was the elimination of double taxation. However, modern treaties, particularly following the OECD's Base Erosion and Profit Shifting (BEPS) project, explicitly state that their purpose includes the prevention of tax evasion and avoidance, ensuring they do not create opportunities for double non-taxation.⁴ This shift has transformed the treaty from a "stencil" into a sophisticated "filter."

6.1 The Principal Purpose Test (PPT)

The PPT is the primary anti-abuse rule under the Multilateral Instrument (MLI). It serves as a general anti-abuse rule within treaties.

• Mechanism: It functions as a subjective test that denies treaty benefits if it is reasonable to conclude that obtaining the benefit was one of the "principal purposes" of the arrangement.⁴
• Threshold: Unlike older tests that required tax avoidance to be the sole purpose, the PPT applies if it is merely one of the principal purposes.
• The Carve-out: Benefits are allowed if granting them is "in accordance with the object and purpose" of the treaty provisions. This balances rights by ensuring that technical compliance with the treaty's wording does not override the treaty's object and purpose.⁵

6.2 Limitation on Benefits (LOB)

The LOB clause is a specific anti-abuse rule that uses objective criteria to determine whether a legal entity has a sufficient nexus (connection) to its state of residence to qualify for treaty benefits.²⁹ It prevents "treaty shopping" by filtering out conduit companies.

The LOB sets forth a series of objective tests. A resident must satisfy one of these to be a "Qualified Person":

By filtering out conduit companies, the LOB protects the sovereign tax base of the source country from erosion.²⁹

6.3 Beneficial Ownership

Included in Articles 10 (Dividends), 11 (Interest), and 12 (Royalties), the concept of "beneficial ownership" prevents the granting of treaty benefits to agents, nominees, or conduits who receive income on behalf of others.⁷

• Concept: The term "beneficial owner" is not defined in the OECD Model but is interpreted to mean the person who has the "right to use and enjoy" the income unconstrained by a contractual or legal obligation to pass the payment on to another person.⁷
• Application to Capital Gains: A significant area of debate is whether the requirement of beneficial ownership applies to Article 13 (Capital Gains). In Vodafone, the court held that it does not, as the term is absent from the text of Article 13. However, some jurisdictions argue that it is an inherent principle of the treaty.³³

6.4 Specific Anti-Avoidance Rules (SAARs)

Treaties contain targeted rules to address specific abuses:

• Triangular Cases: Preventing abuse where income is attributed to a permanent establishment in a low-tax third jurisdiction.
• Land-Rich Entities (Article 13(4)): This rule preserves the source state's right to tax capital gains on shares if the company's value is derived principally (more than 50%) from immovable property in that state.³⁶
  • Purpose: To prevent taxpayers from wrapping real estate (taxable at source) in a corporate shell (taxable at residence) to avoid Source State tax.³⁸
  • Mechanism: It allows the Source State to "look through" the shares to the underlying assets, effectively treating the share sale as a real estate sale.³⁹

7. Interaction with Domestic Anti-Abuse Rules

A critical aspect of the balance is the relationship between treaties and domestic anti-avoidance rules (GAARs).

• No Conflict View: As previously discussed, the OECD Commentary generally takes the view that domestic anti-abuse rules do not conflict with tax treaties, as treaties are not intended to facilitate abuse.⁶
• Guiding Principle: The inherent "guiding principle" allows states to apply domestic substance-over-form doctrines or GAARs without violating international law obligations (pacta sunt servanda).
• Interpretive Approach: Courts may interpret treaty provisions (e.g., the definition of "beneficial owner") in a way that aligns with domestic anti-avoidance principles, thereby preventing the treaty from becoming a shield for tax avoidance schemes.¹⁶

8. Conclusion: The Transformation of the Tax Treaty

The evolution of international tax law from the era of Azadi Bachao Andolan to the post-BEPS landscape represents a fundamental transformation in the nature of the tax treaty. Initially conceived as a "stencil"—a rigid instrument of relief that allocated rights based on form—the treaty has evolved into a "filter."

Tax treaties balance rights by creating a closed system: they restrict sovereign taxation only for genuine residents of the treaty partner who engage in non-abusive transactions. When a transaction fails the PPT, LOB, or beneficial ownership tests, the treaty restrictions are lifted, and the source state regains its full sovereign right to tax under domestic law.

To visualize this relationship, one might consider the tax treaty as a filter rather than a shield. It filters out double taxation for legitimate cross-border economic activity, allowing the flow of trade and investment. However, through mechanisms like the LOB and PPT, the filter becomes impermeable to artificial arrangements, catching them and subjecting them to the full weight of domestic sovereign taxation. The "holes" in the stencil are now guarded by smart gates, ensuring that only those who truly belong to the club of reciprocal benefits are allowed to pass through. The Indian experience with Vodafone and the subsequent retrospective amendments serves as a stark reminder that when the stencil covers too much, sovereignty will eventually tear through the paper to protect its base.