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Who really owns the right to income? And are they declaring it? These are the obvious two questions that tax authorities around the world want to ask. And a third question is, are intermediary entities within a group structure entitled to be separately treated as if they own the income rather than the ultimate beneficial owner?
It all started many years ago in 1971 with the Aikens Industries case, where an intermediary Honduran recipient of interest was disregarded by the tax court. To enable a conduit entity to benefit from withholding tax exemption, or other US tax benefits, it was stated that there should be sufficient business reasons for the existence of the (Honduran) company. Reasons put forward as acceptable were access to foreign financial markets and presumably shareholders’ funds, and the desire to avoid the burdensome requirement of compliance with US corporate or tax law!
The concept of ‘dominion and control’ follows closely the theme of the Aikens Industries case and implies that not only is a mere interest rate differential required to validate the commerciality of any intermediate finance company, but such companies should have a commercial reason to exist other than merely being used for reducing US withholding taxes.
Strategies were then developed by tax payers to capitalise intermediary finance subsidiaries by way of equity, thus eliminating the question of whether the finance company had ‘dominion and control’ over the interest receivable, so that no legal obligation existed to remit interest to the financing parent company. Clearly the thinking was that the use of an ‘equity wall’ in the international finance company together with providing it with actual substance would be sufficient to overcome the conduit argument established in 1984 Revenue rulings.
In August 1991 the IRS dealt a blow to the equity wall practice by release of Technical Advice Memorandum (TAM) 9133004 which stated that in respect of the facts presented in the Memorandum, the double tax treaty provisions between the United States and the country of residence of the international finance subsidiary, which was presumably the Netherlands, did not apply even though the finance subsidiary paid the interest it received from the US subsidiary to its parent by way of a dividend rather than as interest.
In considering the facts, the IRS stated that the international finance subsidiary, notwithstanding its equity base, was merely a conduit for passing interest from the US subsidiary to its parent company, and therefore tax should have been withheld on the interest payment from the US subsidiary to the international finance subsidiary. It was found that the international finance subsidiary was “no less of a conduit of funds because payments to [its parent company] were in the form of dividends rather than interest”. In view of the fact that it was “clear” that the effective purpose of the international finance subsidiary was to avoid withholding tax on interest payments from the US subsidiary to its parent company, the fact that the international finance subsidiary in fact had some substance or that it had substantial shareholders’ equity capital was irrelevant. This approach by the IRS certainly exposes financing strategies which have been developed by taxpayers.
Against this background, tax practitioners in the US and elsewhere waited with bated breath for conduit financing regulations which were promised by the IRS to support Code §7701(1) enacted in 1993 to provide statutory provisions against multi-party conduit financing arrangements. Final regulations were published by the IRS in August 1995 to take effect in respect of payments made after September 10, 1995. These final regulations served to disregard treaty-based intermediary financing companies for US withholding tax purposes where the intermediary’s participation in the arrangement is pursuant to a plan of which one of the principal purposes (see the Principal Purpose Test later in this article) is the avoidance of US withholding tax, and otherwise lacks a legitimate business purpose.
Tax avoidance must be the motive, and this is generally indicated if the intermediary could not have funded the US recipient without the initial loan from the financing entity, and moreover if the intermediary requires interest receipts in order to meet its interest paying obligations to the financier. Tax avoidance will be deemed to exist where the receipt of funds in the intermediary and the onward transmission of these funds to the US company both take place within a relatively short period, considered 12 months in this instance. However, tax avoidance will not be deemed to arise if the intermediary is engaged in an active business, or if it undertakes significant activities in respect of the financing arrangements, which will involve the intermediary in having employees in the country of its residence who perform significant activities.
If an intermediary is unrelated to the financier and the financed US entity, it may nevertheless be caught within the conduit regulations provisions if the avoidance of US withholding tax is one of the principal purposes of its involvement in the financing arrangements, and if it is established that the intermediary company would not have participated in the arrangement on substantially the same terms unless the financier guaranteed the debt of the financed entity, e.g. by way of back-to-back arrangements or parent company guarantees.
Many treaties have ‘beneficial ownership’ conditions that restrict tax treaty benefits to residents of the treaty country who are beneficially entitled to income received; the Israeli Tax Administration interprets this to mean they are not mere ‘conduits’ that pass the income on to others (for example Israel's tax treaties with the Netherlands, Switzerland and Singapore).
The ITA published guidance on its views about beneficial ownership in its Circular 22/2004 of August 26, 2004, where it indicated that although most tax treaties don’t define the term ‘beneficial owner’, the ITA regard this as referring to whoever:
enjoys, in practice, the rights relating to control and ownership of an asset or a right;
enjoys any appreciation and risks any loss or erosion of value of such asset or right;
The onus is on the applicant (i.e. taxpayer) to prove who is the beneficial owner. In the absence of such proof, no treaty relief need be granted, according to the ITA. The ITA goes on to say that an entity is not a beneficial owner if it is merely a conduit for transferring payments to the beneficial owner. Factors indicating that a conduit entity exists include (according to the ITA):
minimal business activity;
officer has a limited minor role (sometimes just an external lawyer);
passing or temporary ownership of receipts;
no justification for a corporate structure other than tax saving;
grant of “back to back” loans at identical interest rates, terms, and parallel redemption arrangements, etc.;
assets collateralized by another party against loans, or provision of a guarantee of another party in some other way;
another entity bears the economic risks;
another entity controls the amounts transferred and can decide how they are used;
contractual or other commitment exists to transfer receipts to another party;
systematic continuous transfer of receipts to another party, even if no formal obligation exists.
These factors were discussed by the Tel Aviv District Court in the case of Yanko-Weiss Holdings (1996) Ltd. vs. Assessing Officer of Holon in a judgement issued December 30, 2007 (Income Tax Appeal 1090/06).
In this case, a company was incorporated in Israel, but in 1999 its shareholders met in Belgium and resolved to make it a Belgian resident company by moving the registered office, management and activity to Brussels. The company also obtained confirmation of Belgian residence from the Belgian tax authorities. Subsequently, the company claimed a reduced rate of withholding tax (apparently 5 per cent) under the Israel-Belgium Tax Treaty on a dividend from an Israeli resident subsidiary company. Presumably, the dividend may have qualified for a "participation exemption" in Belgium, although the judgement does not discuss Belgian tax, only Israeli tax.
The District Court made reference to Article 31 of the Vienna Convention on the Law of Treaties of May 23, 1969, which states: "A treaty shall be interpreted in good faith in accordance with the ordinary meaning of the treaty in their context and in the light of its objects and purpose."
The court clarified that tax treaties are intended first and foremost to create a situation in which a taxpayer trapped in the tax system of two countries will not be exposed to double taxation. Tax treaties are not intended and cannot be construed as intended to be used in an abusive way, only in good faith and in the usual way, whether or not they contain express rules in this regard. Therefore, the court ruled that the ITA was allowed to raise a claim of artificiality, notwithstanding the applicability of a tax treaty.
We can compare this case to a 2006 civil law case in the UK High Court, Indofood International Finance Limited v JPMorgan Chase Bank NA London Branch. This case caused quite a stir amongst the tax fraternity and is the forerunner of the current level of uncertainty in adopting double tax treaty provisions in themselves as gospel. The High Court ruled that the term ‘beneficial owner’ means the actual owner of the interest income who truly has the full right to enjoy directly the benefits of that interest income. A nominee or a conduit company is not regarded as a beneficial owner of the interest, according to the High Court. The decision was not appealed and HMRC has since scrutinised special purpose finance vehicles, particularly those based in Luxembourg.
In this case, an Indonesian company, Indofood, sought to issue loan notes in 2002 with a view to raising capital. Indonesia imposes a 20 per cent withholding tax on interest payments, and to reduce this, Indofood established a wholly owned subsidiary (“IIF”) in Mauritius to take advantage of the reduced rate of withholding tax (10 per cent) under the Mauritius/Indonesia double tax treaty. Indonesia then abrogated its treaty with Mauritius as of January 1, 2005, thus increasing the withholding tax back to 20 per cent. IIF claimed it had the right to redeem the notes. The note trustee, JP Morgan Chase, was opposed to redemption on the basis that the increased withholding tax could be avoided by inserting a Dutch Special Purpose Vehicle (SPV) in place of the Mauritius company in order to take advantage of the reduced rate of withholding tax under the Indonesia/Netherlands treaty.
Indofood claimed that the structure would not work on the basis that the Dutch SPV was not in fact the beneficial owner of the interest. Most double tax treaties have evolved over time in such a way that the recipient of certain types of income, notably dividends, interest and royalties, must be the beneficial owner of such income if treaty benefits (that is reduced rates of withholding tax) are to be availed of. The court found in favour of Indofood on the basis that the Dutch SPV was unlikely to be regarded under Indonesian law as the beneficial owner of the interest. The reason the court came to this decision was not simply that the Dutch company was being interposed purely to take advantage of the treaty. In addition to this the proposal would have resulted in:
no spread of interest being paid to the Dutch SPV;
interest was to be paid directly to the noteholders, i.e. would bypass the Dutch SPV.
Even prior to BEPS, many modern double tax treaties, such as the Netherlands/UK treaty, contain limitation on benefits clauses which seek to limit the benefits of the treaty in specific circumstances, for example if the only reason for inserting a Dutch company in a particular structure is to take advantage of the treaty itself. Some treaties, on the other hand, do not contain a specific limitation on benefits provision and it would appear that HMRC regards Indofood as being a fundamentally important case, especially in structured finance deals.
In the leading Canadian case of 2008, Prévost Car Inc. v The Queen, Swedish and UK parent corporations owned a Dutch holding corporation which in turn held 100 per cent of the shares of Prévost (Canada). The purpose of the Dutch holding corporation was to benefit from the reduced withholding rate of 5-6 per cent compared to the UK rate of 10 per cent. CRA’s case to apply the higher withholding tax rate turned on whether or not the Dutch company was the beneficial owner of the dividends.
The lower court stated:
“In my view the ‘beneficial owner’ of dividends is the person who receives the dividends for his or her own use and enjoyment and assumes the risk and control of the dividend he or she received. The person who is beneficial owner of the dividend is the person who enjoys and assumes all the attributes of ownership. In short, the dividend is for the owner’s own benefit and this person is not accountable to anyone for how he or she deals with the dividend income. When the Supreme Court in Jodrey stated that the ‘beneficial owner’ is one who can ‘ultimately’ exercise the rights of ownership in the property, I am confident that the Court did not mean, in using the word ‘ultimately’, to strip away the corporate veil so that the shareholders of a corporation are the beneficial owners of its assets, including income earned by the corporation. The word ‘ultimately’ refers to the recipient of the dividend who is the true owner of the dividend, a person who could do with the dividend what he or she desires. It is the true owner of property who is the ‘beneficial owner’ of the property. Where an agency or mandate exists or the property is in the name of a nominee, one looks to find on whose behalf the agent or mandatory is acting or for whom the nominee has lent his or her name. When corporate entities are concerned, one does not pierce the corporate veil unless the corporation is a conduit for another person and has absolutely no discretion as to the use or application of funds put through it as a conduit, or has agreed to act on someone else’s behalf pursuant to that person’s instructions without any right to do other than what that person instructs it, for example, a stockbroker who is the registered owner of the shares it holds for clients. This is not the relationship between PHB.V. [the Dutch corporation] and its shareholders.”
The Federal Court of Appeal said that the lower court made no palpable or overriding error in its findings. Thus, the Dutch Holdco was not an agent, mandatory, nominee, or conduit that had “absolutely no discretion as to the use or application of funds” and that had “agreed to act on some else’s behalf [and their] instructions without any right to do” otherwise. The corporate veil should not be pierced. There was no evidence of a predetermined or automatic flow of funds to the shareholders.
Revenue Canada’s interpretation of the Federal Court of Appeal’s confirmation of the findings is currently:
“In the decision, the Federal Court of Appeal confirmed the Tax Court’s finding that the ‘beneficial owner’ of a dividend is the person who receives the dividend for his or her own use and enjoyment and assumes the risk and control of the dividend. In interpreting the meaning of the term ‘beneficial owner’ as it applies to Canada’s income tax conventions, the Court referred to the OECD Conduit Companies Report, and the 2003 amendments to the OECD Commentary, both of which support the position that the term ‘beneficial owner’ requires something more than strict legal title. In this respect, the Court implied that where an intermediary acts as a mere conduit or funnel in respect of an item of income, the intermediary would not have sufficient economic entitlement to the income to be considered the ‘beneficial owner’. The CRA will examine future back-to-back dividend, interest and royalty cases that it encounters with a view to whether an intermediary could, on the facts, be considered a mere conduit or funnel.”
The Prévost Car case in Canada reviewed whether the beneficial owner should have the meaning under domestic law or international fiscal law. The Dutch holding company acted as an intermediary between UK and Swedish shareholders and the Canadian operating company, and was admittedly introduced in order to avoid most of the dividend withholding tax in Canada. Although there was a shareholders’ agreement regulating the onward dividend flow from the Dutch company, it was held that the company itself was not a party to it and therefore was not bound by an agreement of its shareholders. Therefore, it was not considered to be acting purely in a fiduciary capacity and it was indeed the beneficial owner of the dividend income and entitled to treaty benefits.
In another Canadian case of 2007, the MIL Investments case, a Cayman Island company moved its residence to Luxembourg in order to be able to avoid Canadian capital gains tax on the sale of a Canadian company, which would have been levied if the owner were not resident in a tax treaty jurisdiction. There is in fact no beneficial ownership requirement for the capital gains article to apply, but nevertheless it was held that the concept is implied in treaties. In the absence of any substance in Luxembourg, the true residence of the Cayman Island company would have been questioned. In the MIL case however, the Cayman Island company rented an office and had two employees, and was therefore considered to have the degree of substance to be considered resident in Luxembourg for the purposes of the treaty.
In summary, at this stage of the development of so-called treaty shopping, the use of conduit companies could generally be defensible unless the company were acting merely in a fiduciary capacity for the ‘true’ beneficial owner. However, even at this stage, the French concept of ‘abus de droits’ as it relates to treaty shopping was clearly a warning that abusive treaty shopping is unacceptable, and the conduit company must have a proper degree of substance to benefit from double tax treaty arrangements.
As a forerunner to the BEPS initiative of the OECD, the Bundeszentralamt für Steuern in Germany argued that, in relation to obtaining double tax treaty benefits and ensuring the recipient is indeed the beneficial owner of the relevant income:
Holding companies do not qualify for treaty benefits unless they exercise some degree of management and control over their subsidiaries, which denotes the holding company having several employees and its own business premises (although at present only extreme cases are pursued).
The provisions apply not only to withholding taxes but also to any other kind of treaty benefits or provisions under the EU Parent/Subsidiaries Directive.
The Bundeszentralamt may look through a chain of tiered companies to the ultimate individual shareholder in order to determine whether he would be entitled to similar benefits if he received the income directly.
The Bundeszentralamt will not entertain request for advanced rulings on structures.
Of course, prior to Action 6 of the BEPS project, it could have been contended that these provisions cannot override Germany’s double tax treaty obligations, and that where for example withholding tax exemptions should be made available under the terms of the treaty, then unless the treaty itself comprises similar provisions to those enacted under its double tax treaties, these anti-abuse provisions should not be applicable.
However, there have been a number of cases in Germany where treaty benefits have been denied. In one such case a Dutch BV entered into a contract with a German company which held the rights to a sporting event in Germany, the Dutch BV offering expertise and know-how in organising such events, as well as providing the sportsmen taking part. The BV applied for the relevant royalties received to be exempt under arts 15 and 20 of the German/Netherlands’ double tax treaty, such articles providing for royalties only to be taxable in the recipient’s state of residence. The court ruled that in instances where the insertion of a company or other such undertaking achieved no economic goal and served no purpose other than that of avoiding tax, then the treaty provisions should not be applicable. The fact that the BV took no business risks compounded the court’s decision. In this case the court confirmed the German stance on tax avoidance: the deciding factor for the German anti-avoidance legislation is whether the avoidance of German tax is the motive.
The argument that is put forward by the German tax administration is that double tax treaties are not designed to create abusive structures, and therefore the provisions explained above are in accordance with the intentions behind the treaties.
The more persuasive argument, however, is that, if this is the case, there should be provisions in the treaties themselves acknowledging the possibility of introducing such laws, or including specific anti-treaty shopping provisions (as for example the US anti-abuse and limitation of benefits provisions). Prior to BEPS, it was argued that the appropriate remedy was to renegotiate existing treaties, adding protocols or negotiating entirely new treaties, rather than passing internal laws which seem to conflict with other national laws or the constitution itself.
Moreover, international law in the form of the Vienna Convention on the law of treaties suggests that the text of double tax treaties must be presumed to be the definitive intentions of the contracting parties, so that although unwritten intentions of the parties should be considered, the meaning of the text itself coupled with the customary interpretation already exercised by the contracting parties should be of paramount importance.
Despite this art.31(1) of the Vienna Convention requires a treaty to be interpreted in good faith in accordance with the ordinary meaning given to the terms of the treaty in their context and in the light of its object and purpose. It is here that the German tax administration may suggest that literal interpretations are at variance with the purposes of the treaty as a whole.
BEPS Action 6
All of the above explains why the BEPS initiative on treaty abuse has been passed by so many of the OECD countries. However, instead of changing thousands of individual double tax treaties, participating countries were invited to sign a multilateral instrument (MLI) that would bring a host of wholesale amendments. The MLI aims to implement a broad number of BEPS recommendations, of which Action 6 is the most germane to the topic of this newsletter. The Action recommends the following to be introduced into the MLI:
There should be a clear statement that tax treaties are not designed to encourage double non-taxation or to reduce appropriate taxation through evasion or avoidance, which covers the treaty shopping arrangements illustrated above;
There may be a specific anti-abuse rule based on a limitation of benefits provision, which limits treaty benefits only to those persons (companies, individuals or other entities) who are entitled to such benefits as a result of their residence and their business activities;
There may be a more general anti-abuse rule based on the principal purpose of the transactions or arrangements (the PPT rule), which would deny treaty benefits if these are not in accordance with the object and purpose of the treaty.
The multilateral instrument MLI was signed on 7 June 2017 by close to 70 jurisdictions. Despite its unifying nature, each country has a right to reservations to its provisions and we urge our clients to assess the individual impact that the new measure will have on their cross-border tax position. Here is a useful table with the most up-to-date summary of MLI’s implementation [http://danonsalome.com/wp-content/uploads/2017/06/Countries-table-140617.pdf ].
Clearly the OECD has its sights on preventing treaty shopping, whether this be a ploy of multinational or smaller enterprises. But in doing so, the introduction of a general PPT rule rather than specific anti-abuse provisions has introduced an era of subjectivity and uncertainty as to how much professional advisers and their clients may rely on the existing provisions of double tax treaties. The Vienna Convention on the interpretation of treaties would no longer appear to be the over-riding authority, but has been superseded by an arbitrary rule which may have different interpretations in different jurisdictions. What is clear is that the use of double tax treaties to entirely eliminate a tax charge (so-called double non-taxation) will be open to legitimate challenge by tax administrations worldwide.