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BENEFICIAL OWNERSHIP: TREATY ENTITLEMENT, INCLUDING TRANSPARENT ENTITIES

BENEFICIAL OWNERSHIP: TREATY ENTITLEMENT, INCLUDING TRANSPARENT ENTITIES. OECD – IFA TAX CONFERENCE, MUMBAI 23-25 JANUARY, 2008. TARA RAO STEVE TOWERS. Agenda. Agenda. Example of treaty shopping. HK Co. HK Co. Interest. Loan. Loan. HK. HK. MAURITIUS.

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BENEFICIAL OWNERSHIP: TREATY ENTITLEMENT, INCLUDING TRANSPARENT ENTITIES

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  1. BENEFICIAL OWNERSHIP: TREATY ENTITLEMENT, INCLUDING TRANSPARENT ENTITIES OECD – IFA TAX CONFERENCE, MUMBAI 23-25 JANUARY, 2008 TARA RAO STEVE TOWERS

  2. Agenda

  3. Agenda

  4. Example of treaty shopping HK Co HK Co Interest Loan Loan HK HK MAURITIUS Mauritius Co subject to 3% corporate income tax on “spread” SINGAPORE SING Co Mauritius Co (GBLC 1) 0% w/h tax [Mauritius domestic tax law] 15% w/h tax Loan SINGAPORE SING Co 0% w/h tax [Singapore/ Mauritius treaty] Is Mauritius Co the “beneficial owner” of the interest paid by Sing Co?

  5. Attitude of OECD • 1986: 2 reports: • “Double taxation conventions and the use of base companies” • “Double taxation conventions and the use of conduit companies” • OECD Commentary: amended in 2003: • Commentary on Art. 1: “Improper use of the Convention” • Commentaries on Arts. 10, 11 & 12: Expansion of comments on “beneficial owner” test.

  6. OECD Report (1986) : Conduit Companies The Report identifies two types of conduit company : Direct conduit¹: Beneficial owner² Third State (State of beneficiary²) Conduit company State A (State of conduit) Dividend, interest, royalties, etc State B (State of source) Payer of dividend, Interest, royalties, etc ¹ This diagram is adapted from that in Annex 1 to the Report. ² The diagram in Annex 1 calls the resident of the third State, “beneficial owner”. It also calls the third State, “State of beneficiary”.

  7. OECD Report (1986) : Conduit Companies “Stepping stone” conduit¹ : Beneficial owner² Third State (State of beneficiary²) State D (State of secondary conduit company) Secondary conduit company (“sink”) Interest, commissions, service fees and similar expenses State A (State of conduit) Conduit company Dividend, interest, royalties, etc State B (State of source) Payer of dividend, Interest, royalties, etc ¹ This diagram is adapted from that in Annex 1 to the Report. ² The diagram in Annex 1 calls the resident of the third State, “beneficial owner”. It also calls the third State, “State of beneficiary”.

  8. Tax Authority Responses to Treaty Shopping • Choice of treaty partners • Scope of treaties and benefits given • Use domestic anti-avoidance provisions • Build in anti-abuse provisions into tax treaties: specific as well as general • Close examination when determining entitlement to treaty relief, e.g., “beneficial ownership”

  9. Agenda

  10. “Beneficial ownership” • The “first line of defence” against treaty shopping • Used in Arts. 10, 11 & 12 • Not defined in most treaties

  11. Art. 10, OECD & UN Models “ • Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State. • However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State, but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed: • ……….” • Note: Bolding added “

  12. Art. 11, OECD & UN Models “ • Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. • However, such interest may also be taxed in the Contracting State in which it arises and according to the laws of that State, but if the beneficial owner of the interest is a resident of the other Contracting State, the tax shall not exceed…..” • Note: Bolding added “

  13. Art. 12, OECD & UN Models • UN Model: • Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in the other State. • However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the royalties is a resident of the other Contracting Sate, the tax so charged shall not exceed….” • OECD Model: • Royalties arising in a Contracting State and beneficially ownedby a resident of the other Contracting State shall be taxable only in that other State.” • Note: Bolding added “ “ “

  14. Netherlands : Stockbroker Case • Issue: Could the UK-resident stockbroker claim the limitation on Dutch dividend withholding tax, under the UK/Netherlands treaty? In other words, was the UK-resident stockbroker “the beneficial owner” of the dividends? • Held: Yes • Per the Court: • “The [UK-resident stockbroker] has, by purchasing the dividend coupons, become their owner. This Court may further assume that the [UK-resident stockbroker] had, after their purchase, the free disposal of the dividend coupons, and after cashing them, of the distributions received and that, when cashing the dividend coupons, it did not act as agent or nominee. Under those circumstances, the [UK-resident stockbroker] may be considered to be the beneficial owner of the dividends.” ② $ UK-resident stockbroker Luxembourg – resident shareholder ② sale of div. coupons ① declaration of dividends (+ issue of div. coupons) shares ③ payment of dividends Royal Dutch Shell (Netherlands -resident)

  15. Art. 3(2), OECD & UN Models • The terms, “beneficial owner” and “beneficially owned”, are not defined in the OECD & UN Models. • Art. 3(2) : • “ As regards the application of the Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of the State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State.” • Note: Bolding added

  16. “Beneficial owner” : technical term under common law • Under common law, the term, “beneficial owner”, would exclude a legal owner who is trustee for another • OECD Commentary: “The term ‘beneficial owner’ is not used in a narrow technical sense….” • Assume that one or both of the treaty countries uses the common law meaning in its domestic law. Would Art. 3(2) apply? Consider whether the context would “otherwise require”. • What is “the context” for the purposes of Art. 3(2)? Would “the context” include the OECD Commentary?

  17. Is it permissible to consult the OECD Commentary to determine the meaning of “beneficial owner”? • Vienna Convention on the Law of Treaties: • “Article 31 : General rule of interpretation • A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. • The context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes: • any agreement relating to the treaty which was made between all the parties in connexion with the conclusion of the treaty; • any instrument which was made by one or more parties in connexion with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty. Note: Bolding added “ “

  18. Is it permissible to consult the OECD Commentary to determine the meaning of “beneficial owner”? (cont’d) • There shall be taken into account, together with the context: • subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions; • any subsequent practice in the application of the treaty which establishes the agreement of the parties regarding its interpretation; • any relevant rules of international law applicable in the relations between the parties. • A special meaning shall be given to a term if it is established that the parties so intended. Article 32 : Supplementary means of interpretation Recourse may be had to supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion, in order to confirm the meaning resulting from the application of article 31, or to determine the meaning when the interpretation according to article 31: • leaves the meaning ambiguous or obscure; or • leads to a result which is manifestly absurd or unreasonable.” Note : Bolding added “ “ “ “

  19. OECD Commentary • “12.1 Where an item of income is received by a resident of a Contracting State acting in the capacity of agent or nominee it would be inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption merely on account of the status of the immediate recipient of the income as a resident of the other Contracting State. The immediate recipient of the income in this situation qualifies as a resident but no potential double taxation arises as a consequence of that status since the recipient is not treated as the owner of the income for tax purposes in the State of residence. It would be equally inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption where a resident of a Contracting State, otherwise than through an agency or nominee relationship, simply acts as a conduit for another person who in fact receives the benefit of the income concerned. For these reasons, the report from the Committee on Fiscal Affairs entitled ‘Double Taxation Conventions and the Use of Conduit Companies’ concludes that a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties. • “12.2 Subject to other conditions imposed by the Article, the limitation of tax in the State of source remains available when an intermediary, such as an agent or nominee located in a Contracting State or in a third State, is interposed between the beneficiary and the payer but the beneficial owner is a resident of the other Contracting State…”: OECD Commentary (paragraphs 12.1 and 12.2 to the Commentary on Art. 10) [substantially identical comments are contained in the Commentaries on Art. 11 and Art. 12]. First disqualifying condition Second disqualifying condition

  20. Agenda

  21. Indofood Actual Structure: Interest Third Party Noteholders Indofood Mauritius (subsidiary of Indofood Indonesia) Loan (in the form of Notes) Loan (in the form of Notes) Interest Offshore ************************************************************* Indonesia Indofood Indonesia • Indonesia domestic tax law: 20% interest withholding tax • Indonesia/Mauritius treaty: 10% (if beneficial owner) • Indonesia/Mauritius treaty: terminated in 2004 •  Indofood wanted to redeem the Notes, because of an adverse movement in interest rates and because of the increased “gross up” requirement due to the treaty termination. •  The treaty termination allowed Indofood to redeem the Notes, unless it could avoid the additional tax by “taking reasonable measures available to it”.

  22. Indofood Contractual arrangements in the Actual Structure: “… [Indofood Indonesia] is obliged to pay the interest two business days before the due date to the credit of an account nominated for the purpose by [Indofood Mauritius]. [Indofood Mauritius] is obliged to pay the interest due to the noteholders one business day before the due date to the account specified by the Principal Paying Agent. The Principal Paying Agent is bound to pay the noteholders on the due date. …. [Indofood Mauritius] is bound to pay on to the Principal Paying Agent that which it received from [Indofood Indonesia] because it is precluded from finding the money from any other source by the Note Conditions…” (Extract from Court of Appeal judgment of the Chancellor) (bolding added)

  23. Indofood Structure suggested by Trustee for Noteholders: Third Party Noteholders Interest Indofood Mauritius Loan Interest Loan Indofood Netherlands Interest Offshore Loan **************************************************************** Indonesia Indofood Indonesia • Indonesia/Netherlands treaty: 0%/10% (if beneficial owner)

  24. Indofood Issues addressed by Court of Appeal: • Fundamental issue: Would restructuring the loan (as suggested by Trustee) be a “reasonable measure available to” Indofood? •  Would the interposed entity (Indofood Netherlands) be entitled to claim 0%/10% rate limitation under the Indonesia/Netherlands treaty? In other words, would Indofood Netherlands be the “beneficial owner” of the interest paid by Indofood Indonesia? • Consequential issue: Under the Actual Structure, was Indofood Mauritius entitled to claim 10% rate limitation under the Indonesia/Mauritius treaty (prior to termination)? In other words, was Indofood Mauritius the “beneficial owner” of the interest paid by Indofood Indonesia?

  25. Indofood Leading judgment in Court of Appeal: “But the meaning to be given to the phrase ‘beneficial owner’ is plainly not to be limited by [a technical and legal approach which focuses on the contractual arrangements]. Regard is to be had to the substance of the matter. In both commercial and practical terms [Indofood Mauritius] is, and [Indofood Netherlands] would be, bound to pay on to the Principal Paying Agent that which it receives from [Indofood Indonesia]…. In practical terms it is impossible to conceive of any circumstances in which either [Indofood Mauritius] or [Indofood Netherlands] could derive any ‘direct benefit’ from the interest payable by [Indofood Indonesia] except by funding its liability to the Principal Paying Agent or [Indofood Mauritius] respectively. Such an exception can hardly be described as the ‘full privilege’ needed to qualify as the beneficial owner, rather the position of [Indofood Mauritius] and [Indofood Netherlands] equates to that of an ‘administrator of the income’.”

  26. Indofood : impact (thus far) • “Beneficial owner” = international fiscal meaning? • Public bond market has adapted • UK tax authority: • Guidance issued for cases where no tax benefits • OECD Commentary on “conduits” endorsed • Indofood not specifically used by other tax authorities/courts. However, presume increasing focus on “beneficial ownership”

  27. Alfa : an Italian ruling Patentholders • Application for ruling • “Patent intermediary” • “Bundled” patents and sub-licensed to customers • Customers only have to deal with Alfa, not individually with all patentholders • Alfa’s rights to deal with payments from customers restricted • Nonetheless, not tax motivated “back-to-back” • Genuine business, and business purpose and value added Patentholders Patentholders Alfa(US) Indofood(Indonesia) Indofood(Indonesia) Customers(Italy)

  28. UK Shareholder Swedish Shareholder Holding Company(Netherlands) Prevost(Canada) Prevost case • Canadian Court decision awaited • Argue Dutch holding company not “beneficial owner” because: • Lacks substance in the Netherlands: no employees or assets, expenses funded by shareholders • Owned by UK and Swedish shareholders (no Dutch shareholders)

  29. Agenda

  30. Tax Authority Responses to Treaty Shopping • Choice of treaty partners • Scope of treaties and benefits given • Use domestic anti-avoidance provisions • Build in anti-abuse provisions into tax treaties: specific as well as general • Close examination when determining entitlement to treaty relief, e.g., “beneficial ownership”

  31. Other “treaty-based” provisions against treaty shopping • “Subject to tax” / remittance rules • Purpose rules • Exclusion of certain entities • Exclusion of certain parts of entities • “Limitation on benefits” (LOB) articles

  32. “Subject to tax” rule For example: UK/Oman treaty, Art. 11(1): “Interest arising in a Contracting State and paid to a resident of the other Contracting State shall be taxable only in that other State if such resident is the beneficial owner of the interest and subject to tax in respect of the interest in that other Contracting State.” “subject to tax” vs “liable to tax” Note : Bolding added

  33. Remittance rules • For example, Art. 22 of the Singapore/Thailand treaty: • “Where this Convention provides (with or without other conditions) that income from sources in a Contracting State shall be exempt from tax, or taxed at a reduced rate in that Contracting State and under the laws in force in the other Contracting State the said income is subject to tax by reference to the amount thereof which is remitted to or received in that other Contracting State and not by reference to the full amount thereof, then the exemption or reduction of tax to be allowed under this Convention in the first-mentioned Contracting State shall apply to so much of the income as is remitted to or received in that other Contracting State.” • A similar provision is included in most of Singapore’s treaties. Under Singapore domestic tax law, foreign source income is taxable only if and when it is remitted (or deemed to be remitted) to Singapore. • Note : Bolding added

  34. Purpose rules For example: UK/Netherlands treaty, Art. 11(6): “The provisions of this Article shall not apply if the debt- claim in respect of which the interest is paid was created or assigned mainly for the purpose of taking advantage of this Article and not for bona fide commercial reasons.”

  35. Exclusion of certain entities • For example, Luxembourg’s treaties routinely exclude “Luxembourg 1929 companies” from treaty benefits – eg. Art. 29 of the Luxembourg / Indonesia treaty: • “This Agreement shall apply neither to holding companies (societes holding) within the meaning of special Luxembourg laws, currently the Act (loi) of 31 July 1929 and the Decree (arrete grand-ducal) of 17 December 1938 nor to companies subject to a similar fiscal law in Luxembourg. Neither shall it apply to income derived from such companies by a resident of Indonesia nor to shares or other rights in such companies owned by such a person.”

  36. Exclusion of certain parts of entities • For example: • Singapore /Luxembourg treaty: • Art. 1 : • “This Agreement shall apply to persons who are residents of one or both of the Contracting States.” • Protocol: • “At the moment of signing [the Singapore / Luxembourg treaty], the undersigned have agreed that with respect to Article 1, branches of an enterprise of either Contracting State located in third countries are excluded from the scope of the Agreement. • ……”

  37. “Limitation on benefits” (LOB) articles • A particular feature of US treaties – but also now being adopted by other • countries. • Structure of Art. 22 (LOB article) in 2006 US Model: • General rule : residents are entitled to treaty benefits only to the extent provided in Art. 22. • Paragraph (2) has 5 subparagraphs, each of which describes a category of residents that are entitled to all treaty benefits: • Individuals • Contracting States, or political subdivisions or local authorities thereof • (i) Publicly –traded corporations or (ii) subsidiaries of publicly-traded corporations • Pension funds or tax exempt organisations

  38. “Limitation on benefits” (LOB) articles (cont’d) • Two conjunctive tests : • “Ownership test” : Legal entity is majority owned by persons who qualify under (a), (b), (c)(i) or (d); and • “Base erosion test” : Less than 50% of the legal entity’s gross income is paid (as tax deductible payments) to non-residents of either country. • Active trade or business : Paragraph (3) sets out a test under which a resident that is not generally entitled to treaty benefits under paragraph (2), may receive treaty benefits on certain items of income that are connected to an active trade or business conducted in the residence country. • Treaty benefits also may be granted if the competent authority of the source country agrees. • Definitions.

  39. Agenda

  40. Tax Authority Responses to Treaty Shopping • Choice of treaty partners • Scope of treaties and benefits given • Use domestic anti-avoidance provisions • Build in anti-abuse provisions into tax treaties: specific as well as general • Close examination when determining entitlement to treaty relief, e.g., “beneficial ownership”

  41. Bank of Scotland case • Typical “dividend strip” • Usufruct contract: dividends payable on preference shares during three year period • Bank of Scotland guaranteed: • Repayment of amount initially outlaid • Margin Parent(US) Bank of Scotland(UK) Dividends paidto Bank of Scotland Dividends Sale Subsidiary(France)

  42. Domestic tax law provisions against treaty shopping • US: “conduit financing” regulations • Canada: GAAR extends to misuse of treaties (MIL case) • Switzerland: 1962 decree • France and Italy: “business purpose” required • Germany: “substance” and “business purpose” tests • General anti-avoidance doctrines and legislation: • “Substance over form” doctrine (various countries) • US common law anti-avoidance doctrines (substance over form, step transaction, business purpose,economic substance) • “Abuse of law” doctrine (various European countries) • GAARs in, for example, Canada, Australia or Singapore • Furniss v. Dawson in the UK

  43. Korea • Aggressive challenger of perceived treaty shopping • Application of domestic anti-abuse rules • Proposed amendment to Korea/Malaysia treaty to exclude Labuan from Malaysia • 2006 Tax Law revisions: • “Substance over form” rule in international transactions • Clarified doctrine applies to tax treaties • Special withholding tax procedures: • Withholding tax on dividends, interest, royalties and capital gains derived by treaty residents in “blacklisted” locations • Such treaty residents either obtain upfront ruling from Korean tax authorities, or seek refund of withholding tax • So far … only Labuan blacklisted

  44. India • Supreme Court of India (Union of India, et al. v Azadi Bachhao Andolan, et al.): treaty shopping via Mauritius was acceptable from India’s perspective, in the absence of specific anti-treaty shopping provisions in the treaty. [Note that this case concerned Art. 13, which does not contain a “beneficial ownership” or other anti-treaty shopping requirement.]

  45. Indonesia • Government objects to treaty shopping. • Indonesia unilaterally terminated Indonesia/Mauritius treaty in 2004, due to concerns over treaty shopping. • Tax authority circular in 2005 on the interpretation of “beneficial owner” in the dividend, interest and royalties articles of treaties.

  46. Agenda

  47. Case study • Base case : • BCO has very small equity. It has no substantive assets or operations except as described below. • Country B / Country C treaty is identical to the OECD Model, except that the rate of tax mentioned in Art. 11(2) is 5%. • Country C domestic tax law : 25% interest withholding tax. • Country B domestic tax law : nil tax on outbound interest payments. • 1 January 2008 : ACO lends $100 million (“Loan#1”) to BCO on these terms: • Term is 5 years (bullet repayment) • No security • Interest = 7.00% p.a. • Interest payable quarterly in arrears • 1 January 2008 : BCO lends $100 million to CCO on these terms: • Term is 5 years (bullet repayment) • No security • Interest = 7.50% p.a. • Interest payable quarterly in arrears • No treaty : • Country A / Country B • Country A / Country C ACO [resident in Country A] Int. 7.0% p.a. Country A Loan #1 Country B BCO [resident in Country B] Int. 7.5% p.a. Loan #2 Country C CCO [resident in Country C]

  48. Case study • Additional facts : • No ownership relationship between any of the three companies. • Corporate income tax rate in Country B = 35%. • Country B’s tax law has provisions dealing with tax residency certificates. Under those provisions, the Country B tax authority is not permitted to issue a tax residency certificate to a company like BCO unless various “substance and risk” conditions are satisfied. Assume that all of those conditions are satisfied and thus a tax residency certificate is issued to BCO. ACO [resident in Country A] Int. 7.0% p.a. Country A Loan #1 Country B BCO [resident in Country B] Int. 7.5% p.a. Loan #2 Country C CCO [resident in Country C]

  49. Case study • What changes to reduce the risk? • Size of “spread”. • In the base case, the spread is 0.5% (i.e. 50bps). This idea involves increasing the “spread” to say, 1.00% or 1.50%. Obviously, transfer pricing requirements will limit the ability to increase the “spread”. ACO [resident in Country A] Int. 7.0% p.a. Country A Loan #1 Country B BCO [resident in Country B] Int. 7.5% p.a. Loan #2 Country C CCO [resident in Country C]

  50. Case study • What changes to reduce the risk? • Practical payment mechanism. • Instead of Loan#1 and Loan#2 using the same interest payment dates (e.g. 31 March, 30 June, 30 September, 31 December), introduce a degree of “staggering” – e.g. change one of the loans to have interest payable semi-annually in arrears, on 15 May and 15 November. ACO [resident in Country A] Int. 7.0% p.a. Country A Loan #1 Country B BCO [resident in Country B] Int. 7.5% p.a. Loan #2 Country C CCO [resident in Country C]

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