By James J. Tobin, Esq.
You have to give the Organization for Economic Cooperation and Development (OECD) a lot of credit for trying to bring some semblance of symmetry to the hodgepodge of international tax rules around the globe. One of their current forays to bring order to the system is the ongoing project aimed at clarifying the meaning and interpretation of the term "beneficial owner" for tax treaty purposes in light of the risks of double or non-taxation that arise from differing interpretations in various countries. The OECD issued a discussion draft, with proposed changes to the Commentary on the OECD Model Tax Convention, on this subject in April of this year. As with all OECD discussion drafts, interested parties were invited to submit comments. I'm very interested, so consider this my comment.
For the record, I completely agree that guidance in this area would be beneficial indeed (sorry – pun intended). The term "beneficial owner" is being inconsistently defined and interpreted around the world. This creates burdensome and unnecessary uncertainty. Particularly troubling are the attempts to use the beneficial ownership language in a treaty as an all-purpose tool to address any perceived "abuse." The beneficial ownership concept is not a substitute for other anti-abuse concepts that can be incorporated in a bilateral treaty, like anti-treaty-shopping provisions or GAAR-type rules. Where those kinds of provisions have not been negotiated in the treaty agreement, they should not be read into the treaty unilaterally by one of the countries simply by creatively interpreting the beneficial ownership phrase to deny treaty benefits that are due. However, this kind of creative interpretation is clearly a growing trend and consequently a growing problem. Moreover, it has never been more important for multinational businesses to have clarity in understanding the parameters for entitlement to treaty benefits.
The complexity of international business means that simple economic relationships – an ultimate parent company with a direct line to each operating subsidiary in a foreign jurisdiction – are generally the exception rather than the rule. Global economic relationships today can best be described as Gordian knots without the quick solution: there are regional holding company structures, regional operating business models, merger and acquisition activity involving international groups that have their own global operations, joint venture operations, cost-sharing arrangements, etc.
All these common cross-border business dealings create a transactional web of substantive business relationships from country to country under the umbrella of an ultimate parent company. Yes, the parent company – or perhaps the shareholders of the parent company – is the ultimate owner of the entire global group. But that doesn't mean that an intermediate entity in the global group cannot be the economic owner of a cross-border payment from an affiliate or a third party. That intermediate entity should be entitled to treaty benefits in its own right as long as it is the beneficial owner of such income and satisfies any other requirements specified in the treaty.
Another added complexity for multinational groups is the wide disparity in the breadth of countries' treaty networks. The United States has only 59 treaties in force, while the United Kingdom has more than double that number. And then you have an important regional location like Hong Kong with less than 20 tax agreements. Given this uneven patchwork of treaty coverage coupled with the complex global groups described above, multinationals need to know what the true criteria are for eligibility for benefits under a treaty. Unexpected denial of treaty benefits can result in real economic double taxation. Add to this picture the typical multi-tiered structures of most global companies and the result can be a lot worse than mere double taxation!
Today's complex global operating groups arise for a myriad of business reasons. But I am concerned that many countries' tax authorities approach these groups not with a recognition of global business realities but rather with an innate suspicion, or even a negative presumption, with respect to any intermediate entity that is claiming treaty benefits. To be fair, countries have a right to be concerned about who benefits from their carefully crafted bilateral tax treaties. After all, inappropriate use of tax treaties by third-country residents nullifies the whole point of having a bilateral accord. So I get why countries include anti-treaty-shopping provisions in their treaties. What I worry about is the tax authority of one treaty partner trying to stretch the beneficial ownership concept beyond recognition to address what it perceives as a potential treaty shopping situation.
As the OECD's work on the beneficial ownership project continues, I am hopeful that there will be a dual focus: first, on much needed clarifications of what the beneficial ownership concept means; and second, on equally important clarifications of what the beneficial ownership concept does not mean. Based on the discussion draft, I am cautiously optimistic on both fronts.
Under the current OECD Commentary, a resident of a Contracting State would not be considered the beneficial owner of dividends, interest, or royalties received if the resident merely acts as agent or nominee in respect of the income, or if such resident otherwise acts as a conduit with respect to such income.
In the introduction to the discussion draft, the OECD recognizes that the concept of "beneficial owner" contained in Articles 10, 11, and 12 of the OECD Model Tax Convention has given rise to different interpretations by courts and tax administrations globally. The stated purpose of the proposed changes is to clarify the meaning and interpretation of the term to prevent double taxation or non-taxation arising from these different interpretations. A single, accepted meaning of the term is a laudable goal and the OECD is in a unique position to advance this cause.
So what has Jeffrey Owens, et al, come up with for purposes of clarification?
One proposed change (among others) would add the following to the Commentary:12.4 In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the recipient of the dividend is not the "beneficial owner" because that recipient does not have the full right to use and enjoy the dividend that it receives and this dividend is not its own; the powers of that recipient over that dividend are indeed constrained in that the recipient is obliged (because of a contractual, fiduciary or other duty) to pass the payment received to another person. The recipient of a dividend is the "beneficial owner" of that dividend where he has the full right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass the payment received to another person. Such an obligation will normally derive from relevant legal documents but may also be found to exist on the basis of facts and circumstances showing that, in substance, the recipient clearly does not have the full right to use and enjoy the dividend; also, the use and enjoyment of a dividend must be distinguished from the legal ownership, as well as the use and enjoyment, of the shares on which the dividend is paid.
So far, so good. I take from this that the beneficial owner must have the full right to use and enjoy the dividend (or interest or royalty). Any legal (or other) obligation to pass the payment received to another person would disqualify the recipient as the beneficial owner and as a result would jeopardize that person's access to treaty benefits.
Put another way, the OECD is clearly favoring a dominion and control test that focuses on the particular treaty-protected income rather than a test that looks to the ultimate ownership or source of funding for the entity in question. Indeed, the OECD underscores this in proposed paragraph 12.6 of the Commentary:[T]he meaning given to this term [beneficial owner] in the context of the Article must be distinguished from the different meaning that has been given to that term in the context of other instruments that concern the determination of the persons (typically the individuals) that exercise ultimate control over entities or assets. That different meaning of "beneficial owner" cannot be applied in the context of this Article.
For those paranoid advisors among us, there could be a worry about how full the right to use and enjoy the treaty-protected payment must be. For instance, persons that are receiving dividends and other treaty-protected payments naturally will incur operating expenses and funding costs in deriving such payments. It seems clear to me that the use of cash generated from a treaty-protected payment to fund such costs would not impact the beneficial ownership determination.1 After all, that is what owners of income ordinarily do – use their receipts to fund their costs and hopefully have some profit left over. The new Commentary considers there to be a conduit situation if the recipient has an obligation to pass the payment on to another person. The use of some cash proceeds from the payment to fund costs doesn't seem to me to involve an obligation to "pass the payment" on to another. That said, I understand paranoid tendencies and fall prey to them myself, so while the OECD has got the Commentary on the beneficial owner concept open and their pencils sharpened, why not make this point more explicitly.
With these clarifications of what beneficial ownership means, the OECD next turns to the issue of what it doesn't mean and what purposes it doesn't serve. Proposed paragraph 12.5 of the Commentary discusses the potential for anti-abuse rules to be incorporated in a treaty, including provisions to address treaty shopping considerations. The paragraph notes that "[w]hilst the concept of `beneficial owner' deals with some forms of tax avoidance (i.e., those involving the interposition of a recipient who is obliged to pass the dividend to someone else), it does not deal with other cases of treaty shopping …" In this regard, the OECD cites several approaches that could be used to address abuse of treaty benefits, including specific or general anti-abuse rules and substance-focused approaches. The inclusion of the beneficial ownership concept in a treaty does not restrict the ability to include one or more of these anti-abuse provisions; at the same time, the beneficial ownership concept cannot be made to serve the purpose of one or more of such anti-abuse provisions. Here again, I would find the OECD's proposed changes to the Commentary more beneficial to the system if it were made explicit that the other approaches referenced are intended to involve specific language included in a bilaterally negotiated agreement.
The potential for confusion in this regard is real and such confusion is occurring in jurisdictions around the world. Moving on from the beneficial ownership concept to other approaches for addressing treaty abuse (which, as mentioned earlier, often get confused with the subject at hand), I would put them into two broad categories: (1) general anti-avoidance rules or sham-entity-type attacks; and (2) U.S.-style treaty limitation on benefits approaches.
Examples of these types of treaty challenges abound. The ATO in Australia recently took the position in relation to the Texas Pacific Group/Myer case that the general anti-avoidance rule of Part IVA had application to deny the benefits of the Netherlands-Australia Income Tax Treaty where a Dutch holding company was purportedly set up to obtain tax treaty benefits.
Indian tax authorities traditionally have been very aggressive in ignoring intermediate holding companies, both in a treaty context as well as under domestic law, to assert nexus for taxing gains. The well-known Vodafone case is an example of the latter approach. In the treaty shopping context, however, there has been some good news in the form of a favorable ruling by the Indian authority for advanced rulings with respect to the availability of the India-Mauritius Income Tax Treaty in E*Trade Mauritius Ltd. However, a more recent decision by the high court in Bombay (Aditya Birla) upheld a challenge to that treaty based on beneficial ownership grounds where certain voting and management rights were retained by the Mauritius company shareholders. Both the ruling and the case are appealable to the Indian Supreme Court. So the jury is still out so to speak on India and Mauritius.
Another very high profile example of a treaty challenge is in China where so-called Circular 601 provides a list of seven active business-type factors to be evaluated for any entity claiming to be the beneficial owner for treaty purposes. One of the factors is whether the treaty resident has an obligation to distribute a major portion of its income – that one certainly sounds like something that would be relevant to a beneficial ownership determination. The other six factors, however, go way beyond anything that do not involve areas of inquiry that typically have been viewed as relevant to such a determination.
In my view, all of these examples go considerably beyond the concept of beneficial ownership discussed in the OECD Commentary. Clearly, none is premised on a nominee or strict economic or legal conduit relationship. Moreover, none of them involves the interpretation of any other anti-abuse measure contained in the particular treaty at issue. To my mind, the place for discussing these types of treaty limitations is in the bilateral negotiation of the tax treaties themselves. So newly advancing such restrictions is not something that can be done unilaterally but rather requires a visit to the treaty negotiating table. To negotiate a bilateral treaty in good faith with no specific provision limiting treaty benefits in the case of third-country investors and then unilaterally add such restrictions under the guise of international beneficial ownership standards is neither fair play nor good tax policy.
Admittedly, the United States has earned a reputation for treaty overrides – going back at least to our introduction of FIRPTA in 1980. But for the most part, although I find a lot to complain about with respect to our U.S. international tax system, I think the U.S. approach to treaty enforcement is pretty reasonable. The U.S. conduit financing rules are aimed at straight back-to-back arrangements and, while a bit broader than I would think is intended by the proposed OECD Commentary on beneficial ownership, should not have an impact on equity-funded holding, finance, or licensing companies or active financing companies. Moreover, U.S. treaty limitation on benefits rules are bilaterally negotiated (and, as indicated in my prior commentary on "Tricky Derivatives," are perhaps too bespoke a matter). The approach of U.S. treaty limitation on benefits rules in assessing the overall business connection of the affiliated corporate group to the treaty country location of the recipient company and in looking to potential entitlement to equivalent derivative benefits is reasonable by contrast to the approaches followed by some countries. In this regard, the approach of Circular 601 in China, for example, is to look to separate entity business activities and to either ignore or leave unclear the status of derivative benefits.
Overall, I would encourage countries to take a two-prong approach to treaty entitlement: first, to follow the OECD guidelines (hopefully after a bit more clarification) on beneficial ownership; and second, to consider how they want to develop an explicit and reasonable policy on limitation on benefits. Hopefully, any future anti-treaty-shopping policy will clearly recognize the business realities referred to at the outset of this commentary. Countries then could use these new policy standards for negotiating and renegotiating their bilateral tax treaties.
To the OECD, I'd say good start! Once the current beneficial ownership project is completed (with the few points of clarification I have noted, of course), perhaps the OECD would consider turning its attention to encouraging a more consistent approach to anti-treaty-shopping provisions.
This commentary also will appear in the October 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., Payments Directed Outside the United States — Withholding and Reporting Provisions Under Chapters 3 and 4, and Levine and Miller, 936 T.M., U.S. Income Tax Treaties — The Limitation on Benefits Article, and in Tax Practice Series, see ¶7160, U.S. Income Tax Treaties and ¶7170, U.S. International Withholding and Reporting Requirements and FATCA.
* The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.
1 If an obligation specifically tracks to the payment in question, such as a loan that is payable only with regard to a dividend received, for example, that would call beneficial ownership into question. Take, for instance, an extreme case like Indofoods where there was a virtual 100% back-to-back loan with no other activity in the intermediate entity.
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