The general financial services and inward investment community in Ireland has benefited  in no small part from our excellent and expanding treaty network.

This has helped the International Financial Services Centre (IFSC) grow significantly and has also led to many groups structuring transactions through Ireland.

The purpose of this article is to look at the tax treaty concept of “beneficial ownership” which taxpayers and practitioners have to agonise over when it comes to structuring transactions.   Where Irish entities are involved, we need to establish that the beneficial ownership is Irish.

The interpretation of the term “beneficial ownership” is of great importance to the Irish economy due mainly to the following reasons:

• Our long established Financial Services Centre
• Our withholding tax rate in some of our key treaties (e.g. the 0% rate in the Korea treaty which is only available in one of Korea’s other treaties)
• Our domestic law exemption whereby any interest payments to a treaty country can be made free from withholding irrespective of the treaty rate
• Our overall dependence on inward investment

It is particularly relevant to intergroup lending, leasing and in some cases swap or IP transactions.

“Beneficial Ownership” – what does the phrase mean?

When dealing with tax treaties, regard in the first instance, must be had to the OECD Model Double Taxation Convention. This convention was amended in 1997 so that benefits under Articles 10, 11, and 12 (the Interest, Dividend and Royalty Article) were only available where the recipient of the income was also the beneficial owner.  The phrase is included in most of Ireland’s treaties.

Treaty shopping has been a matter of concern for states for a number of years and it was as a result of this that the changes were made to the treaty text.  The OECD Committee on Fiscal Affairs produced a report entitled ‘Double Taxation Conventions and the use of Conduit Companies’ which led to further revision of the commentary in 2003.  However, there has been much discussion on what exactly ‘beneficial owner’ means in this context.

Article 3 of the OECD model provides that where terms are not defined in the convention (as the term beneficial owner is not) then they shall ‘have the meaning that [they have] at that time under the law of the State for the purpose of the taxes to which the Convention applies (i.e. the source state).

However, the concept of beneficial ownership is one inherent to common law jurisdictions, so while states like Ireland, the UK and Australia may have a domestic concept of ‘beneficial ownership’ many civil law jurisdictions do not.

The commentary on the model convention goes some way to helping us understand the concept in general, but a very recent UK case (published 7th October 2005) considering the availability of treaty rates under the Netherlands – Indonesia DTT has shed new light on the matter in a manner which we consider is favourable for taxpayers in general.

Indofood International Finance v JP Morgan Chase Bank [2005] EWHC 2103 (Ch D)

An Indonesian company (Indofood) set up a Mauritian SPV to issue Eurobonds.  Back to back loans were put in place.  The Eurobonds contained a gross-up clause and provided for early redemption in case that due to tax or treaty changes the issuer had to pay additional tax.  They also contained a best endeavours clause requiring the Issuer to try to mitigate any additional tax liability before seeking to redeem the notes.  The financing was structured via Mauritius to avail of the beneficial withholding tax rates under the Indonesia Mauritius Double Tax Treaty.  Mauritius has no outbound withholding taxes.

With effect from 1 January 2005 Indonesia terminated their tax treaty with Mauritius as a result of abuse by conduit companies.  This meant that the gross up, instead of being 10% became 20% under domestic Indonesian law.  As the financial markets had moved since the issue of the notes in 2002 Indofood sought to redeem the notes and refinance more cheaply.  However, JP Morgan Chase acting as trustee for the bondholders was not satisfied that the best endeavours clause had been complied with, alleging that Indofood could have interposed a Dutch entity into their structure and availed of the preferable rates under the Netherlands Indonesia Double Taxation Convention.

As the Eurobonds stipulated that they were governed by the laws of the United Kingdom, it fell to the UK High Court to consider whether the best endeavours clause would require such restructuring, and whether such restructuring was likely to be successful in mitigating the additional tax charge.

The Court concluded that such restructuring could be required, and then considered whether such a restructuring would be successful so as to prevent early redemption.

A new company (“Newco”) would be registered, managed, audited etc in the Netherlands.  Due to the Dutch authorities ‘substance and risk’ requirements, it would have to be fully capitalised, and where the company was to be a finance company then lending had to be done on the basis that it would yield a profit (so the interest rate on the loan from the issuer had to be less than the interest rate on the loan to the parent).  The Dutch Revenue fix the minimum resulting spread that they will accept.

Indofood and the Indonesian Revenue both alleged that this would not work because, amongst other reasons, the Dutch company would not be the beneficial owner of the interest that it received.

Beneficial ownership

The UK Court was therefore in the unique and highly unusual position of having to determine whether an Indonesian tax court would agree with the Indonesian Revenue and deny the treaty benefit, in which case the loan notes would be redeemable.

Can a conduit be the beneficial owner?

OECD commentary

It makes sense to consider the judgement in the light of the OECD commentary on the model treaty. 

The commentary on Articles 10, 11 and 12 tells us that ‘The term “beneficial owner” is not used in a narrow technical sense, rather, it should be understood in its context and in light of the object and purposes of the convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance.’

This is consistent with the analysis by the UK Court that where there is any ambiguity in the term, it should be given its widest possible meaning to prevent abuses.  However, both the Court and the commentary, by detailing specific exceptions accept that there will be cases where a conduit company can be the beneficial owner of income. 

The specific instances where the term beneficial owner would not be applied include situations where the immediate recipient of the income is not treated as the owner in the eyes of the State of residence so that there can be no risk of double taxation.  The UK Court felt that as the Dutch rules required that a minimum spread arise in the Netherlands then some of the income would potentially be subject to double taxation. 

Another instance where the commentary and Court agreed that there would be no beneficial ownership would be where the conduit company was merely acting as an agent or nominee.  The Court held that the interposed entity could not be considered as an agent or nominee as it would be free to dispose of the interest received in any way it saw fit, albeit that it was most likely to pay the interest on to the issuer to satisfy its contractual obligations.

The final instance where beneficial ownership could not exist in the hands of a conduit was the example brought into the OECD commentary by the report ‘Double Taxation Conventions and the use of Conduit Companies’, namely where “though the formal owner, 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.’
The Court in the Indofood case found that since, in accordance with the terms of the Eurobonds, the bond holders ‘will at all times rank pari passu and without any preference among themselves and at least pari passu with all other present and future unsecured obligations of the Issuer, save for such obligations as may be preferred by provisions of law that are both mandatory and of general application’ there was no way that the intermediary could be deemed to be acting in a fiduciary capacity.  In the classic example of the Dutch entity being insolvent, the bondholders would have no greater rights than any other creditors.

The conclusion reached by the High Court and supported by the commentary is that a conduit company can, depending on the facts of the case, have beneficial ownership in income that flows through it.  The Court found that on the facts of the case before it the proposed Dutch entity would have beneficial ownership as it could not be deemed to be a mere nominee or agent, was not acting in a fiduciary capacity, and there would be the risk of double taxation if the treaty benefits were not allowed as the income would be subject to Dutch taxation.  It was perhaps, telling in that case, that the Indonesian authorities terminated their tax treaty with Mauritius on account of it being abused by conduit companies, yet never alleged that the original Indofood structure could have been caught by the phrase ‘beneficial ownership’.  If the Indonesian authorities were satisfied that the existence of that phrase in the articles of a tax treaty was sufficient to catch all conduit scenarios why did they terminate the treaty?

While contracting states may seek to rely on anti abuse provisions of their domestic laws to support arguments that ‘beneficial ownership’ prevents treaty shopping, Article 27 of the Geneva Convention on the Law of Treaties states that ‘A party may not invoke the provisions of its internal law as justification for its failure to perform a treaty.’

There is nothing to prevent contracting states from being more explicit in their wording during bilateral negotiations.  The OECD commentary, when discussing conduit companies in relation to Article 10, gives the example of a standard provision included by Switzerland in Double Taxation Conventions denying benefits, if more than a certain proportion of the income is used to satisfy connected party claims and concluded that it ‘appears to be the only effective way of combating "stepping-stone" devices'.

However, in the absence of such specific provisions it would seem that the concept of ‘beneficial ownership’ will not always be sufficient to prevent conduit companies availing of the rates under tax treaties, especially in cases where the rules of the jurisdiction of residence of the conduit company are such, that there is the possibility of double taxation in the absence of treaty relief.

In our view, this UK case will be of particular importance not only to structuring future cross border transactions, but also to the ongoing challenges by foreign Revenue authorities to structures that they consider as abusive. Thus, the case strengthens Ireland’s position as an important country in the structuring of international transactions.