By Gavin Helmer, Tax Partner, PwC Services LLP
There is a lot going on in the corporate tax world at the moment, both domestically (almost wherever you are) and internationally. Depending on one’s particular field of expertise or responsibility one will form a view as to which are the most important developments, but I think the issue of beneficial ownership should be high on most people’s agenda, and I would even venture to say that this must rank as one of the three most important international tax issues at present, if not also for some years to come.
So what is the issue and why is it so important?
In an international tax context – and specifically in the context of the OECD Model Tax Treaty – beneficial ownership is a term that is used in the dividend, interest and royalty articles to define entitlement to the benefit of those articles (generally to a reduced or zero rate of withholding tax). So the concept is relevant to investing, lending or dealing in IP and receiving income in a cross-border context; withholding tax can affect the economics of any transaction, and obtaining treaty relief that may be due can be a critical part of any investment / dealing decision.
In an OECD context the term was first introduced into the 1977 model treaty to counter a perceived weakness with the language used before that time. Essentially the model treaty used to reference the benefit of the dividend, interest and royalty articles to the person to whom the income in question was “paid”. Recognising that in many situations the person to whom the income was paid might be the bare legal owner (e.g. a nominee – such as custodians use – or an agent) with no rights to the income, the term beneficial owner was adopted to clarify that the benefits of the treaty were not intended to be conferred on recipients of income with minimal ownership rights – i.e. intermediaries such as agents and nominees receiving the income on behalf of another person. This was an entirely sensible development
Subsequent to the introduction of the term in the 1977 model treaty, there have been various developments in the OECD guidance in relation to the term. The 1986 Conduit Companies report was intended to address concerns on the improper use of tax treaties, and sought to further develop the concept of beneficial ownership by, in essence, also excluding from the definition of a beneficial owner a conduit company with very narrow powers which rendered it a “mere fiduciary or an administrator acting on behalf of the interested parties” (i.e. the shareholders of the company). This is not inconsistent with the original intent, since a conduit company in such circumstances could be viewed as tantamount to an agent with minimal ownership rights over the income. In 2003 the treaty commentary was updated to include the conduit company carve-out, although some of the language used arguably created some ambiguity and uncertainty, even if the original intent seemed to have been preserved.
So, against this background, what is the problem? Essentially it is that various tax authorities have, over time, and increasingly since the late 90s, been using the beneficial ownership concept as an anti-abuse / anti-treaty shopping test, contrary to the original OECD meaning of the term. Challenges, many of which have reached the courts, have been based either on the lack of substance of the beneficial owner, or on the basis of the economic position of the beneficial owner, in as much as that person may pay on some or all of the income that it receives to another party. Cases have been heard in – among others - Canada, Denmark, Switzerland, the UK, France and the Netherlands, and with mixed end results, but with some notable defeats for the tax authorities. In short, countries that have been looking to use beneficial ownership as an anti-abuse concept have, to some extent, been thwarted in their attempts by the courts, which have in many important cases maintained the original meaning and intent of the term in their decisions.
This brings us on to the latest development, the publication by the OECD in April 2011 of a discussion draft entitled “Clarification of the Meaning of “Beneficial Owner” in the OECD Model Tax Convention”. As the title suggests, the purpose of the draft is to provide clarification, but most respondents have expressed concern that the draft goes beyond clarification and will be used by tax authorities to pursue substance-based and / or economics-based interpretations of the term, contrary to its original meaning in the 1977 model. So this is not clarification, commentators say, but change. And the main change comes from introducing the concept of the beneficial owner as the person who has the “full right to use and enjoy” the income unconstrained by any contractual or legal obligation to “pass on the payment” to another person. Any obligation is to be ascertained from the legal documentation, but also based on the substance of the relevant facts and circumstances. The wording – if adopted in the commentary to the model treaty - would seem to introduce subjectivity and ambiguity, and open the door for tax authorities to apply a much broader anti-abuse concept in the interpretation of the term.
So what, one might say? Well, if incorporated into the model commentary as currently drafted, this has the potential to affect significant amounts of commercially driven cross-border business. Take the basics of bank lending. A bank borrows and lends. A bank may seek to match borrowing and lending to minimise interest rate, currency, tenor, etc risk. So in a case where a bank has borrowed from A and lent to B on equivalent terms (albeit at different rates to make its spread), will the “new” beneficial owner test be interpreted by a tax authority to mean that the bank is passing on the interest received from B to A, with the consequence that it is not to be regarded as the beneficial owner for treaty purposes as it does not have the “full right to use and enjoy the income…unconstrained by any contractual or legal obligation to pass on the payment”? Clearly this must be the wrong conclusion, but a challenge based on the wording in the draft cannot be ruled out. Without going into examples, a whole range of commercial transactions and dealings could be affected – sub-participations, equity / fixed income swaps, credit derivatives, collateral, repo and stock loan arrangements, to name a few – all of which, to a greater or lesser extent, have some form of on-payment by the recipient. Taken to an extreme, the “new” test incorporated in the discussion draft could be invoked where a security is debt and equity financed, the payment of interest and dividends on the financing being treated as passing-on of receipts on the security even though not directly related to the receipts.
It will be regrettable – and cause a significant amount of uncertainty, contrary to the stated intention of the OECD to promote certainty in international tax matters – if the draft is incorporated into the model commentary as it stands. Many respondents have expressed concern on the direction and have suggested changes to the wording of the draft, as well as changes in the conceptual approach, the concern being that the draft invokes a new anti-abuse dimension to the term beneficial owner. Many are of the view that the term should largely retain its original meaning and intent in the model treaty, and that abuse should be handled through other means. Specific and targeted anti-abuse provisions – such as anti-conduit and limitation of benefit clauses – are already available. The danger in using beneficial ownership as an anti-abuse concept is that it has the potential to create significant uncertainty and could catch – and therefore impede – substantial amounts of commercial cross-border business. The OECD is due to report back later this year on how it proposes to proceed, but early indications are that the on-payment concept will remain and be incorporated into the commentary, which could be a very unwelcome development, and possibly disastrous to cross-border business if applied in a heavy-handed way by tax authorities.