The impact of the beneficial ownership test is becoming clear
Jos Hellebrekers, partner in Otterspeer, Haasnoot & Partners, Rotterdam, the Netherlands
Svetlana Klakar
Introduction
Ever since Ukraine introduced the term beneficial ownership test into the Tax Code (TC) in 2011, this has been an important issue for the Tax Administration and tax practitioners, and by now a number of Court cases have been published. Chapter 1 of this article describes the historic background of the beneficial ownership test, and the challenges that the Ukrainian Courts will fact. Ukrainian case law is addressed in chapter 2. From a practical perspective, landmark cases in international case law and recent trends within the OECD are discussed. In Chapter 4 we conclude that so far the Ukrainian Courts are very reluctant to refuse tax treaty benefits to a foreign company based on the beneficial ownership test, that these decisions of the Ukrainian Courts are in line with the international and OECD trends and conclusions regarding future challenges for the Courts are drawn.
1. Background and challenges for the Courts
If a foreign company receives dividend, interest or royalty payments from Ukraine, Ukraine levies a withholding tax on such payments. Often the company receiving this income cannot claim a (full) tax credit in its state of residence, resulting in double taxation. Tax treaties – nearly always based on the OECD Model Tax Conventions (OECD MTC) of 1977 or later, or the United Nations equivalent - provide a reduction of these withholding taxes, or even a full exemption. Firstly, the foreign company could only claim these treaty benefits if it was a resident of the other state . Secondly, the foreign company has to be the beneficial owner (English) of the dividends, interest or royalties to claim lower withholding tax rates. From the French equivalent - bénéficiaire effectif - it becomes clear that the term means the actual beneficiary to the income. Discussing the (history of the) OECD MTC and the Official Commentary thereto (the Commentary) would go beyond the scope of this article; please refer to the literature in the footnote.
As a result, the beneficial ownership test was also included in most tax treaties concluded by Ukraine; an important exception is the current tax treaty with Cyprus. In October 2012, however, a new treaty with Cyprus was announced which should also include the beneficial ownership test. Once this new treaty with Cyprus will have entered into force, use of foreign companies will only result in a reduction of withholding taxes on dividends, interest or royalties if the beneficial ownership test is fulfilled.
In 2011 the concept of the "beneficial owner" was also introduced in the Tax Code (TC) of Ukraine. The definition of article 103 § 3 TC reads: "a person who has the right to receive such income", but this person "cannot be a juridical or physical person, even the above stated person has the right to receive income, in cases where she/he is an agent, nominee or only an intermediary in respect of such income." This appears to be in line with the Commentary to the OECD MTC. The Ukrainian tax authorities may – but are not obliged to – interpret the term beneficial owner in line with the Commentary to the OECD MTC’s . This suggests that the TC could have its own definition of the term beneficial owner which automatically will apply for interpretation of the tax treaty. Unfortunately, the Ukrainian legislature did not expres its reasons for introducing the beneficial ownership test in the TC very clearly.
For the Ukrainian Courts this means that, once disputes regarding the beneficial ownership test are submitted to them, they can only explain their decision, if they confirm their thoughts on the following issues:
a. What exactly is the importance of the Commentaries to the OECD MTC’s? If the treaty is based on the OECD MTC, it will not contain a definition of the term beneficial owner. In such a case the term beneficial ownership shall have the meaning that it has at that time under the law of Ukraine (article 103 § 3 TC), unless the context requires otherwise (article 3 § 2 OECD MTC). Will the Ukrainian Courts accept that the updated Commentary to the OECD MTC are part of the context as meant in article 3 § 2, so that this context can require otherwise (see c.)? In any case, the definition of article 103 TC does not seem to deviate from the official commentaries so far.
b. Which version of the Commentaries? The commentaries to the OECD MTC are updated from time to time. Usually, before a new version is adopted and published, Working Parties are instructed to work out proposals. On 29 April 2011, the OECD released a public discussion draft entitled ‘Clarification of the meaning of ‘beneficial owner’ in the OECD Model Tax Convention’ . On 19 October 2012, revised proposals were published .
c. Does the definition of the OECD MTC prevail over the Ukrainian definition of the TC if those definitions turn out to be different? Yes, according to the current Commentaries , and also according to the text proposed in its report of 19 October 2012: “Since the term “beneficial owner” was added to address potential difficulties arising from the use of the words “paid to … a resident” in paragraph 1, it was intended to be interpreted in this context, and not to refer to any technical meaning that it could have had under the domestic law of a specific country (in fact, when it was added to the paragraph, the term did not have a precise meaning in the law of many countries), rather, it should be understood in its context, in particular in relation to the words “paid … to a resident”, and in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance.” From the comments to this text it follows that not all OECD members agree whether beneficial owner should have an autonomous treaty meaning .
d. How does the beneficial ownership test relate to anti-abuse provisions aimed at treaty shopping? The term “beneficial owner” was added to the 1988 OECD MTC to address potential difficulties arising from the use of the words “paid to … a resident” according to the 1963 OECD MTC. Internationally there is consensus that, if the contracting parties to a tax treaty prefer additional anti abuse provisions, they should include separate provisions in the tax treaty, and not try to achieve the same result by giving a more extensive interpretation of the term beneficial owner.
2. Ukrainian case law about the concept of the “beneficial owner”
2.1. The Semki and Flint cases
The first decisions regarding beneficial ownership by the Dnipropetrovsk Regional Administrative Court of First Instance - in the open model - appeared only at the beginning of 2012. In both cases, TM «SEMKI» and TM «FLINT», the rate of Ukrainian withholding tax on royalties was disputed. The factual circumstances in both cases were similar. Companies resident in the British Virgin Islands (BVI) held trademarks. Under license agreements, the right to use the trademarks in the territory of Ukraine was licensed to companies resident in Cyprus. Next, the Cyprus companies signed sub-license agreements with Ukrainian companies for the use of the relevant trademarks in Ukraine.
Due to the fact that no tax treaty is in force between Ukraine and the BVI, withholding tax on royalties paid by the Ukrainian companies directly to the BVI companies would have amounted to 15% . By interposing the Cyprus companies, the effective withholding tax on royalties would have been reduced to 0%.
Taking into account of the Ukraine Trademark Certificate, the Ukrainian inspector concluded that the Cyprus companies were not the beneficial owners of the royalties and therefore were not entitled to the reduction of the royalties under the tax treaty with Ukraine.
The Court of First Instance dismissed the decision of the inspectors in first instance. The Court observed that the Tax Administration had failed to investigate the economic substance of the transactions, that is, the on-payment of the income received to the BVI companies.
The Court ruled that based on the text of the license agreement, that is the agreement on the disposition of the intellectual property rights, the Cyprus companies can be considered as the beneficial owners of the income from sources in Ukraine. Possibly the Court meant that the license agreement did not include any obligations for the Cyprus companies to pass on the income to a third party. Certificates of residence of the Cyprus companies has been provided to the Court. Based on (only) these documents (the certificate of residence and the license agreement), the Court ruled that the Ukrainian companies had the right to apply the reduced rate in accordance with the tax treaty with Cyprus.
The Court paid attention to the fact that the beneficial ownership test is not included in the ttreaty between Ukraine and Cyprus, only in Ukraine national law, the TC. However, under article 3, paragraph 3.2 of the TC, (tax) treaties override Ukraine domestic law, such as the TC.
The Court decisions at first instance and the application of the tax treaty with Cyprus have been reflected in the letter № 8229/6/15-1215 of the State Tax Service of Ukraine dated 05/14/2012. In accordance with this letter if the taxpayer and the right holder signed the contract which is not the commission, errands or agency contract the taxpayer is allowed to use the article 103 of the TC and the tax treaty.
In both cases, the Court of First Instance could have decided in favor of the taxpayers by simply stating that application of the beneficial ownership test is not possible, since this implies that Ukraine national law overrides the Cyprus tax treaty (which does not contain a beneficial ownership test). By also dealing with the beneficial ownership test, the Courts have provided some clues. More importantly the Tax Administration decided to provide guidance how the expression ‘intermediary’ must be interpreted in its letter of 14 May 2012 .
2.2. The RIXOS case
RIXOS GROUP NV was a public limited liability holding a trademark (the text of the Court’s decision does not confirm the state of residence of RIXOS Group NV). Under a license agreement, the right to use the trademark in the territory of Ukraine was licensed to RIXOS HOLDING & FINANCE BV, a close limited liability company resident in the Netherlands. Next, RIXOS HOLDING & FINANCE BV signed a sub-license agreement with the Ukrainian company RIXOS Prykarpattya TOV for the use of the relevant trademark in Ukraine.
The Ukrainian Tax Inspector concluded that the RIXOS HOLDING & FINANCE BV was not the beneficial owners of the royalties and therefore was not entitled to the reduction of the royalties under the tax treaty with Ukraine. In first instance, however, the Lviv District Administrative Court decided that RIXOS HOLDING & FINANCE BV was the beneficial owner of the royalty income. This decision is based on the sub-license agreement and the certificate of residence issued by the Dutch Tax Administration. Apparently the Dutch Tax Administration had also confirmed its opinion that RIXOS HOLDING & FINANCE BV was the beneficial owner of the royalty. The Lviv Administrative Court of Appeal upheld the decision of the Court of First Instance that RIXOS HOLDING & FINANCE BV can be regarded as the beneficial owners of the income from sources in Ukraine, based on the same factual circumstances as those mentioned by the Court of First Instance.
3. Practical examples, OECD Commentary and international case law
3.1. Conduit companies in the current OECD Commentary
According to the Commentary, (holding) company will not fulfill the beneficial ownership test if it merely 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, through 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 The case law below is based on this version of the Commentary. In 3.6 we discuss the additions to the Commentary as proposed in the October 2012 report.
3.2. Holding companies – the Canadian Prevost case (2009)
Prevost Car Incorporated (Prevost) was a Canadian company resident company the share of which were held by a Dutch holding company, Prevost Holding BV. In turn, 51% of the shares in DHC were held by Volvo Bus Corporation (Volvo), a company resident in Sweden and the other 49% by Henlys Group plc (Henlys), a company resident in the UK.
Volvo and Henlys had signed a shareholders’ agreement, in which they had agreed that 80% of the profits of Prevost Holding BV would be distributed to Volvo and Henlys. Withholding tax on dividends paid by the Prévost directly to Henlys and Volvo would have amounted to 10% and 15% respectively. A Dutch company would be able to claim an effective withholding tax rate of 5% under article 10 § 1 and § 2 of Canadian-Dutch tax treaty, which includes a beneficial ownership test. The Canadian Tax Inspector concluded that this test was not met.
The Federal Court of Appeal held that, in its 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 … 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.” Prevost Holding BV indeed had the freedom regarding the payments of the dividends and there was no automatic flow of funds to the shareholders. The Court ruled that Prevost Holding BV was the beneficial owner of the dividends.
3.3. Financing and licensing companies
This category covers the cases like the ones disputed in Ukrainian case law that we described in Chapter 2. The Ukraine Tax Administration can deny a reduction of withholding tax based on the interpretation of the beneficial ownership test if the foreign company is legally obliged to pass on 100% of the interest or royalties as an agent/nominee or as a conduit as described in 3.1 (also see 3.6). If so, the foreign company does not have the full right to use and enjoy the income, as such a right is constrained by a contractual or legal obligation to pass on the payment received to a third party. For international tax planning the question is under which circumstances the obligations to third parties can be regarded as unrelated to the payment for which beneficial ownership is claimed.
The Indofood case (2006)
When the Indofood case was decided in 2006, this seemed to provide an argument that Tax Administrations worldwide should be able to refuse treaty benefits to an intermediate financing company based on the beneficial ownership test. In 2002, the Indonesian company PT Indofood Sukses Makmur TBK (Indofood) issued 10.375% loan notes amounting to USD 280 million for business purposes, to be repaid in 2007: if it had done so directly, 20% withholding tax would have been due on the interest payments. As this was unattractive, Indofood incorporated a 100% Mauritius subsidiary, borrowing from the creditors and on-lending to the Indonesian company. Under the tax treaty with Mauritius, the Indonesian withholding tax rate on interest was reduced to 10% (apparently in 2002 the Indonesian Tax Administration (DGT) accepted that the Mauritius company fulfilled the beneficial ownership test of that tax treaty), and Mauritius did not levy any withholding tax on outbound interest payments. A UK Bank was appointed as trustee for the noteholders.
So, all parties were satisfied … until Indonesia terminated its tax treaty with Mauritius effective 1 January 2005. As a result, upon termination of the tax treaty the Indonesian withholding tax on interest doubled to 20%, the national rate. For this case, the Note Conditions provided that the Mauritius company (and Indofood) could repay the loan notes, provided the Mauritius company could not avoid the 20% rate by “taking reasonable measures available to it”. Probably by then Indofood was able to borrow at a lower interest rate than 10.375% and wanted to redeem the loan. The Mauritius company claimed it could not avoid the withholding tax exceeding 10% by taking reasonable measures that were available. The UK bank, however, refused to give its approval on the ground that the Issuer was not entitled to redeem the loan notes, arguing that there were reasonable measures available: the simple solution proposed was to interpose a Dutch company between the Indonesian company and the Mauritius company. According to the Indonesia-Netherlands tax treaty the withholding tax on interest would then be reduced to 10% (the Indonesian-Dutch tax treaty had entered into force after the issue of the loan notes, on 1 January 2004). Indofood submitted a statement from the Indonesian Tax Administration that a Dutch intermediate financing company, being a conduit and nominee company, would not be the beneficial owner of the interest income.
The High Court decided that the proposed Dutch company could not have been the beneficial owner of the interest paid by Indofood as meant in the interest article of the Dutch tax treaty. It can be concluded that this decision had some very special features:
The Velcro case
The Dutch company Velcro Holding BV (VH BV) licensed intellectual property (IP) from an affiliated company in the (former) Netherlands Antilles (NA), Velcro Industries BV (VI BV) and sublicensed this IP to a Canadian company, Velcro Canada Inc. (VC Inc.). VH BV was obliged to pay 90% of the royalties received from VC Inc. within 30 days after receipt to VI BV.
The issue was whether VH BV could be qualified as beneficial owner and consequently was entitled to application of the tax treaty with Canada, particularly the application of Article 12 of that treaty, which provides a reduction of withholding tax on royalties from 25% (the Canadian domestic rate) to 10% ( the rate under the treaty between Canada and the Netherlands). As there is no tax treaty between Canada and the NA, withholding tax on royalties paid by Canada direct to the NA IP owner would be 25%.
In his decision, the Canadian Judge based on and singled out four supporting aspects to confirm that VH BV is the beneficial owner of the royalties: possession, use, risk and control. As long as the (sub) licensor embodies these aspects, he will be entitled BO and the corporate veil will not be pierced. To begin with, VH BV was legally entitled to the royalties. This was supported by the fact that it was VH BV which had the license agreement with the Canadian company. Then, the royalties (on the bank account) were “comingled” with other revenues on account of VH BV and the proceeds had to be converted from Canadian dollars to U.S. dollars. These two facts were confirmed two other aspects: the use of royalties and the currency risk which VH BV had. The income (royalties) was not passed directly – and not in the same form,- but first remained on the bank account of VH BV, which meant that the (other) creditors could claim it.
It was noted that the royalties did not just flow through VH BV but, at the discretion of VH BV, payments were co-mingled with other funds of VH BV exercised its control, subjecting the funds to increases or decreases by virtue of earning interest or losing value because of the risk of currency exchange and using the funds, in part, to pay other outstanding obligations. At the same time it was shown that VH BV was no agent and certainly not a conduit company. The court made a decision that the beneficial ownership of the royalties rests in VH BV.
“Often foreign financing and licensing companies are resident in the Netherlands … “
The Netherlands have a longstanding tradition of dealing with financing companies. In 2003, a new ruling practice was introduced under which the Dutch Tax Administration support that a financing company which incurs realistic equity risks – like a bank – is regarded as the beneficial owner of its interest income . Of course it is the state of source (Ukraine) that applies the beneficial ownership test, but if requested the Dutch Tax Administration will advise the Ukraine Tax Administration that in its view the financing company is the beneficial owner of the interest income ; to the contrary if the company will not incur realistic financing risks, it probably will inform Ukraine that this is a conduit company .
3.4. An extreme case: the total return swap
Another case where economically a part of the income is passed on to a third party was decided by the Swiss Federal Administrative Tribunal (SFAT) on 7 March 2012 . The SFAT held that a Danish Bank was considered the beneficial owner of Swiss source dividends although from an economic perspective it had to pass on all income to a third party under a total return swap . An appeal against this decision has been filed with the Swiss Supreme Court (Federal Tribunal).
The Danish Bank had concluded total return swap contracts in respect of the shares of listed Swiss companies in the period from 2006 to 2008. To hedge the attendant risks the Danish financial institution bought the corresponding shares. The SFAT held that key to determining the issue of beneficial ownership is the extent of the complainant’s power to decide on the use of the dividends paid to it. According to the available documents, there was no civil law obligation whatsoever to hedge the swap contracts and/or to purchase the corresponding shares. The tribunal next considered whether there was a de facto obligation to pass on the dividends, based on a ‘substance over form’ approach or based on economic considerations. Two questions had to be answered:
The SFAT was well aware that in the case of the (hedged) swap contracts described it was not the bank but ultimately the counterparty of the total return swap who bore the risk that the Swiss companies might pay no dividends. But this did not preclude qualifying the bank as the beneficial owner of the dividends. Neither was the holding period of the shares relevant to the issue of beneficial ownership. Also irrelevant are the bank’s motives: the concept of beneficial ownership does not depend on any subjective factors. The motives and the holding period are only potentially relevant within the context of other regulations aimed at abuse of a tax treaty.
3.5. What if the income is not received by the owner of the underlying share, receivable or license?
The beneficial owner of for example a dividend is not necessarily the owner of the share. An example is the decision of the Dutch Supreme Court regarding a UK resident company acting as a Market Maker . The Market Maker had purchased dividend certificates for dividends which had been declared at the time of purchase, but were not yet payable, for a price of 80% of the gross nominal value. It claimed a refund of 10% Dutch dividend withholding tax under the UK tax treaty. The Supreme Court did consider the Market Maker as the beneficial owner. Firstly, by way of the purchase, the Market Maker became the owner of the dividend certificates. Secondly, the Supreme Court assumed that, after the purchase, the Applicant could freely do with the dividend as it pleased, and that in collecting the dividends it was not acting as an agent or nominee.
This reasoning is now confirmed in the proposed § 12.4 of the Commentary according to the October 2012 report (3.6).
3.6. The October 2012 proposals for amendments to the Commentary
The October 2012 report is of course just a draft. But it is a draft which has been reviewed by representatives of all member countries, which makes it likely that in future the OECD will be heading in this direction. And also, the report proposes to add the following sentences to the Commentary to article 10 , which eliminate some uncertainties that still exist under the current Commentary:
“In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the recipient’s right to use and enjoy the dividend is constrained by a contractual or legal obligation to pass on 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 right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person. This type of obligation must be related to the payment received; it would therefore not include contractual or legal obligations unrelated to the payment received even if those obligations could effectively result in the recipient using the payment received to satisfy those obligations. Examples of such unrelated obligations are those unrelated obligations that the recipient may have as a debtor or as a party to financial transactions or typical distribution obligations of pension schemes and of collective investment vehicles entitled to treaty benefits under the paragraphs 6.8 to 6.34 of the Commentary to article 1 [italics JH/SK]. Where the recipient of the dividend does have the right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment to another person, the recipient is the “beneficial owner” of that dividend. It should also be noted that Article 10 refers to the beneficial owner of a dividend as opposed to the owner of the shares, which may be different in some cases.”
If these proposals will result in a clearer distinction between unrelated and related obligations to on-pay the income, this will mean a big step forward for the tax practice.
4. Conclusions
The beneficial ownership test - of article 103 § 3 TC and of the tax treaties concluded by Ukraine - plays an important role in international tax planning, in particular after the new tax treaty with Cyprus will have entered into force.
A universal and very specific definition of the expression beneficial owner will never exist, but the headlines are clear. In international case law often the beneficial owner is described as the “person who receives the income for his or her own use and enjoyment and assumes the risk and control of the income he or she received”. Only when it is clear that the foreign company is an agent, nominee or conduit will it not be the beneficial owner. An economic approach to the criterion is refused by most Tax Courts . And the beneficial ownership test is not a motive test either. The beneficial owner of a dividend is not necessarily the owner of the relevant share. If and when the October 2012 report of the OECD will be adopted in the Commentary, an even clearer distinction will exist between unrelated and related obligations to on-pay the income, and this will mean a big step forward for the tax practice (3.6).
The case law of the Ukrainian Courts so far shows that the Courts are very reluctant to refuse tax treaty benefits to a foreign company which can provide a certificate of residence and a contract evidencing that it is entitled to the Ukrainian source income. The outcome of their decisions is (still) in line with the international and OECD trends as described in chapter 3. Compared with international case law, in particular the Velcro case (3.2), the decisions of the Ukrainian Courts contain little explanation as to which activities a foreign company should have to fulfill the beneficial ownership test . This is why the motivations of the Ukrainian Courts in the cases described in chapter 2. appear to be very brief, compared to decisions of the Tax Courts elsewhere in a.o. Canada, Switzerland and the Netherlands. In future decisions, the Courts may decide to explain to what extent they rely upon the criteria and guidance offered by the official commentaries and discussions within OECD and United Nations member states.
The approach of financing and licensing companies in Dutch tax law and by the Dutch Tax Administration since 2003 was described in 3.3. If a Dutch company meets the relevant “substance” requirements, this can be confirmed in an advance pricing agreement. If so, if requested, the Dutch Tax Administration would also help the Dutch company in an attempt to convince the Ukraine Tax Administration that the Dutch company must be regarded as the beneficial owner of the income.
Odessa/Rotterdam, 2 December 2012
Svetlana Klakar
Introduction
Ever since Ukraine introduced the term beneficial ownership test into the Tax Code (TC) in 2011, this has been an important issue for the Tax Administration and tax practitioners, and by now a number of Court cases have been published. Chapter 1 of this article describes the historic background of the beneficial ownership test, and the challenges that the Ukrainian Courts will fact. Ukrainian case law is addressed in chapter 2. From a practical perspective, landmark cases in international case law and recent trends within the OECD are discussed. In Chapter 4 we conclude that so far the Ukrainian Courts are very reluctant to refuse tax treaty benefits to a foreign company based on the beneficial ownership test, that these decisions of the Ukrainian Courts are in line with the international and OECD trends and conclusions regarding future challenges for the Courts are drawn.
1. Background and challenges for the Courts
If a foreign company receives dividend, interest or royalty payments from Ukraine, Ukraine levies a withholding tax on such payments. Often the company receiving this income cannot claim a (full) tax credit in its state of residence, resulting in double taxation. Tax treaties – nearly always based on the OECD Model Tax Conventions (OECD MTC) of 1977 or later, or the United Nations equivalent - provide a reduction of these withholding taxes, or even a full exemption. Firstly, the foreign company could only claim these treaty benefits if it was a resident of the other state . Secondly, the foreign company has to be the beneficial owner (English) of the dividends, interest or royalties to claim lower withholding tax rates. From the French equivalent - bénéficiaire effectif - it becomes clear that the term means the actual beneficiary to the income. Discussing the (history of the) OECD MTC and the Official Commentary thereto (the Commentary) would go beyond the scope of this article; please refer to the literature in the footnote.
As a result, the beneficial ownership test was also included in most tax treaties concluded by Ukraine; an important exception is the current tax treaty with Cyprus. In October 2012, however, a new treaty with Cyprus was announced which should also include the beneficial ownership test. Once this new treaty with Cyprus will have entered into force, use of foreign companies will only result in a reduction of withholding taxes on dividends, interest or royalties if the beneficial ownership test is fulfilled.
In 2011 the concept of the "beneficial owner" was also introduced in the Tax Code (TC) of Ukraine. The definition of article 103 § 3 TC reads: "a person who has the right to receive such income", but this person "cannot be a juridical or physical person, even the above stated person has the right to receive income, in cases where she/he is an agent, nominee or only an intermediary in respect of such income." This appears to be in line with the Commentary to the OECD MTC. The Ukrainian tax authorities may – but are not obliged to – interpret the term beneficial owner in line with the Commentary to the OECD MTC’s . This suggests that the TC could have its own definition of the term beneficial owner which automatically will apply for interpretation of the tax treaty. Unfortunately, the Ukrainian legislature did not expres its reasons for introducing the beneficial ownership test in the TC very clearly.
For the Ukrainian Courts this means that, once disputes regarding the beneficial ownership test are submitted to them, they can only explain their decision, if they confirm their thoughts on the following issues:
a. What exactly is the importance of the Commentaries to the OECD MTC’s? If the treaty is based on the OECD MTC, it will not contain a definition of the term beneficial owner. In such a case the term beneficial ownership shall have the meaning that it has at that time under the law of Ukraine (article 103 § 3 TC), unless the context requires otherwise (article 3 § 2 OECD MTC). Will the Ukrainian Courts accept that the updated Commentary to the OECD MTC are part of the context as meant in article 3 § 2, so that this context can require otherwise (see c.)? In any case, the definition of article 103 TC does not seem to deviate from the official commentaries so far.
b. Which version of the Commentaries? The commentaries to the OECD MTC are updated from time to time. Usually, before a new version is adopted and published, Working Parties are instructed to work out proposals. On 29 April 2011, the OECD released a public discussion draft entitled ‘Clarification of the meaning of ‘beneficial owner’ in the OECD Model Tax Convention’ . On 19 October 2012, revised proposals were published .
c. Does the definition of the OECD MTC prevail over the Ukrainian definition of the TC if those definitions turn out to be different? Yes, according to the current Commentaries , and also according to the text proposed in its report of 19 October 2012: “Since the term “beneficial owner” was added to address potential difficulties arising from the use of the words “paid to … a resident” in paragraph 1, it was intended to be interpreted in this context, and not to refer to any technical meaning that it could have had under the domestic law of a specific country (in fact, when it was added to the paragraph, the term did not have a precise meaning in the law of many countries), rather, it should be understood in its context, in particular in relation to the words “paid … to a resident”, and in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance.” From the comments to this text it follows that not all OECD members agree whether beneficial owner should have an autonomous treaty meaning .
d. How does the beneficial ownership test relate to anti-abuse provisions aimed at treaty shopping? The term “beneficial owner” was added to the 1988 OECD MTC to address potential difficulties arising from the use of the words “paid to … a resident” according to the 1963 OECD MTC. Internationally there is consensus that, if the contracting parties to a tax treaty prefer additional anti abuse provisions, they should include separate provisions in the tax treaty, and not try to achieve the same result by giving a more extensive interpretation of the term beneficial owner.
2. Ukrainian case law about the concept of the “beneficial owner”
2.1. The Semki and Flint cases
The first decisions regarding beneficial ownership by the Dnipropetrovsk Regional Administrative Court of First Instance - in the open model - appeared only at the beginning of 2012. In both cases, TM «SEMKI» and TM «FLINT», the rate of Ukrainian withholding tax on royalties was disputed. The factual circumstances in both cases were similar. Companies resident in the British Virgin Islands (BVI) held trademarks. Under license agreements, the right to use the trademarks in the territory of Ukraine was licensed to companies resident in Cyprus. Next, the Cyprus companies signed sub-license agreements with Ukrainian companies for the use of the relevant trademarks in Ukraine.
Due to the fact that no tax treaty is in force between Ukraine and the BVI, withholding tax on royalties paid by the Ukrainian companies directly to the BVI companies would have amounted to 15% . By interposing the Cyprus companies, the effective withholding tax on royalties would have been reduced to 0%.
Taking into account of the Ukraine Trademark Certificate, the Ukrainian inspector concluded that the Cyprus companies were not the beneficial owners of the royalties and therefore were not entitled to the reduction of the royalties under the tax treaty with Ukraine.
The Court of First Instance dismissed the decision of the inspectors in first instance. The Court observed that the Tax Administration had failed to investigate the economic substance of the transactions, that is, the on-payment of the income received to the BVI companies.
The Court ruled that based on the text of the license agreement, that is the agreement on the disposition of the intellectual property rights, the Cyprus companies can be considered as the beneficial owners of the income from sources in Ukraine. Possibly the Court meant that the license agreement did not include any obligations for the Cyprus companies to pass on the income to a third party. Certificates of residence of the Cyprus companies has been provided to the Court. Based on (only) these documents (the certificate of residence and the license agreement), the Court ruled that the Ukrainian companies had the right to apply the reduced rate in accordance with the tax treaty with Cyprus.
The Court paid attention to the fact that the beneficial ownership test is not included in the ttreaty between Ukraine and Cyprus, only in Ukraine national law, the TC. However, under article 3, paragraph 3.2 of the TC, (tax) treaties override Ukraine domestic law, such as the TC.
The Court decisions at first instance and the application of the tax treaty with Cyprus have been reflected in the letter № 8229/6/15-1215 of the State Tax Service of Ukraine dated 05/14/2012. In accordance with this letter if the taxpayer and the right holder signed the contract which is not the commission, errands or agency contract the taxpayer is allowed to use the article 103 of the TC and the tax treaty.
In both cases, the Court of First Instance could have decided in favor of the taxpayers by simply stating that application of the beneficial ownership test is not possible, since this implies that Ukraine national law overrides the Cyprus tax treaty (which does not contain a beneficial ownership test). By also dealing with the beneficial ownership test, the Courts have provided some clues. More importantly the Tax Administration decided to provide guidance how the expression ‘intermediary’ must be interpreted in its letter of 14 May 2012 .
2.2. The RIXOS case
RIXOS GROUP NV was a public limited liability holding a trademark (the text of the Court’s decision does not confirm the state of residence of RIXOS Group NV). Under a license agreement, the right to use the trademark in the territory of Ukraine was licensed to RIXOS HOLDING & FINANCE BV, a close limited liability company resident in the Netherlands. Next, RIXOS HOLDING & FINANCE BV signed a sub-license agreement with the Ukrainian company RIXOS Prykarpattya TOV for the use of the relevant trademark in Ukraine.
The Ukrainian Tax Inspector concluded that the RIXOS HOLDING & FINANCE BV was not the beneficial owners of the royalties and therefore was not entitled to the reduction of the royalties under the tax treaty with Ukraine. In first instance, however, the Lviv District Administrative Court decided that RIXOS HOLDING & FINANCE BV was the beneficial owner of the royalty income. This decision is based on the sub-license agreement and the certificate of residence issued by the Dutch Tax Administration. Apparently the Dutch Tax Administration had also confirmed its opinion that RIXOS HOLDING & FINANCE BV was the beneficial owner of the royalty. The Lviv Administrative Court of Appeal upheld the decision of the Court of First Instance that RIXOS HOLDING & FINANCE BV can be regarded as the beneficial owners of the income from sources in Ukraine, based on the same factual circumstances as those mentioned by the Court of First Instance.
3. Practical examples, OECD Commentary and international case law
3.1. Conduit companies in the current OECD Commentary
According to the Commentary, (holding) company will not fulfill the beneficial ownership test if it merely 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, through 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 The case law below is based on this version of the Commentary. In 3.6 we discuss the additions to the Commentary as proposed in the October 2012 report.
3.2. Holding companies – the Canadian Prevost case (2009)
Prevost Car Incorporated (Prevost) was a Canadian company resident company the share of which were held by a Dutch holding company, Prevost Holding BV. In turn, 51% of the shares in DHC were held by Volvo Bus Corporation (Volvo), a company resident in Sweden and the other 49% by Henlys Group plc (Henlys), a company resident in the UK.
Volvo and Henlys had signed a shareholders’ agreement, in which they had agreed that 80% of the profits of Prevost Holding BV would be distributed to Volvo and Henlys. Withholding tax on dividends paid by the Prévost directly to Henlys and Volvo would have amounted to 10% and 15% respectively. A Dutch company would be able to claim an effective withholding tax rate of 5% under article 10 § 1 and § 2 of Canadian-Dutch tax treaty, which includes a beneficial ownership test. The Canadian Tax Inspector concluded that this test was not met.
The Federal Court of Appeal held that, in its 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 … 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.” Prevost Holding BV indeed had the freedom regarding the payments of the dividends and there was no automatic flow of funds to the shareholders. The Court ruled that Prevost Holding BV was the beneficial owner of the dividends.
3.3. Financing and licensing companies
This category covers the cases like the ones disputed in Ukrainian case law that we described in Chapter 2. The Ukraine Tax Administration can deny a reduction of withholding tax based on the interpretation of the beneficial ownership test if the foreign company is legally obliged to pass on 100% of the interest or royalties as an agent/nominee or as a conduit as described in 3.1 (also see 3.6). If so, the foreign company does not have the full right to use and enjoy the income, as such a right is constrained by a contractual or legal obligation to pass on the payment received to a third party. For international tax planning the question is under which circumstances the obligations to third parties can be regarded as unrelated to the payment for which beneficial ownership is claimed.
The Indofood case (2006)
When the Indofood case was decided in 2006, this seemed to provide an argument that Tax Administrations worldwide should be able to refuse treaty benefits to an intermediate financing company based on the beneficial ownership test. In 2002, the Indonesian company PT Indofood Sukses Makmur TBK (Indofood) issued 10.375% loan notes amounting to USD 280 million for business purposes, to be repaid in 2007: if it had done so directly, 20% withholding tax would have been due on the interest payments. As this was unattractive, Indofood incorporated a 100% Mauritius subsidiary, borrowing from the creditors and on-lending to the Indonesian company. Under the tax treaty with Mauritius, the Indonesian withholding tax rate on interest was reduced to 10% (apparently in 2002 the Indonesian Tax Administration (DGT) accepted that the Mauritius company fulfilled the beneficial ownership test of that tax treaty), and Mauritius did not levy any withholding tax on outbound interest payments. A UK Bank was appointed as trustee for the noteholders.
So, all parties were satisfied … until Indonesia terminated its tax treaty with Mauritius effective 1 January 2005. As a result, upon termination of the tax treaty the Indonesian withholding tax on interest doubled to 20%, the national rate. For this case, the Note Conditions provided that the Mauritius company (and Indofood) could repay the loan notes, provided the Mauritius company could not avoid the 20% rate by “taking reasonable measures available to it”. Probably by then Indofood was able to borrow at a lower interest rate than 10.375% and wanted to redeem the loan. The Mauritius company claimed it could not avoid the withholding tax exceeding 10% by taking reasonable measures that were available. The UK bank, however, refused to give its approval on the ground that the Issuer was not entitled to redeem the loan notes, arguing that there were reasonable measures available: the simple solution proposed was to interpose a Dutch company between the Indonesian company and the Mauritius company. According to the Indonesia-Netherlands tax treaty the withholding tax on interest would then be reduced to 10% (the Indonesian-Dutch tax treaty had entered into force after the issue of the loan notes, on 1 January 2004). Indofood submitted a statement from the Indonesian Tax Administration that a Dutch intermediate financing company, being a conduit and nominee company, would not be the beneficial owner of the interest income.
The High Court decided that the proposed Dutch company could not have been the beneficial owner of the interest paid by Indofood as meant in the interest article of the Dutch tax treaty. It can be concluded that this decision had some very special features:
- It was not a dispute between taxpayer and Tax Administration. The British Court decided a case between Indofood and the UK Bank – whether it could be expected from Indofood to implement the Dutch alternative - entirely relying upon tax expert witnesses for each party;
- The UK High Court accepted that after 2002 the DGT had developed a policy as described in its circular letter from the DGT of 1 July 2005, based upon which a Dutch company would be under attack from the DGT – based on an economic approach of the beneficial ownership test - and that the Indonesian Tax Courts would agree with this approach.
The Velcro case
The Dutch company Velcro Holding BV (VH BV) licensed intellectual property (IP) from an affiliated company in the (former) Netherlands Antilles (NA), Velcro Industries BV (VI BV) and sublicensed this IP to a Canadian company, Velcro Canada Inc. (VC Inc.). VH BV was obliged to pay 90% of the royalties received from VC Inc. within 30 days after receipt to VI BV.
The issue was whether VH BV could be qualified as beneficial owner and consequently was entitled to application of the tax treaty with Canada, particularly the application of Article 12 of that treaty, which provides a reduction of withholding tax on royalties from 25% (the Canadian domestic rate) to 10% ( the rate under the treaty between Canada and the Netherlands). As there is no tax treaty between Canada and the NA, withholding tax on royalties paid by Canada direct to the NA IP owner would be 25%.
In his decision, the Canadian Judge based on and singled out four supporting aspects to confirm that VH BV is the beneficial owner of the royalties: possession, use, risk and control. As long as the (sub) licensor embodies these aspects, he will be entitled BO and the corporate veil will not be pierced. To begin with, VH BV was legally entitled to the royalties. This was supported by the fact that it was VH BV which had the license agreement with the Canadian company. Then, the royalties (on the bank account) were “comingled” with other revenues on account of VH BV and the proceeds had to be converted from Canadian dollars to U.S. dollars. These two facts were confirmed two other aspects: the use of royalties and the currency risk which VH BV had. The income (royalties) was not passed directly – and not in the same form,- but first remained on the bank account of VH BV, which meant that the (other) creditors could claim it.
It was noted that the royalties did not just flow through VH BV but, at the discretion of VH BV, payments were co-mingled with other funds of VH BV exercised its control, subjecting the funds to increases or decreases by virtue of earning interest or losing value because of the risk of currency exchange and using the funds, in part, to pay other outstanding obligations. At the same time it was shown that VH BV was no agent and certainly not a conduit company. The court made a decision that the beneficial ownership of the royalties rests in VH BV.
“Often foreign financing and licensing companies are resident in the Netherlands … “
The Netherlands have a longstanding tradition of dealing with financing companies. In 2003, a new ruling practice was introduced under which the Dutch Tax Administration support that a financing company which incurs realistic equity risks – like a bank – is regarded as the beneficial owner of its interest income . Of course it is the state of source (Ukraine) that applies the beneficial ownership test, but if requested the Dutch Tax Administration will advise the Ukraine Tax Administration that in its view the financing company is the beneficial owner of the interest income ; to the contrary if the company will not incur realistic financing risks, it probably will inform Ukraine that this is a conduit company .
3.4. An extreme case: the total return swap
Another case where economically a part of the income is passed on to a third party was decided by the Swiss Federal Administrative Tribunal (SFAT) on 7 March 2012 . The SFAT held that a Danish Bank was considered the beneficial owner of Swiss source dividends although from an economic perspective it had to pass on all income to a third party under a total return swap . An appeal against this decision has been filed with the Swiss Supreme Court (Federal Tribunal).
The Danish Bank had concluded total return swap contracts in respect of the shares of listed Swiss companies in the period from 2006 to 2008. To hedge the attendant risks the Danish financial institution bought the corresponding shares. The SFAT held that key to determining the issue of beneficial ownership is the extent of the complainant’s power to decide on the use of the dividends paid to it. According to the available documents, there was no civil law obligation whatsoever to hedge the swap contracts and/or to purchase the corresponding shares. The tribunal next considered whether there was a de facto obligation to pass on the dividends, based on a ‘substance over form’ approach or based on economic considerations. Two questions had to be answered:
- Firstly: would the Danish bank have been obliged to pay the dividend amount to the counterparty even if on its part it had not received the dividends? Answer: yes.
- Secondly, would the Danish Bank have received the dividends even if it had not been obliged to pay the dividend amount to the counterparty? Answer: yes.
The SFAT was well aware that in the case of the (hedged) swap contracts described it was not the bank but ultimately the counterparty of the total return swap who bore the risk that the Swiss companies might pay no dividends. But this did not preclude qualifying the bank as the beneficial owner of the dividends. Neither was the holding period of the shares relevant to the issue of beneficial ownership. Also irrelevant are the bank’s motives: the concept of beneficial ownership does not depend on any subjective factors. The motives and the holding period are only potentially relevant within the context of other regulations aimed at abuse of a tax treaty.
3.5. What if the income is not received by the owner of the underlying share, receivable or license?
The beneficial owner of for example a dividend is not necessarily the owner of the share. An example is the decision of the Dutch Supreme Court regarding a UK resident company acting as a Market Maker . The Market Maker had purchased dividend certificates for dividends which had been declared at the time of purchase, but were not yet payable, for a price of 80% of the gross nominal value. It claimed a refund of 10% Dutch dividend withholding tax under the UK tax treaty. The Supreme Court did consider the Market Maker as the beneficial owner. Firstly, by way of the purchase, the Market Maker became the owner of the dividend certificates. Secondly, the Supreme Court assumed that, after the purchase, the Applicant could freely do with the dividend as it pleased, and that in collecting the dividends it was not acting as an agent or nominee.
This reasoning is now confirmed in the proposed § 12.4 of the Commentary according to the October 2012 report (3.6).
3.6. The October 2012 proposals for amendments to the Commentary
The October 2012 report is of course just a draft. But it is a draft which has been reviewed by representatives of all member countries, which makes it likely that in future the OECD will be heading in this direction. And also, the report proposes to add the following sentences to the Commentary to article 10 , which eliminate some uncertainties that still exist under the current Commentary:
“In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the recipient’s right to use and enjoy the dividend is constrained by a contractual or legal obligation to pass on 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 right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person. This type of obligation must be related to the payment received; it would therefore not include contractual or legal obligations unrelated to the payment received even if those obligations could effectively result in the recipient using the payment received to satisfy those obligations. Examples of such unrelated obligations are those unrelated obligations that the recipient may have as a debtor or as a party to financial transactions or typical distribution obligations of pension schemes and of collective investment vehicles entitled to treaty benefits under the paragraphs 6.8 to 6.34 of the Commentary to article 1 [italics JH/SK]. Where the recipient of the dividend does have the right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment to another person, the recipient is the “beneficial owner” of that dividend. It should also be noted that Article 10 refers to the beneficial owner of a dividend as opposed to the owner of the shares, which may be different in some cases.”
If these proposals will result in a clearer distinction between unrelated and related obligations to on-pay the income, this will mean a big step forward for the tax practice.
4. Conclusions
The beneficial ownership test - of article 103 § 3 TC and of the tax treaties concluded by Ukraine - plays an important role in international tax planning, in particular after the new tax treaty with Cyprus will have entered into force.
A universal and very specific definition of the expression beneficial owner will never exist, but the headlines are clear. In international case law often the beneficial owner is described as the “person who receives the income for his or her own use and enjoyment and assumes the risk and control of the income he or she received”. Only when it is clear that the foreign company is an agent, nominee or conduit will it not be the beneficial owner. An economic approach to the criterion is refused by most Tax Courts . And the beneficial ownership test is not a motive test either. The beneficial owner of a dividend is not necessarily the owner of the relevant share. If and when the October 2012 report of the OECD will be adopted in the Commentary, an even clearer distinction will exist between unrelated and related obligations to on-pay the income, and this will mean a big step forward for the tax practice (3.6).
The case law of the Ukrainian Courts so far shows that the Courts are very reluctant to refuse tax treaty benefits to a foreign company which can provide a certificate of residence and a contract evidencing that it is entitled to the Ukrainian source income. The outcome of their decisions is (still) in line with the international and OECD trends as described in chapter 3. Compared with international case law, in particular the Velcro case (3.2), the decisions of the Ukrainian Courts contain little explanation as to which activities a foreign company should have to fulfill the beneficial ownership test . This is why the motivations of the Ukrainian Courts in the cases described in chapter 2. appear to be very brief, compared to decisions of the Tax Courts elsewhere in a.o. Canada, Switzerland and the Netherlands. In future decisions, the Courts may decide to explain to what extent they rely upon the criteria and guidance offered by the official commentaries and discussions within OECD and United Nations member states.
The approach of financing and licensing companies in Dutch tax law and by the Dutch Tax Administration since 2003 was described in 3.3. If a Dutch company meets the relevant “substance” requirements, this can be confirmed in an advance pricing agreement. If so, if requested, the Dutch Tax Administration would also help the Dutch company in an attempt to convince the Ukraine Tax Administration that the Dutch company must be regarded as the beneficial owner of the income.
Odessa/Rotterdam, 2 December 2012
