Saturday, March 25, 2006

UK Court of Appeals decides whether a special purpose vehicle is a "beneficial owner"

One common tax planning technique widely used by multinational groups involves the setting up of special finance companies (located offshore or onshore) to channel loans to foreign subsidiaries. By routing interest income to the finance company, profits may be shifted from the foreign subsidiary to the finance company, which pays little or no tax on the interest received. For a finance company, the main benefit lies in receiving interest subject to the minimum possible rates of withholding tax since it pays out most of this interest to another territory. The interest payment by the financing company represents a deductible expense, with only a small margin or spread being subject to corporate tax in the territory where the finance company is established.

A recent UK Court of Appeals decision on Indofood International Finance Ltd v JP Morgan Chase Bank N.A. London Branch ([2006] EWCA Civ 158, 02 March 2006), dealing with the meaning of beneficial ownership and the use of special purpose vehicles on financing transactions and their impact under tax treaties called upon my attention. This case, as you will understand from the summary below, raises very interesting issues, which rarely reach high courts, and its impacts may be considered somewhat far reaching.

The case, which was raised because of the termination of a treaty between Indonesia and Mauritius, concerns a dispute over the right of a debtor to early redeem its loan notes under a specific redemption clause as a result of the negative effects of the termination of the tax treaty on the tax costs of the financing structure.

Indofood Indonesia, as any large company, was in need of capital and therefore considered recourse to issuance of loan notes on the international market. In order to minimize the Indonesian domestic withholding tax impact on interest payment, which amounts to 20% of the gross interest payable to the note holders, Indofood Indonesia structured the deal as a back-to-back lending transaction. For that purpose, a wholly owned subsidiary was incorporated in the Mauritius reducing thereby the withholding tax liability on payments from Indonesia to Mauritius to the 10% treaty rate. The Mauritius then issued the loan and on the same day lent the capital, under substantially the same terms, to its Indonesian Parent.

Commonly in complex financing arrangements, the issue and servicing of the loan notes is left to a financial institution, which acts as a trustee and paying agent (in this case JP Morgan Chase Bank) for the note holders. Under the Loan Agreement (scheduled to be redeemed on June 2007) a provision was inserted to deal with a possibility of premature redemption in the event that the withholding tax exceeded the agreed rate of 10%. Accordingly, in that event the Mauritius Company could seek to redeem the loan notes earlier if, but only if, “...such obligation cannot be avoided by the issuer....taking reasonable measures available to it...”.

In fact, as a consequence of the termination in January 2005 of the tax treaty between Indonesia and Mauritius, the 20% domestic withholding tax rate would be applicable to the interest payments. Taking into account the increased gross-up obligation on the bonds, the issuer sought to exercise its redemption option on the grounds that there was no reasonable measure available to it to avoid paying the increased withholding tax. JPMorgan, however, claimed that the increased withholding could be avoided by interposing a Dutch special purpose vehicle (SPV) in the structure, which would allow for reduced withholding under the Indonesia- Netherlands tax treaty. The assignment of the loan to a Newco would reduce the withholding tax payable back to the original 10% or even less (since the treaty included a zero rate on interest for long-term loans).

It should added that in this case, between the moment of the issue of the loan and the call for early redemption the interest rates moved in favour of borrowers. Thereby, it was of interest to the note holders to secure the loan and of interest to the issuers or debtors to repay earlier the loan.

When two parties disagree, the courts appear to be the last resort. In this case the parties were simply seeking to determine whether or not there were reasonable measures available to avoid the increased liability for withholding tax in Indonesia. The added complication is that the judges asked to verify the fulfilment of the clause were not tax experts.

In order to arrive to a decision the UK Court was asked to rule, assuming the loan would be restructured, whether for the purposes of the Netherlands -Indonesian treaty: (i) the Newco would be the beneficial owner of the interest payable by the Indonesian Parent; (b) Newco would be resident in the Netherlands; (c) the effects of the obligation of the assignment to Newco. i.e. whether the obligation to pay interest would be that originally owed by the Parent Guarantor to the Issuer under the Loan Agreement.

Before going further on the way in which the court dealt with each of the above-mentioned issues, I would like to point out that the ill effect of a termination of a treaty in financing structures can be traced back to a similar case, namely the partial termination by the US of the Netherlands Antilles treaty. In short, in 1987, the US notified the Netherlands Antilles and Aruba that it was terminating the extension of the 1948 U.S.-Netherlands income tax treaty to those territories. Since the treaty was widely used in Eurodollar Financing structures and as a response to protests from various U.S. institutional holders, the notice of termination was revised leaving in force provisions exempting tax on interest income. The treaty was later fully terminated but include a grandfathering clause preserving the zero rate of withholding on pre-1984 Eurobonds issued by Netherlands Antilles corporations.

In this case, when Indonesia terminated the treaty with Mauritius it argued that Mauritius non-residents were setting up special purpose vehicles to do treaty shopping and treaty tax abuse. Nevertheless, albeit the Indonesian concerns about the uses and abuses of the treaty, no significant attempt, besides plain and simple termination, was apparently made to deny treaty benefits to Mauritius companies. In addition and contrary to the example of the US, no grandfathering clause was included, suddenly exposing current structures to a higher withholding tax.

It should also be noted the Indonesian tax authorities issued a circular letter dated 7 July 2005 in which guidance is given on how the term "beneficial owner". According to the circular letter, the beneficial owner is the actual owner of the income in the form of dividend, interest and royalty. The beneficial owner must be either an individual or a corporate taxpayer that is fully entitled to directly enjoy the benefits of the dividend, interest or royalty. Special purpose vehicles like conduit companies, paper box companies, pass through companies, etc. are not considered to be the beneficial owner.

Back to the case, it is time to see how the UK courts dealt with the issue. On 7 October 2005, Justice Evans-Lombe (High Court) gave its decision in favour of the note holders or its trustee (JP Morgan) by considering that there was no ambiguity in the application of the concept of beneficial ownership to the loan transaction involving the interposition of a financing company in the Netherlands, which in turn receives interest payment from Indonesia.

According to that Judge, as result of the assignment of the benefit of the loan agreement by the Mauritius Company to the NL Newco, the Newco will be the lender and in any case Newco will be acting as nominee or administrator for the Mauritius Company or note holders. The Judge pointed out that if after restructuring one entity should qualify as beneficial owner of the interest, that entity should be Newco (the judge apparently considered the position of Newco as beneficial owner to be stronger than that of the Mauritius company, because of the apparent greater rate or spread taxable in the Netherlands). The Judge also referred to the apparent contradiction of the Indonesian tax authorities of not challenging the beneficial ownership under the Indonesia-Mauritius treaty and the position after interposing a Newco in the Netherlands.

The Mauritius Company appealed the decision to the UK Court of Appeals. This Court reversed on 2 March 2006 the earlier decision of the High Court and concluded that the interposition of Newco is not a measure available to the Mauritius Company and its Indonesian parent company whereby to avoid the obligation to pay withholding tax at a rate in excess of 10%. In the Court of Appeals view the conditions for the application of Arts. 11(2) and 11(4) are not satisfied, concluding that there were no available measures for the purposes of redemption clause to restructure the loan agreement.

Although the case should be carefully interpreted as a case involving an interpretation of a redemption clause and not as a tax case, the reversal of the first decision is generating some concern about the use of special purpose vehicles in financing structures. There is a risk that beneficial ownership will be increasingly used as an instrument to deny treaty benefits as the position of Indonesia circular letter well demonstrates.

Another relevant aspect that the Court addresses (and which I plan to tackle in the next note) relates to the issue of residence of Newco. The Court considered that Newco would be resident in Indonesia for the purpose of the treaty or that Indonesian Tax Authorities would likely challenge any suggestion that Newco was not resident in Indonesia! This topic raises other problems, which I would prefer to adress on another occasion!

In the meantime, given the lack of case-law on the term beneficial owner and the references to the OECD commentaries, relevant reports and Scholars, this decision (like it or not) is an essential reading for any tax lawyer involved in tax treaty planning.

Tuesday, March 21, 2006


"To the extent that some people are dishonest or careless in their dealings with the government, the majority is forced to carry a heavier tax burden. "

by John Fitzgerald Kennedy (May 29, 1917 – November 22, 1963), 35th President of the United State, also often referred to as John F. Kennedy, JFK, or Jack Kennedy.

Monday, March 20, 2006

Place your bets, it's the ECJ turn

A legal mess reached the ECJ and now risks being one of the judgments that attracts more attention since the Marks & Spencer case. This attention is due to the possible introduction, for the first time in a tax case, of some sort of temporal limitations to the effects of a judgment. This case is also being closely followed by Hungary, another EU country that is facing large claims for similar refunds of its regional tax. To understand why is this tax case so high profile, it should be noted that according to the press the amount of taxes, which may be claimed back by various taxpayers, reaches the “symbolic amount” of EUR 120 billion!

All of this because Advocate General Stix-Hackl issued a second opinion on 14 March 2006, of in the case of Banca Popolare di Cremona (C-475/03) which concerns the compatibility of the Italian regional tax on productive activities (IRAP) with the Sixth VAT Directive.

In the second opinion, the new Advocate General followed the previous opinion of Advocate General Jacobs by concluding that the IRAP conflicted with the principles of the Sixth Directive. It should be noted that following the first opinion issued on 17 March 2005, several governments requested the ECJ to reopen the oral procedure. In fact, the new procedure focused in large extent on the issue of temporal limitation of an ECJ judgment.

The issue of limitation of effects is not limited to this particular case in Italy. Currently there is a German case which may be decided before the IRAP case and may set th ground for the position of the ECJ on this topic. The Meilicke case or if you prefer the German Manninen relates to German corporation tax credits for foreign dividends. As you may recall, in the Manninen case Finnish tax authorities were required to grant a tax credit to Finnish shareholders in receipt of dividends from EU (Swedish) resident companies in circumstances where a credit was available for Finnish dividends. As you may understand the chances of the Germans to avoid refunding taxes are very slim. Nevertheless, again in this case the tax authorities suggested that the estimated budgetary effect of a decision in favor of the taxpayer would amount to EUR 5 billion. In that case the Advocate General has indeed suggested that the temporal effect of the judgment should be limited to dividends paid after 6 June 2000 (i.e. the date the Verkooijen judgement was handed down).

As such where a judgment has a dramatic budgetary effect, a new line of defense that may be open to governments is to raise the possible temporal limitation of effects of ECJ decision! In essence, any sort of limitation has the efect of making more difficult for taxpayers to lodge successful repayment or damages claims.

In the IRAP case and according to the Advocate General Stix-Hackl three questions have to be answered before giving any limitation: (a) are there grounds for limiting the temporal effect of the judgment, (b) if so, from what date should it be possible to rely on the ruling and (c) should any exception be made in favour of claims raised before a certain date?

With regard to the first issue, it was said that good faith and the risk of serious budgetary difficulties set the case for awarding a limitation. Secondly the Advocate General considered that the ex futuro effect is the appropriate approach in the specific circumstances of this case. The Advocate General, from the various possibilities regarding the date as of which a limitation may take effect (i.e. ex tunc; ex nunc; new approach used on the Meilicke case; and setting a date in the future), proposed limiting the decision until the end of the tax period when the ECJ's judgment is delivered. This would ensure a smooth replacement of the IRAP Finally, in respect of the last issue, the Advocate General considers the date of delivery of Advocate General Jacobs's Opinion (17 March 2005) the least arbitrary and most objective date as to establish which claims should be paid or not.

As we all know the ECJ can only decide whether a provision is legal and not with what such provision should be replaced with. Therefore, by accepting the temporal limitation of effects of their decisions the ECJ will give one more step towards deviating attention from its negative integration that has battered the European tax systems since the Case Commission v France (‘Avoir Fiscal’) (C-270/83). Governments, companies, lawyers and academics will await anxiously the conclusion of this case. Will there be a limitation of the effects of the judgment for budgetary reasons?

Place your bets, it's the ECJ turn.

As a side note, this case has a curious background. Let's say that once upon a time Mr. X, Minister of Finance of a EU Member State decides to nominate a ministerial commission to study the possibility to introduce some sort of regional tax on productive activities. Bye the time the Commission presented its results, the Minister in question was relocated to another ministry, and therefore when the said regional tax was introduced Mr. X, was still part of the government (although not overseeing finance and tax issues). As in any case where a new tax is introduced, thorough notification procedures have to be complied in order to pass the scrutiny of the EU Commission. In this regard, the Government in question followed the procedures and received from the EU Commission a letter, which could be interpreted as an assurance that the so-called regional tax would be compatible with Community law. A couple of years passed and Mr. X was back to his law firm. Coincidence or not, a high profile case brought him recently to the ECJ to argue the case of the (in)compatibility of the so-called regional tax with EC Tax Law. Beware the reader that the law firm of the ex-minister was not advising the government but defending the plaintiff, i.e. arguing the incompatibility of the tax he oversaw the introduction (vide. Italian source).

Thursday, March 02, 2006

Circumventing the tax veto through enhanced cooperation – is it time to use it?

The mismatch between the powers of the ECJ, to strike down tax legislation of the EU Members States, that is in contravention of the EU fundamental freedoms and secondary legislation, and the lack of a harmonized EU income tax rules is often seen by many commentators as a road to abyss!

It leads somewhere but that somewhere is in the end only fine-tuning, repairing, and adjusting domestic law provisions taking into account the ECJ rulings without, in the end, eliminating all the asymmetries derived from having 25 different tax systems (see for example the responses of member states to the recent ruling on the Marks & Spencer case).

As the EU Tax Commissioner recently described, most of the barriers to the functioning of the Internal Market are now related to the 25 different tax systems and such differences result in high compliance costs, huge administrative burdens, and have some negative impact on competitiveness, growth and employment. So that means that something needs to be done. But that “ultimate quest” would require over passing the unanimity limitation and convincing member states to partially do away with one of their last national powers: Fiscal Policy.

The project that is sparkling some attention is the Common Consolidated Corporate Tax Base (CCBT), which would mean the EU companies would be able to compute their aggregate profits in the EU internal market according to a single set of EU tax rules.

As you can imagine, although the debate around this project is still in its infancy, several Member States already expressed their preliminary reservations and uncertainties. In a recent speech held recently in Ireland (coincidence or not one of the notorious Reservationists) the EU Tax Commissioner (EU tax policy and its implications for Ireland) reinstated that its plans do not intend to propose a harmonised corporate income tax rate but only harmonise the method of calculating the tax base. The Commissioner added in the last line that if necessary (sic if the Reservationists persist with their opposition) the Commission is ready to propose the “atomic bomb”, i.e. the adoption of the common tax base only by those Member States who are interested. According to Mr. Kovacs, “we cannot allow some States to hold others back”!

In summary, the enhanced cooperation mechanism, adopted by the Treaty of Nice (2000) allows a group of Member States to establish closer cooperations in certain areas, while still remaining in the framework of EU institutions, independently from Member States not participating in this process. At least 8 Member States are required to form closer cooperation, which in any case should respect the acquis communautaire (The entire body of EU legislation). In the end, if used in the field of corporate taxation it represents abolishing the national veto on closer EU tax integration and opens the way to a “Europe at two speeds”.

What I am afraid is that although CCBT would eliminate asymmetries between different tax systems, enacting a CCBT under the “enhanced cooperation mechanism” would in itself create asymmetries between the members states “IN” and “OUT”. In the end, I doubt what is more prejudicial!

With all this discussion, no wonder that the degree of tax harmonization/coherence achieved within Europe, with so little “voting power”, is grabbing the attention of scholars from outside Europe. I recall that during last summers visit to Brazil, I came across a very comprehensive and inciting book on EU Law written by a Brazilian Scholar. This time, Michael J. Graetz (Yale Law School) and Alvin C. Warren, Jr. (Harvard Law School) provide their very useful insights on the European Court of Justice (ECJ) jurisprudence on tax matters, comparing the ECJ jurisprudence with the resolution of related issues in the US taxation of interstate commerce and international taxation.

Income Tax Discrimination and the Political and Economic Integration of Europe (still a draft to be published in Yale Law Journal, April 2006), is a very interesting reading, both from a US and European perspective, on the importance of the growing bulk of ECJ jurisprudence on direct taxation and its potential impacts.