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.
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.
posted by Talk Tax Blog at 8:03 pm
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