Friday, October 13, 2006

Beneficial owner what?

The concept of beneficial owner has never been clear. Long debates about the use of SPVs, some landmark cases, and a sort of tolerance, particularly in the financial sector. Something similar to the Dutch approach to coffee shops, where youngsters (and non-youngsters) get stoned before biking back home in the bike lanes and upsetting the local Dutch crowd. SPVs in the financial industry can be compared to coffee shops in the Netherlands, they are tolerated.

No one really even thought about this, it was simply something taken for granted (with more or less dubious moral/economic justification, which is: it makes cost of funding lower and therefore positive for the economy).

Then came the day that a multinational (which needed some cash) and the investment bank (which structured the deal) started quarrelling about their contract. They started arguing so vehemently that they ended up in Court!

The issue to be decided by the UK judge, competent on the basis of the agreement the two parties had signed few years before over a bottle of champagne, was the following:

(i) our contracts say that Indofood can pull out of the agreement if the 10% withholding tax levied on the interest paid to the special purpose vehicles (SPV) set up in Mauritius to get money from the market is no longer available and ‘no reasonable measure can be taken’ to reinstate the same conditions;
(ii) Indonesia, which is sick and tired of seeing Mauritius as one of its biggest inbound investors (not they do not like particularly Mauritius, but rather they only see Mauritius companies), decides to terminate the treaty;
(iii) As consequence, Indofood would have to pay 20% withholding tax;
(iv) It is not a reasonable measure to interpose another SPV in the Netherlands (by the way, a 0% withholding tax under the Dutch-Indonesia tax treaty could have been available);
(v) Why? Because the Dutch SPV is not the beneficial owner, no reasonable measure would be then available and therefore no contract (and I would stop paying this damned high interest rates, since the interest rates had gone down meanwhile).

The UK Court of Appeals looked at the treaty, at the OECD Commentary, at Prof. Philip Baker book on Double Tax Convention and said: forget about it. The Dutch SPV is not the beneficial owner. Why? Because it has no power over the interest it gets from Indofood, it simply has to pay everything to the bond holders.

This created a small tsunami in the London financial world. Advisors, lawyers, accountants, bankers, and the other guys that move the world (by the way, is it the right direction?) started wondering What? And so what about this structure, and what about this deal? And think about that? Investment funds, hedge funds, mezzanine funds, etc... It's gonna be a mess.

Back in HMRC headquarters they were simply flabbergasted. They had a weapon of mass destruction in their hands without having the trouble of litigating the issue themselves. Simply for free and even served on a silver plate.

What would you do?

Lawyers start going around saying that instability and uncertainly is the last thing the market needs, big deals are going on right now and we can’t mess everything up because of a provision that has been there for ages.

Calm down because the HRMC is gonna issue guidance to clarify everything. Let's see some pieces of that guidance:

“the decision is also likely to be of persuasive force where related issues for UK DTCs are being considered and that, where it is relevant, HMRC is obliged to follow it. Since the Court of Appeal decision is fully consistent with the UK’s existing policy HMRC does not think that, in general, the case will have a significant impact on its current practice”.

In other words, do not worry. But remember, every time they tell you do not worry, start worrying (carrot and stick approach). And here it comes:

“It is HMRC policy that, where there is treaty abuse (such as, say, “treaty shopping”), interpreting “beneficial ownership” in what the Court of Appeal called its “narrow technical” UK domestic law meaning would not give effect to the purpose and object of the DTC. It would be contrary to the object of the DTC to allow such treaty abuse. On the other hand, interpreting “beneficial ownership” in what the Court of Appeal called its “international fiscal meaning” clearly gives effect to the purpose and object of the DTC by excluding abusive cases such as “treaty shopping” from the benefits of a DTC”.

By the way, what is the UK narrow technical sense? Is it any different from the international law meaning, i.e, the meaning the context requires (by the way, is tax avoidance against the object and purpose of the treaty?). Forget about this theoretical issue for now and let's look at real life situations.


But then the carrots come:

"HMRC will also accept that there is no need to invoke the “international fiscal meaning” of beneficial ownership to deny treaty benefits where the lender receiving income directly from the SPV (the “true” beneficial owner of the interest) would, if they had been the direct recipient of the interest, have been entitled to treaty benefits as a resident of a state with which the UK has a DTC with zero withholding on interest.
HMRC will therefore accept that there is no need to invoke the “international fiscal meaning” of beneficial ownership to deny treaty benefits where the bond issued by the non-resident SPV is a Eurobond as defined in s349(4) ICTA 1988."


So far, so good. Nothing new. But the stick is ready to be used. Look at this example:

"A claim is made under the UK/Luxembourg DTA for relief from UK withholding tax in respect of a loan from a Luxembourg resident company (LuxCo) to a UK group borrower.
• LuxCo was set up (or has been maintained in the group) specifically to deal with this intra group loan and is taxed on a small “turn” for administering loans;
• the source of the loan is an affiliate in a territory with which the UK has no DTA (NoA Co)
• the NoA Co/LuxCo loan agreement shows that this interest bearing loan was predetermined to be onlent to the UK
• similarly, the interest payable by the UK on its loan from LuxCo is predetermined to be passed on to NoA Co.
The conduit company is not beneficial owner of the relevant income within the “international fiscal meaning”, because it has clear obligations to forward the interest to NoA Co. The terms and conditions of the loan agreements show that the flow of income out of the UK is predestined to be passed on to NoA Co. It is clear that one of the main purposes of the Luxembourg company is to avoid the withholding tax which would be due on payments of interest to NoA Co. The interest will not benefit from the Luxembourg/UK treaty and tax will be withheld".


In the end, if you do this from the US, no problem. There would be no withholding tax under the treaty anyway, so why bother. What about all the other cases?

It is circulating these days a memo from the London firms claiming this is not fair play, both on legal and moral grounds. They attack a draft they received in confidence from HRMC and discussed during a meeting they had. Critics are based on arguments such as foreign funds do not pay VAT on management services rendered from the UK, that's’ why they are abroad, what about the UK borrowers that for years have been paying free of withholding tax. Why did you need to insert an LOB provision in the treaty with the US then? We had even showed you the structures and you said it was ok, now you say you did not realize there was a back-to-back!

Beneficial owner what?

Ralph Red


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