There is a lot going on in the corporate tax world at the moment, both domestically (almost wherever you are) and internationally, but one of the issues that should in our view, be reasonably high on most tax agendas is the issue of beneficial ownership - and this issue is likely to become even more important in years to come.

Yvonne Thompson

In an international tax context – and specifically in the context of the OECD Model Tax Treaty – beneficial ownership is a term that is used in the dividend, interest and royalty articles to define entitlement to the benefit of those articles (generally to a reduced or zero rate of withholding tax). The concept is relevant to investing, lending, dealing or leasing and receiving income in a cross-border context; withholding tax can affect the economics of any transaction, such that obtaining treaty relief that may be due can be a critical part of any investment / leasing decision.

So, what is the issue? It is clear that the main issue has been the lack of any clear – let alone common – understanding of what constitutes beneficial ownership. Various tax authorities have, over time, and increasingly since the late '90s, been using the beneficial ownership concept as an anti-abuse / anti-treaty shopping test, contrary to the original OECD meaning of the term. Challenges, many of which have reached the courts, have been based either on the lack of substance of the beneficial owner, or on the basis of the economic position of the beneficial owner, in as much as that person may pay on some or all of the income that it receives to another party. Cases have been heard in Canada, Denmark, Switzerland, the UK, France and the Netherlands, amongst others, with mixed end results, but with some notable defeats for the tax authorities. In short, countries that have been looking to use beneficial ownership as an anti-abuse concept have, to some extent, been thwarted in their attempts by the courts, which have in many important cases maintained the original meaning and intent of the term in their decisions. Another important point has been whether it is right to apply a state’s domestic law in interpreting the term, or whether it should be given a more general treaty based meaning. Both interpretations have been followed in recent case law. Given the controversy around the world centred on the topic, the tax treaty working party of the OECD Committee on Fiscal Affairs has since 2008 been carrying out work aimed at clarifying the concept. The intention is that this will be achieved through amendments to the Commentary to the OECD Model. Draft proposals to deal with this issue were issued by the OECD in 2011, and following heavy consultation and comment, they were then revised in October 2012.

The most important of the OECD’s proposed 2011 changes was the attempt in that new text to clarify why agents, nominees and companies acting in a similar capacity are not beneficial owners. The text stated that the recipient in such cases does not have the 'full right to use and enjoy' (i.e., the powers of the recipient are constrained, as the recipient is obliged to pass the payment on to another person). The text went on to state that the beneficial owner, on the other hand, has the “full right to use and enjoy” the income unconstrained by any contractual or legal obligation to ‘pass on the payment’ to another person. It also states that it is normally possible to tell if there is any obligation to pass on payment from the relevant legal documentation. However, facts and circumstances may also be relevant in showing that, in substance, the recipient clearly does not have the full right to use and enjoy the income.

Following heavy criticism, the OECD issued a revised draft and reduced the “full right to use and enjoy” income test to the “right to use and enjoy” but comments on the beneficial owner test being failed where the owner is “constrained by a contractual or legal obligation to pass on the payment received to another person” were retained. Also retained were the comments that such an obligation may be found to exist on the basis of “facts and circumstances” which show “in substance” that the recipient does not have the right to use and enjoy the income. The OECD now seeks to meet these objections in two ways. First, it is stated that an obligation to pass on the payment must be “related” to the payment received – so that if an obligation to make a payment is “unrelated” it will not be relevant to the beneficial ownership issue. Second, examples are given of payments which are not problematic in this context, being “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”.

However, this simply leads to the obvious question: what does it mean for a payment to be related or unrelated? It is clear that this is the key concept: the terms are used four times in the space of the proposed text but there is no word of explanation on the meaning of this term. The OECD state that the new wording is intended to provide some comfort with respect to some of the situations identified in previous taxpayer comments. This suggests that some criteria have been recognised – and are intended to be reflected – in the related/unrelated wording. What such criteria are, however, remains unclear. Whether payments are related might be determined by a large number of possible criteria, such as: same counterparty to the transactions; same time of execution of transactions; same subject matter or same reference asset/currency; same or similar interest rates or rates of return; same duration of transactions; same amount or quantum of contracts; etc. The point, in short, is that use of the terms related/unrelated without any explanation relocates the discussion on the beneficial owner test but does not solve it.

Given that the overall objective of the current work of the OECD is to improve clarity on the meaning of the beneficial owner test, it is not clear that the current proposals advance the position on this central issue. Indeed, the greatest danger in this area is the potential for confusion between beneficial ownership and economic ownership. On the basis of the proposed revisions, there is a risk that the dividing line between these two concepts had become further blurred.

While the OECD continues its deliberations, local tax authorities the world over continue to apply their own interpretation. Most recent has been China who has been active in providing comment on its view of beneficial ownership in the context of its treaties Circular 165 - which follows the release of the (in)famous Circular 601, published in Oct 2009 - was issued at a federal level by the State Administration of Taxation (SAT), but in the context of the China/Hong Kong treaty and dividends - it is however, expected to have potentially wider application.

The circular clarifies the operation of the "seven unfavourable factors" under the previous Circular 601. Positives include the recognition of the commercial rationale for maintaining intermediate holding companies, acceptance of singular activities in any entity (which we have seen widely accepted in a leasing context already), looking beyond the share capital of an entity and indeed, the transaction in question to understand the level of investment or risk at the level of the income recipient, considering the nature of work, responsibilities and expertise of staff and not just the number of staff in an entity and finally, taking account of the recipients right of control or disposal. The Circular helpfully also confirms that an applicants beneficial ownership status should not be denied simply because of the failure to satisfy one of the "seven" factors.

So where does that leave us now… we have had recent clarifications from China, but challenges (from any number of other countries) continue on a regular basis - the OECD has collated the comments from the consultation period so we await the final output from them. This would have been awaited in the hope that the OECD would provide some globally acceptable level of clarification. What is worrying is that in seeking the most recent consultation, the OECD expected comment on drafting issues only, not any issues of substance. This is likely to mean modest change at best to the draft as is currently stands - leaving us with beneficial owner proposals, possibly not so beneficial.