The Portuguese Arbitration Court has recently issued the first decision on the application of the concept of beneficial owner in the context of the Interest & Royalties Directive (“IRD”).
The case dealt with the withdrawal of the withholding tax exemption on interest payments made by a Portuguese company (“PTCo”) to its UK corporate shareholder (“UKCo”). UKCo then paid upstream interest received through a chain of UK entities via back-to-back tax-exempt dividend payments. The ultimate UK entity (“UKTopCo”) passed on the proceeds as tax-exempt interest payments to two Hong Kong companies.
The Portuguese Tax Authority (“PTA”) denied the application of the withholding tax exemption on the basis that the UKCo was not the beneficial owner of the interest. The Court upheld the PTA’s assessment arguing that the financing structure at hand was abusive. Based on these findings, the court concluded that PTCo should be liable for the tax not withheld.
The nature of the beneficial owner requirement
The court briefly addressed the definition of beneficial owner mentioned in the IRD without substantiating the scope of the concept.
Nevertheless, based on the fact pattern above, the Court concluded that UKCo was not the beneficial owner of the interest payments on the basis of the following indicia:
(i) absence of an adequate structure (premises, equipment and staff);
(ii) lack of an economic activity aside from the holding of shares and the financing of PTCo; and
(iii) the upstreaming of the interest payments to the ultimate Hong Kong parent companies and its timing.
Furthermore, the Court backed up its conclusion on additional elements, such as: (i) the similarities between the loan granted to PTCo and the loan granted by the Hong Kong entities to UKTopCo (i.e., the rates and amounts involved); (ii) UKCo’s lack of power to freely dispose of the income because it is wholly (indirectly) owned by the Hong Kong companies; and (iii) the credit risk was not borne by UKCo.
The Court’s ruling seems to construe the concept of beneficial ownership on the basis of a dichotomy between artificiality and economic substance, rather than ascribing it a specific meaning rooted on the basis of allocation of taxing rights.
This approach is especially striking as it seems to reverse the rationale adopted by the European Court of Justice in the Danish Cases: instead of considering the lack of beneficial ownership to be an indication of abuse, the Court uses evidence typically linked to tax abuse cases to determine whether or not UKCo was the beneficial owner of interest payments.
Considering the hierarchy of the relevant indicia for the assessment of beneficial ownership, as well as the nature of anti-abuse provision that the Court assigned to it, the ruling raises the question of whether a recipient of income with sufficient substance and economic activity could be considered the beneficial owner of interest even if the income were on-payable to a third party.
Burden of proof lies with the payer
Since UKCo was not considered the beneficial owner, the Court held that PTCo was liable for the payment of the tax that should have been withheld. The Court noted that PTCo was legally required to provide evidence that UKCo was the beneficial owner of the interest payments and that there was no obstacle to obtaining such evidence as that there was a relationship of control with UKCo.
This conclusion leads, in substance, to a shift of the burden of proof on the assessment of beneficial ownership to the payer, which does not find support in the IRD nor in domestic law. As a matter of fact, both the IRD and Portuguese law require only that the payer obtains from the recipient of the income confirmation of beneficial ownership through the presentation of an official form (which had been provided by UKCo to PTCo).
Furthermore, the Court also states that it is irrelevant to discuss whether it should be PTCo or UKCo to bear the liability for the tax not withheld due to the relationship of control between those entities. This is a troubling interpretation because a relationship of control does not lead to piercing the corporate veil nor does lack of beneficial ownership lead to tax transparency of the companies involved.
Subsidiary application of the Portugal-UK Treaty
Once the application of the IRD’s withholding tax exemption was set aside, PTCo claimed the application of the reduced withholding tax rate provided by the Portugal-UK Double Tax Treaty (“DTT”). The Court expressed its concerns about whether it had the power to order the PTA to subsidiarily apply a legal provision (article 11 of the DTT) that had not been referred to in the tax assessment issued when denying the withholding tax exemption.
Despite not reaching a definitive ruling on this point (as the Court still analysed provisions of the DTT), this position is nonetheless debatable because, under Portuguese procedural rules, the judgment of a court is not restricted to the arguments raised by the PTA or the taxpayer, and other arguments or legal provisions may be considered in reaching a ruling.
Implicit beneficial ownership requirement in treaties
In the absence of a beneficial ownership requirement in the DTT (which dates back to 1968), the Court stated the an implicit beneficial owner clause should be deemed existent in all treaties, as it underlies the term “paid to” included in article 11.
Furthermore, the Court links the concept of beneficial owner with conduit companies and treaty shopping arrangements, confirming the interpretation of this concept as an anti-abuse provision.
Treaty look-through approach
As a final note, the Court appears to admit the application of a look-through approach according to which, when DTT benefits are denied to the recipient of the income, they can still be granted to its actual beneficial owner. This interpretation could represent an important safeguard for taxpayers in the future.
However, the Court denied the application of the Portugal-Hong Kong DTT because no proof that the two holding companies were the beneficial owners of the income was provided.
