Article 10 of the OECD Model Tax Convention provides for the requirement of beneficial ownership to clarify the meaning of the words "paid to a resident" and was especially introduced to deal with a specific form of abuse affecting the source state, i.e. the transfer of treaty-favoured income to residents of a third state.
To date, the Swiss Federal Court has had the occasion to rule on three separate cases dealing with beneficial ownership, which involved the use of derivatives in the context of financial transactions, namely the use of total return swaps (TRS) in an international framework and the use of stock index futures both in a treaty context and in a domestic situation. These cases have attracted significant attention being the first court cases dealing with the concept of beneficial ownership with regard to derivatives transactions in a double tax treaty context.
This article presents the concept of beneficial ownership in the context of financial transactions and examines the OECD's Multilateral Instrument, as well as the principal purpose test that will be briefly exposed, in order to illustrate new developments in connection with tax treaty abuses.
According to the Vienna Convention on the Law of Treaties of May 23 1969 (VC), a treaty must be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of the object and purpose of the treaty (Article 31, para 1, or the VC). Since the OECD Commentary constitutes relevant context for the interpretation of bilateral tax treaties, the Vienna Convention suggests that its statements on the meaning of beneficial ownership should be given considerable weight in the interpretation of this term.
Interpretation of an international treaty in accordance with domestic law is a last resort, the rule being an autonomous interpretation.
VOGEL defines the beneficial owner as the person who is free to decide "(i) whether or not the capital or other assets should be used or made available for use by others or (ii) on how the yields therefrom should be used or (iii) both". Subjectively, this definition thus focuses on the power of the beneficial owner to control the use and the subsequent attribution of the capital or the yields, which is coherent with the goal of this provision, i.e. to prevent the abusive use of the double tax treaty (DTA), in particular for companies having the sole purpose of channelling the income via a state benefiting from a DTA. Objectively, the beneficial ownership test only concentrates on the attributes of ownership. Thus, the status of beneficial owner could not be denied to a person for the reason that it benefits from a tax exemption or due to the intensity of its link with the resident state (existence of a commercial activity, local substance, etc.).
OECD Commentary 2010 and the 2014 revision
With regard to the OECD Commentary, which plays an important role for the interpretation of DTA, this Commentary explicitly states that an entity which, "has, as a practical matter, very narrow powers which renders it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties", cannot normally be regarded as the beneficial owner even though it is the formal owner. Furthermore, in accordance with the above-mentioned provision of the Vienna Convention regarding interpretation of treaties, the OECD Commentary expressly states that "the term 'beneficial owner' is not used in a narrow technical sense, rather, it should be understood in its context and in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance". In this context, the OECD Commentary provides two examples of situations where the immediate recipient of interests, in particular, cannot be considered as being the beneficial owners of these interests, i.e. persons acting in the capacity of agent of nominee and conduit companies, which cannot be regarded as beneficial owners of the interests, due to their very narrow powers which render them a fiduciary or mere administrator acting on account of the interested parties.
The OECD Commentary was revised in 2014 and provides for the following in relation with the notion of beneficial ownership: "In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the direct recipient of the interest is not the 'beneficial owner' because that recipient's right to use and enjoy the interest is constrained by a contractual or legal obligation to pass on the payment received to another person. Such an obligation will normally derive from relevant legal documents but may also be found to exist on the basis of facts and circumstances showing that, in substance, the recipient clearly does not have the right to use and enjoy the interest unconstrained by a contractual or legal obligation to pass on the payment received to another person. This type of obligation would not include contractual or legal obligations that are not dependent on the receipt of the payment by the direct recipient such as an obligation that is not dependent on the receipt of the payment and which the direct recipient has 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 […]".
The OECD Commentary 2014 basically requires two elements that are relevant to deny the right to use an interest recipient:
- The existence of a legal obligation (contractual or legal obligation) to transfer the proceeds; and
- A relation of interdependence between the receipt of the original payment and the transfer (a contrario: "would not include contractual or legal obligations that are not dependent on the receipt of the payment by the direct recipient").
It follows from this new version of the OECD Commentary that, in certain cases, a mere factual duty to transfer is not sufficient to deny the right to use of the income recipient. Indeed, with respect to financial transaction, the OECD Commentary 2014 explicitly states that the right to use of the income recipient cannot be denied on the sole grounds of a de facto transfer of income. Moreover, it appears clearly that the OECD considers as harmful only a commitment that is related to a received payment (in the sense of interdependence). The situation where the recipient of income satisfies other obligations without the existence of a link between the income and the expense is not considered as harmful.
Regarding the lack of possibility to deny the right to use in case a transfer of income is only supported by facts. It is interesting to note, however, that this was addressed in a consultation procedure which took place in 2011. Some commentators were of the opinion that the proposed definition of beneficial owner at the time, as the one with the "full right to use and enjoy the dividend" was "excessively broad" and would prevent withholding tax refund in legitimate cases. As examples of cases in which legitimate refund requests could be affected, the activities of bank or other financial institutions were mentioned in particular, as well as hedging risks in the financial sector. Concerns have been expressed regarding to the effect that an excessively broad wording could have for financial institutions for which refund requests could be denied in cases where they take risks and hedge those risks in the course of their normal business.
In this context, it can be read in the OECD revised proposals that "[i]n light of all these comments, the Working Party recognised that the drafting of paragraph 12.4 could give rise to significant uncertainty and that the paragraph needed to better identify the kind of obligations that would mean that the recipient of a dividend would not be considered to be the beneficial owner of that dividend. After extensive discussions, it agreed on the proposed redraft included in the box at the beginning of this section". In the current version of the OECD Commentary 2014, the word "full" has thus been deleted. Therefore, this tends to the conclusion that a transfer of income taking place in the normal business activity of a financial actor should not justify a denial of right to use and to a refusal of withholding tax refund.
Decisions of the Swiss Federal Court in relation to beneficial ownership or the right to use in the context of financial transactions
All these decisions (2C-364/2012, 2C-895/2012, 2C-383/2013) deal with the rejection of Swiss withholding tax refunds in cases where derivatives are used in the relevant financial transactions and lead to a transfer of income to third parties. The Federal Court denied the possibility for the taxpayer to recover Swiss withholding tax, because it considered it was not the beneficial owner of the underlying asset, respectively it lacked the right to use on the income. With regard to the interpretation of beneficial ownership, the Federal Court unfortunately did not take into consideration the above-mentioned OECD Commentary 2014.
Regarding the notion of interdependence, the Federal Court first considered that there is a relation of interdependence if the obtaining of the income is linked to a direct obligation to transfer this income. Hence, if the income had not existed, there would have been no obligation to transfer such income. The Federal Court retained the possibility to have a legal or a factual obligation. In all these cases, the Federal Court held that the bank would not have concluded the underlying transaction without the conclusion of the derivative contract, and it did not have a free power of disposal on such income that it committed to transfer to its counterparty to the derivative contract. For these reasons, the bank did not bear the risks inherent in the holding of the underlying asset, the latter being transferred to the counterparty to the derivative contract.
The consequences from these Federal Court decisions are that a financial institution issuing derivatives could not be considered as a beneficial owner of the underlying asset, if some of the following conditions are met:
- Derivative and underlying assets are transacted in a simultaneous way and in the short term;
- Temporal proximity to the time of dividend payment;
- Underlying performance related to a prior agreement of transfer to a third party;
- Obligation (legal, economic or factual) to transfer the performance of the underlying asset to a third party; and
- Almost no risk borne by the issuer.
The OECD's Multilateral Instrument
In the context of base erosion and profit shifting (BEPS), referring to tax planning strategies that exploit gaps and mismatches in tax laws to artificially shift profits to low or no-tax jurisdictions where there is little or no economic activity, the OECD developed the Multilateral Instrument (MLI) in order to implement the BEPS measures in tax treaties.
Switzerland signed the MLI implementing the treaty-related BEPS provisions. It has announced that it only included 14 double tax treaties at time of signature. Switzerland's focus is primarily on the minimum standards, in particular the transparent and dual resident entities (Articles 3 and 4 of the MLI) and the anti-abuse provisions for permanent establishments located in third states. With regard to the alternative rules available to satisfy the minimum standards, Switzerland has opted for the principal purpose test (PPT) (Article 7 of the MLI) to counter abuses and tax avoidance.
The PPT in double tax treaties
The PPT is intended to catch situations that meet the following conditions and can be read as follows: "Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item or income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in the circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement."
While being difficult to implement in practice, the PPT arguably lowers the abuse threshold by stating that obtaining the benefit must be one of the principal considerations that justified entering into the arrangement or transaction. In this context, the burden of proof is reversed to the detriment of the taxpayer.
In connection with tax abuses, in particular the transfer of treaty-favoured income to residents of a third state, given the legal nature of the PPT, it will be interesting to observe the new developments that will arise in relation to the interpretation and application of the PPT test.
In particular, it might not be as flexible as pre-MLI policies and as the above-mentioned administrative practice and jurisprudence applicable in Switzerland. Indeed, the interpretation of the PPT will obviously depend on serious coordination at international level in order to implement the changes on a large and global scale. As for the concept of beneficial ownership, the interpretation and application of the PPT will hence depend on guidance of international nature (international law rules), such as the OECD Commentary, domestic law and foreign jurisprudence. In any case, the value and relevance of these sources of interpretation will have to be analysed on a state-by-state basis, which will lead to various questions and to a risk of increased tax treaty disputes. In case of disputes, one can only hope that the courts will apply the PPT with a view to improving legal certainty with respect to the allocation of income in a tax treaty context.
Jean-Blaise Eckert and Charlotte Rossat
Lenz & Staehelin