My client who lives in the State of Residonia wants to structure a business opportunity through a foreign company resident in the State of Forenzia, a jurisdiction with a double tax treaty with the State of Bizlandia where the company’s business is to be carried on. He has heard that the OECD wants to deny treaty access to such a Forenzian company under Action 6 of the BEPS (Base Erosion and Profit Shifting) Action Plan, and asks me to advise him on whether setting up this foreign company will be respected by Bizlandia where the business is being carried on.

Most modern double tax treaties have traditionally been based on one of the model tax conventions (MTCs). While the US has relied on its own MTC, most of the developed countries followed the MTC developed by the OECD. Since the first tax treaties were negotiated, their primary function has been the promotion of international trade through the elimination of double taxation, and mitigation of foreign taxation in the source State. This has meant that companies have structured their international businesses utilising the double tax treaties entered into by different States, leading to the recognition of treaty shopping through the use of conduit companies as one the primary forms of tax avoidance. In response, changes have been made to the MTCs and their accompanying guidelines, which eventually found their ways into the treaties themselves.

Nowadays, most treaties based on the OECD MTC normally include the provision whereby preferential source taxation of passive income such as dividends, interest and royalties is only available where the income belongs to its beneficial owner. Conversely, in its own MTC, the US has traditionally included a much broader limitation on benefits provision, which, unless satisfied, makes treaty benefits unavailable to the persons claiming them.

The OECD in its Action Plan 6 of the BEPS initiative identified treaty shopping as one of the most important sources of base erosion and profit shifting, and proposed drastic changes to the current MTC. The most significant changes are reflected in the departure from the beneficial ownership condition, and introduction of the extensive limitation on benefits (LOB) provision, which in many respects is identical to that already existing in most of the US treaties. However, the OECD supplemented the LOB with an additional more general anti-abuse rule based on the principal purposes of transactions or arrangements, also known as the “principal purposes test” (PPT). Finally, in addition to their traditional role of avoidance of double taxation, the general spirit of tax treaties reflected in the name and the preamble was made to strongly reflect their goal to prevent fiscal evasion.

From its inception the BEPS Action Plan has unrolled according to a tight schedule aiming to ensure its fastest implementation and the possibility to rely on its recommendations. Nevertheless, it might take several years before its Actions will find their ways in national and international jurisprudence. In the case of Action 6, international businesses will continue operating within the existing beneficial ownership (OECD) or limitation on benefits (US) framework until gradually treaties are amended according to the new recommendations. However, one thing is certain, and that is that my client already should start preparing himself to operate in the new stricter anti-avoidance reality.

Therefore, we can start advising the client by examining whether his Forenzian-resident company that he owns from Residonia will actually be the beneficial owner of the profits derived from the business activities and investments in Bizlandia. Because the LOB provisions in the existing US treaties largely form part of the Action 6’s much broader recommendations, I will examine these in turn and will not specifically focus on the US MTC.

Beneficial ownership under OECD MTC

Beneficial ownership aims to prevent avoidance of source tax and therefore it is normally invoked by the source States. However, beneficial ownership does not have a single legal definition. The OECD states generally that:

“... the State of source is not obliged to give up taxing rights over dividend income merely because that income was paid direct to a resident of a State with which the State of source had concluded a convention." (para 12.1 of the Commentary to Article 10 of the OECD MTC).

The OECD then goes on to explain that whether the person is the beneficial owner of the income item depends on whether he or it:

“has the right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person”.

HMRC define beneficial ownership in even more Spartan terms as:

“the sole and unfettered right to use enjoy or dispose of the asset or income in question.” (INTM332010)

Therefore, in finding the meaning of the term it has been customary to turn to judiciary interpretation in a string of international court cases. These include Indofood and Velcro Canada, which we have described in substantial details in previous publications (click here) and (click here).

Another recent decision is by a Swiss Federal Administrative Tribunal (A-6537/2010 of 7 March 2012). In defining the meaning of beneficial ownership, the tribunal pointed out that:

“... beneficial ownership serves to determine the intensity of the relationship between a taxpayer and the taxable object viewed from an economic point of view. Beneficial ownership is a 'substance over form' approach based on the underlying economic reality rather than the (civil law) form ... The aim is to ensure that a fiduciary or manager acting purely on behalf of the beneficial owner is excluded from the advantages of the Convention." (click here).

So if the Forenzian–Bizlandian double tax treaty is based on the OECD model and the client wants to benefit from its limitation of withholding tax on the passive income that his Forenzian company receives from Bizlandia, the client should demonstrate that the company is the beneficial owner of the same income. Conversely, if Bizlandia finds that the company acts as a mere conduit that was placed in Forenzia simply to allow the client to benefit from the lower tax rates under the Forenzian–Bizlandian double tax treaty in the absence of the Residonia–Bizlandian tax treaty, the benefits will be denied.

As summarised in Velcro Canada:

"…there are really four elements in considering the attribution of beneficial ownership and those are: (a) possession; (b) use; (c) risk; and (d) control [of the income in question]." (at paragraph 29.)

However, beneficial ownership is not required should the Forenzian company claim any other treaty benefits. These could be source taxation of business profits derived from Bizlandia only if these are associated with a Bizlandian permanent establishment (art. 7); abolition of taxation of capital gains arising in connection with a disposal of another Bizlandian company (art. 13); or credit of Bizlandian corporation tax against Forenzian taxes (art. 23). As I explain to the client below, such shortcomings are addressed under Action 6.

Anti-treaty shopping provisions under Action 6

If Forenzia and Bizlandia review their treaty according to OECD’s recommendations, my client will have to observe the terms of the new LOB clause in order to obtain any benefit under the treaty whatsoever, and not just in respect of the passive income. Every tax year in which the Forenzian company wishes to rely on the tax agreement, it should demonstrate that it is (1) a “qualified person” or, failing which, (2) it meets the requirements of certain additional tests. Additionally, the company should not fall foul of the Principal Purpose of Transaction Test, which will apply regardless of whether conditions 1 or 2 are satisfied.

What is a qualified person?

The LOB clause lists entities that can be considered a qualified person; however, for a private business owned and operated internationally, this requirement might be difficult to satisfy. The following is a list of alternatives available to my client.

Firstly, the Forenzian company will be a qualified person if amongst other things the principal class of its shares is regularly traded on one or more recognised stock exchanges, and either: (1) its principal class of shares is primarily traded on one or more recognised stock exchanges located in Forenzia where the company is resident; or (2) the company’s primary place of management and control is in Forenzia. With an independent Forenzian board the company will meet condition (2); however, considering that my client has no plans of making the company public it will not be a qualified person under this test.

Secondly, the Forenzian company will be a qualified person if at least 50 per cent of its shares belong to the client who also becomes resident in Forenzia. Additionally, less than 50 per cent of the company’s gross income can be paid directly or indirectly, to persons who are not residents of Forenzia or Bizlandia entitled to the benefits of the treaty under the terms of the LOB clause, in the form of payments that are deductible for purposes of the taxes covered by that treaty in Forenzia. However, these do not include arm’s length payments in the ordinary course of business for services or tangible property. Together the two conditions are referred to as the stock ownership and base erosion test.

Unless my client agrees to move to Forenzia or transfers the controlling stake in his company to a Forenzian resident, the company will not be a qualified person. For the sake of completeness, if he satisfies the ownership test, if the Forenzian company pays say royalties or consulting fees to the client’s other entities, which are resident outside Forenzia or Bizlandia, these should be set strictly at an arm’s length level (although this has always been a requirement under the transfer pricing rules).

Thirdly, qualified persons include individuals resident in Forenzia, Forenzian governmental authorities, certain non-profit organisations, pension funds and possibly collective investment vehicles. However, none of these will be relevant for my client as he wants to operate through his private company.

Active conduct of a business

Where the company is not a qualified person under the previous test, it can still satisfy an alternative test under which it may receive treaty benefits with respect to certain items of income that are connected to an active business conducted in Forenzia. More particularly, in order to be eligible for the treaty benefit, the company should meet two conditions: (1) it should be engaged in the active conduct of a business in Forenzia, and (2) payments from Bizlandia for which treaty benefits are sought are related to this business. This is regardless of the nature and ownership of the company.

Generally the company is not limited in the kind of business it can pursue for as long as the company’s employees and officers conduct substantial managerial and operational activities in Forenzia. There are, however, limitations regarding certain investments management activity unless it is pursued by a bank or similar institution.

A business activity in Forenzia generally will be considered to form part of a business activity conducted in Bizlandia if the two activities are connected. For example, this may involve the design, manufacture or sale of the same products or type of products, or the provision of similar services. The line of business in Forenzia may be upstream, downstream, or parallel to the activity conducted in Bizlandia. Thus, the line of business may provide inputs for a manufacturing process that occurs in Bizlandia, may sell the output of that manufacturing process, or simply may sell the same sorts of products that are being sold by the business carried on in Bizlandia. The company in Forenzia can even licence technology to its branch in Bizlandia, which it will use to manufacture goods, and the royalty payments will then be subject to potential withholding tax exemption if the double tax treaty permits this.

After reviewing the client’s business, I found that in addition to pursuing active business, the Forenzian company also holds passive investments that generate dividend income, which would not fall under the active conduct of business test. Therefore, I also researched the possibility of the client relying on the final derivative benefits test.

Derivative benefits

Under this test the company will be entitled to the beneficial treatment of the dividends if in the year when they are paid, at least 95 per cent of the company’s shares is owned, directly or indirectly, by seven or fewer persons that are equivalent beneficiaries, provided that in the case of indirect ownership, each intermediate owner is itself an equivalent beneficiary. Additionally, less than 50 per cent of the company’s gross income should be paid directly or indirectly, to persons who are not equivalent beneficiaries, in the form of payments that are deductible for purposes of the taxes covered by that treaty in Forenzia. However, these do not include arm’s length payments in the ordinary course of business for services or tangible property. Although the derivative benefits test uses the term equivalent beneficiary, in many respects it resembles the stock ownership and base erosion test discussed above.

The client has informed me that he owns 100 per cent of the company’s shares, so whether he meets the test depends on whether he is an equivalent beneficiary or not. According to the definitions clause of the LOB article, the client as a resident of Residonia will be the equivalent beneficiary provided that (1) there is a double tax treaty between Residonia and Bizlandia i.e. the State from which the Forenzian company receives income and where it seeks treaty benefits; (2) the client would be entitled to the benefits under this Residonia–Bizlandian treaty had it contained a similar LOB clause; and (3) the rate of withholding tax on dividends under the Residonia–Bizlandian treaty is at least as low as the rate under the Forenzian–Bizlandian treaty.

Happily for the client, Residonia has concluded a tax treaty with Bizlandia, although it does not contain a similar LOB clause. I further note that both under the Forenzian–Bizlandian and Residonia–Bizlandian treaties, the source taxation of dividends is limited at 5 per cent, which means that the client is an equivalent beneficiary.

However, there is a fly in the ointment! I recall that like the UK, Residonia allows its residents to be taxed on the remittance basis of taxation and the client has been so taxed for the past couple of years. At the same time, the Residonia–Bizlandian treaty contains a remittance ‘saving’ clause under which only the income that is remitted to Residonia can be subject to the treaty beneficial treatment. Thus I have to inform the client that in the year in which he wants to be considered the equivalent beneficiary to allow the Forenzian company to rely on the Forenzian–Bizlandian treaty, he cannot be taxed on the remittance basis in Residonia.

Also to satisfy the base erosion test, if the Forenzian company pays say royalties or consulting fees to the client’s other entities, which are not equivalent beneficiaries, these should be set strictly at an arm’s length level (although this has always been a requirement under transfer pricing rules).

Discretionary relief

It looks like the client is the equivalent beneficiary for the purposes of the derivative benefits relief and provided the Forenzian company meets the base erosion test, it will receive dividends from Bizlandia subject to a reduced rate of tax. However, I explain to the client that if he fails to meet the above tests, he can still approach the Bizlandian tax authorities and ask to be entitled to the benefits of the treaty. The burden of proving why he should receive such entitlement is high. The client must establish, to the satisfaction of the tax authorities, that there were clear reasons, unrelated to the obtaining of treaty benefits, for the formation, acquisition, or maintenance of the Forenzian company and that any reasons related to the obtaining of treaty benefits were clearly secondary to those unrelated reasons.

Whilst it is impossible to provide a detailed list of all the facts and circumstances that would be relevant in support of the client’s case, examples include the history, structure, ownership and operations of the client and his company, whether that company is a long standing entity that was recently acquired by the client for non-tax reasons, whether the company carries on substantial business activities, whether the company’s income for which the benefits are requested is subject to double taxation and whether the establishment or use of the company gives rise to non-taxation or reduced taxation of the income.

Principal Purpose of Transaction Rules

I am satisfied that the client would meet the terms of the LOB clause; however, there is still an additional hurdle that he has to overcome. The Principal Purpose of Transaction rule has the effect of denying a benefit under the Forenzian–Bizlandian treaty where one of the principal purposes of an arrangement or transaction that has been entered into is to obtain a benefit under the treaty. Where this is the case, however, the Rule allows the company to whom the benefit would otherwise be denied the possibility of establishing that obtaining the benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the treaty.

The Rule supplements and does not restrict in any way the scope or application of the LOB provisions. Conversely, the fact that the Forenzian company is entitled to benefits under the LOB provisions, does not mean that these benefits cannot be denied under the PPT provisions.

The terms “arrangement or transaction” should be interpreted broadly and include any agreement, understanding, scheme, transaction or series of transactions, whether or not they are legally enforceable. An example of an “arrangement” would be where steps are taken to ensure that meetings of the board of directors of the client’s Residonia registered company are held in Forenzia in order to claim that the company has changed its residence to benefit from the Forenzian–Bizlandian tax treaty.


My client may be forgiven for thinking that the OECD and bureaucracy may be jeopardising global investment by making applications of withholding tax exemptions and other treaty benefits so complex. And perhaps the time has come to suggest alternative means of determining ways of limiting so-called tax avoidance through the use of double tax treaty planning.

It is one of the functions of a double tax treaty to stimulate international investment by foreign investors, and this may be sufficient reason for reducing withholding taxes on the distribution of dividends, interest and royalties from domestic corporations, such as the on in Bizlandia. If countries are concerned about tax avoidance, then perhaps they should focus more on legislation affecting the investors, rather than the use of companies by these investors to minimise foreign taxes. In other words, whilst conduit companies which have no substance may be ignored for treaty purposes on the basis that they are not beneficially entitled to the income derived from the foreign corporations, so called intermediary companies which have substance and an economic purpose should indeed benefit from double tax treaty reliefs. The focus should then be on how that income (of the foreign intermediary company in countries such as Forenzia) is taxed in the hands of the investors. Most sophisticated jurisdictions will have anti-avoidance provisions which may attribute such income to the investors on an arising basis, unless perhaps the foreign intermediary company is substantial in its own right, with a considerable number of shareholders and perhaps quoted on a foreign stock exchange. These foreign intermediary companies may be used by the investors as subsidiaries of a pooled collective investment vehicle, typically located in an offshore jurisdiction where tax is not an impediment to the way investment funds are channelled into business opportunities. Again, the focus should not be on denying treaty benefits in these cases, but more on the taxation of investors in these collective investment vehicles (which apparently would not qualify for Forenzia-Bizlandia treaty benefits under the OECD recommendations as they are currently presented.

In other words, maintaining withholding taxes and denying treaty benefits to entities with the proper degree of economic activity and substance is a sword on which foreign investment and global growth may fall figuratively and literally.

Roy Saunders

Roy Saunders qualified as a chartered accountant in 1967 and created his own niche international tax practice in 1971. He wrote his first book “Tax Planning for Businesses in Europe” in 1976 which was published by Butterworths and his second book “Principles of Tax Planning” which was published by Bureau of National Affairs in Washington in 1978. His best known work has been “International Tax Systems and Planning Techniques” which was published by what is now Thomson Group/Sweet and Maxwell in 1983 as a loose-leaf work, and is still the only major international tax reference work which was written by one person covering the tax legislation of more than 20 countries at that time. Since then, it has been updated in 60 releases as a loose-leaf edition until its first bound work was published in 2010 and is now published on an annual basis. The number of countries now covered within the book is more than 30 and includes chapters on personal and corporate tax legislation of the United States, the United Kingdom, Spain, Italy and Russia as may affect the potential client (there may also of course be other jurisdictions in which the client has an interest which are covered by the book). Other books written by Roy Saunders include “Cyprus in International Planning” for Longman Group, “Structuring International Real Estate Transactions” for Sweet and Maxwell and “Principles of International Tax Planning” published by his own company IFS in 2005 as an update to the 1978 version.

Roy has lectured around the world on international tax issues for many organisations including his own institute, the Institute of Chartered Accountants in England and Wales, the International Tax Planning Association of which he is on the Executive Committee, the Economist Intelligence Unit, many commercial conference organisations such as IBC, and for his own company IFS. He runs an annual conference in London as an IFS sponsored conference at which the contributors to “International Tax Systems and Planning Techniques” are invited as speakers on specific topics, this year’s topic being personal and corporate migration. Roy is currently teaching an MA Course on International Taxation at the Institute of Advanced Legal Studies at the University of London.

Roy practices as an international tax consultant with his own company International Fiscal Services (IFS). He specialises in personal and corporate international tax issues for entrepreneurial clients and covers inter alia income tax, capital gains tax and inheritance tax issues. As his boutique practice grew, he established offices in London, Amsterdam, New York, Madrid, Jersey, Cyprus and Curacao which provided international tax advice in the relevant jurisdictions through a team of specialist tax accountants and lawyers. Now in his mid sixties, Roy has divested himself of these offices and operates his consultancy practice from a small base in St John’s Wood, London.

The client base of IFS has been very diverse over the years. In the past ten years say, the following clients have been advised by IFS:

  • A leading Russian gas and other energy conglomerate as regards their international structure from the ownership point of view as well as subsidiary enterprises, acquisitions and sales, IPO arrangements etc.
  • Switzerland’s largest bank in establishing an $8 billion Global Real Estate Fund with investments in the US, Japan, Western Europe and specifically the UK.
  • A leading UK law firm in a negligence claim against an international tax advisory firm where Roy acted as expert witness on a failed IPO in which the tax legislation of several countries were relevant factors.
  • A significantly wealthy family whose interests range from Spain, UK, US and central Europe to review problematic tax issues relating to succession planning and personal residence of relevant family members in respect of assets in various jurisdictions.
  • Advising a wealthy Italian family with a manufacturing business on their trust arrangements for succession planning.

On a personal note, Roy has been married to his wife Sonia for 44 years, has four children and (currently) four grand-children. He is a keen golfer and his hobbies include music, painting, writing and the theatre.

Website: www.interfis.com


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