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'Beneficial owner': 2014 update to the OECD commentary

26 January 2015   (0 Comments)
Posted by: Author: Dan Foster
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Author: Dan Foster (Webber Wentzel)

In parallel to work on the BEPS project, the OECD has sought to clarify the meaning of 'beneficial owner' in a tax treaty context.  Dan Foster considers the 2014 Update to the Commentary.

The Council of the Organisation for Economic Co-Operation and Development (OECD) approved the 2014 Update to the Model Tax Convention (MTC) and Commentary on 15 July 2014. 

The update includes the outcome of the revised proposals concerning the meaning of "beneficial owner", issued as a discussion draft on 19 October 2012, and approved in its final form by the OECD Committee on Fiscal Affairs on 26 June 2014.  A consolidated version of the OECD MTC and Commentary incorporating the 2014 Update was published on 5 September 2014.

The OECD Model Tax Convention

The OECD MTC proceeds on the presumption that a contracting state will rightly seek to tax the worldwide income of its residents.  The MTC recognises, however, that the state of source should retain taxing rights to certain types of income arising within its borders.  The so-called 'distributive' articles of the MTC are consequently divided into three categories:

1. May be taxed without limit in the Source State:

Article 6 - Income from immovable property

Article 7 - Profits attributable to a Permanent Establishment (except Art. 8)

Article 13 and 22 - Disposal of immovable property

Article 15 - Long-term employment in the private sector (or remuneration paid or borne in the source state)

Article 16 -Director's fees

Article 17 - Entertainers, sportspersons and 'star companies'

Article 19 - Foreign government service of a source-state national

2. Limited taxation in the Source State

Article 10 - Dividends

Article 11 - Interest

3. Not taxed in the Source State (Resident State taxation only):

Article 7 - Profits of a non-resident with no permanent establishment

Article 8 - Ships, aircraft, boats

Article 12 - Royalties

Article 13 - Disposal of shares

Article 15 - Short-term employment in the private sector (and remuneration not paid or borne in the source state)

Article 18 - Private pensions

Article 20 - Students

Article 21 - Other income (other than with respect to a permanent establishment)

Article 22 - Capital (other than immovable property)

Any residual double taxation that is not relieved by the distributive articles may be eligible for exemption or credit in terms of Article 23 or in terms of domestic law.

It is important to note that tax treaties negotiated by states may differ significantly from the model outlined above.

Treaty relief for dividends, interest and royalties

As will be recognised above, interest and dividends may be taxed in the source state, but such taxing right is not unlimited.  In terms of the MTC, the source state's right to tax is recommended to be capped at between 5 percent and 15 percent of the gross income (depending on the circumstances), while the state of residence retains unlimited taxing rights.

Royalties, on the other hand, may only be taxed in the state of residence and must be exempted from tax in the source state, in terms of the MTC.  In practice, however, many tax treaties provide for limited taxation of royalties in the source state, in the same manner as for dividends and interest.

The maximum rates of source state taxation in a selection of South Africa's tax treaties is summarised in Table A.

Table A

  

Treaty with:

Dividends (15%) (qualifying companies)

Interest

(15% WHT to be introduced from 2015)

Royalties

(15% from 2015)

United Kingdom

5%

0%

0%

Mauritius

5%

0%

0%

Cyprus

0%

0%

0%

Italy

5%

10%

6%

Australia

5%

10%

10%

India

10%

10%

10%

The 'beneficial owner' test

Importantly, the relief from source state taxation provided for by the MTC is only available if the "beneficial owner" of the dividend, interest or royalty is resident in the other contracting state.  This test is incorporated into most of South Africa's tax treaties. Notably, the MTC does not automatically provide relief based on where the immediate recipient of the payment is resident, since the recipient and the beneficial owner may be different persons.  Where the beneficial owner of the income is not a resident of the other contracting state, the source state's right to tax is not limited.  In other words, if the beneficial owner is not resident in the other treaty state, the source state may subject the income to taxation in full according to its local laws and need not apply any exemption or reduced rate of withholding afforded by the tax treaty.

The updated Commentary retains the interpretation that a nominee, agent or "conduit company" will not be the beneficial owner of the income paid and received, and the source state may consequently deny relief if the immediate recipient is resident of the other state, but the beneficial owner is not.

Consequently, the "beneficial owner" test has been the subject of considerable debate, and even litigation, in many countries. At the root of the debate is the lack of a definition for "beneficial owner" in Article 3(1) of the MTC, or within Articles 10, 11 or 12.  Normally, this would mean that, in terms of the so-called "Renvoi clause" of Article 3(2), the phrase would take its meaning from the domestic laws of the state applying the treaty (in other words, the state giving up its taxing rights, being the source state in this instance).  The OECD MTC Commentary ("the Commentary") notes, however, that the phrase is "not used in a narrow technical sense" but rather it should be understood in its context and in light of the object and purpose of the MTC, being the elimination of double taxation and prevention of fiscal evasion.  This rule of interpretation is in keeping with Article 31(1) of the Vienna Convention on the Law of Treaties, and the principles laid down in the Commerzbank and Memec cases, so is not necessarily at odds with the Renvoi rule.  This approach was also confirmed by the South African Appeal Court (as it then was) in the Mango case, which found that treaties should not be strictly interpreted using ridged domestic rules of construction.  A potential conflict therefore arises with respect to the definition of "beneficial owner" in section 64D, which is discussed below. Although no South African court has ruled on the issue, it has been considered at length by foreign courts.

The Velco case

On 24 February 2012, Associate Chief Justice EP Rossiter of the Tax Court of Canada handed down judgement in Velcro Canada Inc. v Her Majesty the Queen.  The ruling extended the approach taken to "beneficial owner" in the earlier Prevost case, finding that the Dutch recipient of royalties retained the attributes of beneficial ownership, namely "possession, use, risk and control", despite having a contractual obligation to pay 90 percent of such royalties to a subsidiary in the Dutch Antilles within 30 days.  Canada's source state taxing rights were therefore limited to 10 percent (and 0 percent from 1998) in terms of the Canada-Netherlands tax treaty, rather than the full 25 percent which would apply to a resident of a non-treaty state such as the Dutch Antilles.  

Importantly in this case, there was no "pre-determined flow of funds" since the royalties were inter-mingled with the Dutch company's own funds (in other words, not segregated), used for various commercial purposes during the 30 days, and were exposed to creditors of the Dutch company while in its account.  The Dutch company could not bind the Antilles company, and acted on its own behalf, so was not an agent or nominee.  Furthermore, the Dutch company was not a "mere channel" with no discretion as to the use of the funds, and was therefore not a so-called "conduit company". The court found that it could not "pierce the corporate veil" of the Dutch company unless that company had absolutely no discretion with respect to the funds received.

The case highlighted the appropriate tests for beneficial ownership of income, and has been the touchstone for tax treaty interpretation of the term over the past few years.

The 2014 update to the commentary

The present update to the Commentary on "beneficial owner" focuses on three main issues:

i) The use of an autonomous versus a domestic meaning of the concept of "beneficial owner";

ii) The obligations, facts and circumstances that may impact the determination of the "beneficial owner"; and,

iii) Considerations applicable to so-called abusive arrangements.

With regards to i), the Commentary notes that the term "beneficial owner" is specifically used to identify the person eligible for treaty relief when an amount is "paid direct to a resident" (as paragraph 12 of the Article 10 Commentary now reads) and should be interpreted in that context.  The existing caution against using a technical meaning from domestic law is further emphasised, particularly with reference to common law countries where the term has a specific meaning under trust law.  Such meaning should be ignored for treaty purposes - for example, the trustees, or the trust (if a separate taxpayer), can be the "beneficial owners" of the income even if it does not vest in beneficiaries, despite that term not being appropriate for trustees in a domestic trust law context.

The caution against using a domestic definition in a treaty context would also apply to our section 64D, where "beneficial owner" means "the person entitled to the benefit of the dividend attaching to a share".  This definition would apply in the application of the Dividend Tax, but not in the determination of entitlement for treaty relief (in other words, a reduced rate of withholding).  In practice, however, the two considerations are inextricably linked, but fortunately in this case not incompatible.  Until one or both definitions are considered by our courts, there appears to be no risk in assuming they refer to the same person.  That is, a beneficial owner for treaty purposes will be the beneficial owner for Dividend Tax purposes, and vice versa. It is also submitted that, as there is no obvious conflict between the defined term and the treaty term, the inclusion of the relevant treaty term in domestic law, via section 108, does not create a situation where we must determine if the treaty over-rides section 64D.  It is also clear that the section 64D definition is not particularly "narrow" or "technical", but rather reflects the "ordinary meaning", which is compatible with both domestic and treaty rules of interpretation.

The Commentary further notes that a meaning ascribed to "beneficial owner" for the purposes of, for example, identifying individuals who exercise "ultimate effective control over a legal person or arrangement" is not appropriate to the context.  The Commentary also emphasises that the beneficial owner of the dividend is being tested "as opposed to the [beneficial] owner of the shares, which may be different".

With regards to ii), the Commentary, at paragraph 12.4 of Article 10, confirms that the existing examples ("agent, nominee, conduit company acting as a fiduciary or administrator") are not beneficial owners since they are constrained by a contractual or legal obligation to pass on the payment to another person and "on the basis of facts and circumstances… in substance… do[es] not have the right to use and enjoy the dividend unconstrained" by such obligations.  This statement can arguably be distinguished from the facts of the Velcro case, discussed above.  Notably, references to "related" and "unrelated" obligations appearing in the 2012 discussion document have been omitted from the final Commentary and replaced with: "This type of obligation would not include contractual or legal obligations that are not dependant on the receipt of the payment…" [my emphasis].  In this context, the Commentary further notes that financial arrangements such as pension and collective investment schemes would generally qualify as beneficial owners.

Another important aspect of the 2014 Update is the Commentary on abusive arrangements at paragraph 12.5 of Art. 10 (point iii) above).  While confirming the OECD's general stance on abuse of tax treaties (they are against it, unsurprisingly), the Commentary states that the "beneficial owner" provision targets a specific type of arrangement ("in other words, those involving the interposition of a recipient who is obliged to pass on the dividend to someone else"), and is not meant to be used to counter "treaty-shopping" generally.  Other approaches to counter general treaty abuse are recommended, namely limitation of benefits ("LoB") clauses, as seen in South Africa's treaties with Japan and the US, and substance-over-form challenges (as available under South African common law). 

Impact in South Africa

Taxpayers and advisors must be alert to the new Commentary with respect to the "facts and circumstances" which are relevant in the determination of the "beneficial owner" of cross-border income flows, particularly where a resident has an obligation to pass on the income to another person in a non-treaty state.  While the Commentary confirms the "right to use and enjoy" the dividend as a pre-requisite of beneficial ownership, there may be a very fine line between acceptable arrangements (as the Canadian court found in Velco) and unacceptable arrangements as contemplated by the OECD.

If a South African court were asked to consider the application of, say, the OECD Commentary on "beneficial ownership" as opposed to the Velco interpretation, two important considerations would arise:

i) the status of the OECD Commentary in South African law; and

ii) the status of foreign case law in treaty interpretation.

Volumes have of course been written on this topic, which I shall not add to here except to note the following:

  • Section 232 of the Constitution states that customary international law is the law in South Africa unless it is inconsistent with the Constitution or an Act of Parliament.  For various reasons, this only gets us so far (What is included in customary international law? What qualifies as inconsistent?)
  • Section 233 of the Constitution, more helpfully, states that "when interpreting legislation, every court must prefer any reasonable interpretation of the legislation that is consistent with international law over any alternative interpretation that is inconsistent".  But again, is international law the Commentary, or foreign judgements?
  • While SIR v Downing would appear to give persuasive weight to the OECD Commentary, that court's ruling was not in fact based on such Commentary, and merely recognised that an international guide to fiscal interpretation did exist.  Furthermore, the main reference to the Commentary was made by the Natal court (not the Appeal Court) and is therefore of little precedent value.
  • As noted above, Article 31(1) of the Vienna Convention provides arguably binding guidance to our courts with respect to treaty interpretation:

"A treaty must be interpreted in good faith in accordance with the ordinary meaning to be given to terms of the treaty in their context and in light of its object and purpose" 

Article 32 goes on to state that recourse may be had to supplementary means of interpretation "including preparatory work of the treaty", in order to confirm the meaning resulting from the application of Article 31(1) above (which would include an analysis of the context, object and purpose).  Supplementary material would also be appropriate if the meaning is ambiguous or obscure, or the result is manifestly absurd or unreasonable. 

Although "preparatory work" of the treaty is kept secret in South Africa, it is reasonable to assume that part of National Treasury's preparation for treaty negotiations involved consulting the OECD MTC and Commentary.  South Africa's tax treaties are, after all, based on that model.  In the celebrated Smallwood case, the UK Special Commissioners noted, when considering the UK-Mauritius tax treaty, that "the negotiators on both sides could be expected to have the Commentary in front of them" and "can be expected to have intended that the meaning in the Commentary should be applied in interpreting the Treaty when it contains identical wording".  Even in Smallwood, however, the court was not helped by the Commentary, which it said merely confirmed the extent of the controversy under consideration (namely, "place of effective management").

  • We should also be conscious of the judgement of the UK Court of Appeal in the Memec case, which noted that commentaries, and decisions of foreign courts, have persuasive value only, and in any case their use in interpretation is discretionary rather than mandatory.
  • The OECD Commentary has been routinely referred to by the UK courts since at least 1984, but the lack of treaty-related cases in South Africa leaves it untested here.  In the UK, HMRC's International Tax Manual states that the Commentary may be used as an aid to interpretation, while SARS has issued no such guidance.
  • The Commentary is largely the work of officials from OECD revenue authorities and finance ministries, and not necessarily drafted as an impartial guide for taxpayers.  In this respect, it may be considered mere "expert opinion" on par with other commentators and indeed foreign judges.
  • As Judges Avery Jones and Sadler noted in the FCE Bank case, it is indeed not uncommon for courts in OECD countries to rule contrary to the OECD Commentary applicable to their own states.  The Commentary in fact played no part in the subsequent Court of Appeal ruling on the FCE Bank matter.  So why should a non-OECD state put more faith in the Commentary than in foreign judgements of superior courts?

Until such time as a South Africa's Supreme Court of Appeal rules on the meaning of "beneficial owner" we may, it is submitted, give equal weighting to both Velco and the Commentary.  This does not get us far, admittedly, but I would be cautious to place a heavier weighting on the Commentary, and neither should we ignore it completely.  

This article first appeared on the January/February edition on Tax Talk.


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