Beneficial Owner–The debate continues

With this in mind, it is interesting to note the Bombay High Court’s recent dismissal of the Revenue’s appeal in the case of DIT vs. Universal International Music BV4 on the issue involving beneficial ownership of royalty payment. The question of law raised before the High Court was whether on the facts and circumstances of the case and in law, the Tribunal was correct in holding that the Dutch company (Universal International Music BV) is the ‘beneficial owner’ of the royalty received from the Indian Company (Universal Music India Private Ltd) and therefore entitled to be taxed at a rate of 10 % as per the Tax Treaty?

The facts of this case are not fully clear because as noted by the Tribunal in its Order, the taxpayer did not furnish all the information before the tax inspector. 5 However, it is clear that, during the year, the taxpayer-a company incorporated in the Netherlandsreceived a royalty from the Indian company(Universal Music India Private Ltd). The Universal Music Group is known as one of the largest music publishing groups in the world,with global group headquarters in USA. According to its business model, the group companies enter into contracts with singers, performers,etc. Such companies are known as repertoire companies.The repertoire companies license these rights to other group companies outside their home territories for its commercial exploitation.Accordingly, Universal Music India Pvt. Ltd. was granted rights of exploitation in India, with the result that the Indian Company paid royalties to the Dutch company on acquired licences of musical tracks.

As mentioned, the taxpayer did not file before the tax inspector copies of the agreement between the taxpayer and repertoire companies and did not furnish information of the persons from whom the taxpayer had acquired the musical rights.The Assessing Officer therefore held that the taxpayer was not the ‘beneficial owner’ of the royalty but was merely a collecting agent of the repertoire companies.The Assessing Officer deniedthe taxpayerthe benefit of the reduced rate of withholding tax available under Article 12 of the tax treaty and taxed the royalty at the maximum rate (30 %). The CIT(A) and the ITAT decided the appeal in favour of the taxpayer6.

The High Court decided the appeal in favour of the taxpayer on following basis:

1. The CIT(A) and the Tribunal arrived at the finding of fact on the basis of the certificate from revenue authorities in the Netherlands certifying that the taxpayer was a ‘beneficial owner’ of the royalty received in respect of musical tracks given to Universal Music India Pvt. Ltd.

2. CBDT Circular No.789 dated 13-04-20007, which states that the certificate from the revenue authorities is sufficient evidence of beneficial ownership.

3. The Revenue was not able show anything on record to contradict the finding of fact arrived at by the CIT(A) and the Tribunal that the taxpayer is the ‘beneficial owner’ of the royalty received on musical tracks given to Universal Music Private Limited.

Apparently, there was no one to argue the Revenue’s appeal before the High Court. Otherwise, arguments might have been placed that, firstly, in the absence of agreement, it could not be ascertained as to whether the Dutch company acted or did not act as an ‘agent’ or ‘nominee’ of other group companies or was a ‘conduit’ between one of the group companies and the Indian company. Therefore, on the given facts,the Tribunal could not have reached the legal finding which it did reach. Secondly, the certificate of beneficial ownership furnished by the taxpayer is the interpretation arrived at by the Netherlands authorities. Indian Courts may not necessarily agree with the interpretation of the Netherlands authorities. Thirdly, Circular 789 specifically deals with the India-Mauritius tax treaty. It cannot be applied to India-Netherlands tax treaty. Fourthly and most importantly, the Tax Residency Certificate (TRC), which is subject matter of Circular 789 relied upon by the Court, has nothing to do with the beneficial ownership.

The same view on the relationship of the TRC to beneficial ownership was expressed in a different context by the Indian Finance minister Mr. P. Chidambaram. On the proposed insertion of section 90A(5)8 he stated that “all that the Section 90A(4) intends to say is, if you produce a TRC that is a complete answer to your status as a resident. But whether you are the beneficial owner is a separate issue. The TRC certifies that you are a resident. It does not certify you are a beneficial owner.”9 His statement only supports the fact that the reliance placed by the High Court on the TRC to decide the beneficial owner issue is misplaced.

In context, one cannot avoid the feeling that the High Court and the Tribunal lost a valuable opportunity to provide guidance as to the meaning of ‘beneficial owner’. In other words, this judgment highlights the fact that this concept has not received the attention of the experts in India as much as it has received outside India.

This Article proposes to discuss the meaning of theexpression ‘beneficial owner’ in light of the revised draft guidelines on ‘beneficial owner’ released by the OECD last year10 and position of the Indian law on ‘beneficial owner’. However, it might be worthwhile first to discuss other related aspects of this concept.

I. Background

The term ‘beneficial owner’ is found in the Double Taxation Avoidance Agreements (DTAAs) in Articles 10, 11 and 12 on interest, dividend and royalty payments respectively. These tax treaty articles provide for withholding tax at the reduced rate, if the recipient is a ‘beneficial owner’ of the dividends, interest or royalties and is a resident of the state which is a party to the DTAA. It may be mentioned that the concept of ‘beneficial owner’ was introduced in the tax treaties as a countermeasure against treaty shopping11 to confine bargaining only to the contracting states which were intended to benefit from the treaty. 12

J David, B Oliver et al have noted that it was Article III of the 1945 United Kingdom-United States tax convention which referred to beneficial ownership, prior to the usage of the term by the OECD13. The OECD used it for the first time in the Model Convention in 1977. This term is neither defined in the OECD Model Convention nor in any of the Indian tax treaties. The term is not used by civil law countries but is used in many common law countries.14 In fact, Indian income tax law and other laws also use the term ‘beneficial owner’. Therefore, one would be tempted to apply the meaning of ‘beneficial owner’, as explained in the Indian domestic law, to the Indian tax treaties, when it is not defined in the tax treaty. However, it is now widely accepted that this term should be given international fiscal meaning and not domestic law meaning. There are several reasons for coming to this conclusion. These reasons are discussed in the subsequent paragraphs:

II. Meaning of ‘beneficial owner’-what is the context?

The expression ‘beneficial owner’ is not defined in the tax treaties. When a particular term is not defined in a tax treaty, Article 3(2)15 of both the OECD and UN Model treaties requires that the domestic law meaning may be adopted unless the context otherwise requires. Therefore, before applying the domestic law meaning, one has to conclude that the context does not otherwise require adopting a meaning other than the meaning given in the domestic law. The basic question-here is:what is the context for ‘beneficial owner’? The OECD commentary also 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.16 This raises a further question, as to what extent OECD commentary is relevant for interpreting tax treaty? Another broader question is, as to how text treaties are to be interpreted?

Tax treaties are to be interpreted according to the Article 3117 and Article 3218 of the Vienna Convention of Tax Treaties, 1969. Article 31(1)requires that atreaty shall be interpreted in ‘good faith’ (pacta sunt servanda) in its context and in light of its object and purpose.The obvious object and purpose of the tax treaty is to avoid double taxation and to counter treaty shopping. To achieve these objectives, it is necessary that a meaning accepted by all, that is, international autonomous meaning, should be given. Further, the meaning derived from the OECD material, including OECD documents considered at the time of writing commentary, is the special meaning referred in the Ar-ticle 31(4)19. This meaning is also articulated in the OECD commentaries, which call for adoption of international meaningof this term. It may be appreciated that OECD material can also be used as supplementary means of interpretation of tax treaty.20 Thus, it can be concluded by following above approaches that an international fiscal meaning is to be used for interpreting the term ‘beneficial owner’. This position is affirmed again by the OECD in the revised discussion draft on ‘beneficial owner’, in which references to the domestic law mean-ing of beneficial owner, which were appearing in the first draft were deleted.21 It may be interesting to note that the Court of Appeal in the Indofood decision has also stated that, “the term ‘beneficial owner’ is to be given international fiscal meaning not derived from the domestic laws of the contracting states.”22

Further, on examination of the object and purpose of the tax treaty, it can be seen that the treaty does not use the general term ‘owner’ but uses the specific term ‘beneficial owner’. Therefore, the treaty intends to give the benefit of withholding tax at the reduced rate only to the person who can be loosely described as a ‘final’ owner of income. The concept of ‘final owner of income’ can be elaborated with the help of attributes of ownership of income. Income ownership has several attributes, such as the right to possess, use or manage income, the power to alienate and ability to consume waste or destroy, the risk of depreciation and hope of appreciation.23 It is possible to split these attributes among different persons by entering into a legal or contractual arrangement to avail benefit of the favourable treaty without losing ownership of income. Therefore, the ‘beneficial owner’ is the one which has more attributes of ownership of income than others. This explanation is described by Charl Du Toit as ‘beneficial owner is the person whose ownership attributes outweigh those of any other person’.24 Considering these aspects,the domestic law meaning of the ‘beneficial owner’ is not relevant in interpretation of this concept; instead, autonomous fiscal meaning is to be given.

As mentioned, the OECD revised draft implicitly accepts this position by deleting references to resorting to domestic law for its interpretation. However, it needs to clearly mention the adoption of international fiscal meaning in the Commentary.

III.    Meaning of ‘beneficial owner’

As mentioned, the term ‘beneficial owner’ historically under common law had the objective of distinguishing the concept of ‘legal ownership’ for trust law purposes, which referred to the formal attributes of trustee ownership, from beneficial ownership, which was held by the ‘true’ beneficiaries, who could enforce their rights against third parties.25

The OECD Commentary of 1977 defined ‘beneficial owner’ in a negative manner by denying treaty benefits to ‘agents’ and ‘nominees’. It stated in 2003 that normally a ‘conduit company’ will not be regarded as a ‘beneficial owner’. The Commentary did not decline tax treaty benefits to ‘conduit companies’ in all the cases. Because as Baker has pointed out, it is perfectly possible in certain cases that intermediary holding company can be regarded as a ‘beneficial owner’.

26    However, ‘beneficial owner’ was not defined in a positive manner and its meaning continued to remain uncertain.

Several Court decisions deciding this issue one way or the other only added to the uncertainty and did not conclusively resolve the issue. For example, in one of the most quoted decisions, Indofood,27 the issue before the Court was not related to tax28 . The tax issue was hypothetical and incidental29. The case was argued by lawyers and heard by judges, who both were not expert in tax matters30. The Court of Appeal in Indofood held that, as shown by the commentaries and observations, the concept of beneficial ownership is incompatible with that of the formal owner who does not have the full privilege to directly benefit from the income.31 This meaning is based on the Indonesian domestic Circular on Beneficial Owner.32 Although the decision states that international fiscal meaning should be adopted, it has decided the appeal based on elements of Indonesian domestic law.33

The Canadian Prevost34 decision is criticised as a narrow legalistic interpretation of beneficial ownership35. It did not consider substance of the arrangement. Whereas, in the case of Bank of Scotland36, the Court applied anti-abuse doctrine and found that the arrangement was entered into for the sole purpose of obtaining treaty benefits37. Strictly speaking, this decision does not consider the attributes of ‘beneficial owner’ for deciding the case. The more recent decision of Velcro38 follows the approach adopted by the Court in Prevost. There are several other decisions on ‘beneficial owner’; however, it is difficult to arrive at a common meaning of the term after considering all the judgments.

Experts and scholars are also not unanimous in their views on beneficial ownership. According to Vogel, a ‘beneficial owner’ is one who is free to decide (1) whether or not the capital or other assets should be used or made available for use of others or (2) on how the yields therefrom should be used or (3) both39. Danon is of the view that for deciding beneficial ownership, legal, economic and factual control over use of income should be decisive over the element of enjoyment of income and ownership attributes. He also believes thatthis issue should be examined on the basis of the substance-over-form approach40. For Charl du Toit, the beneficial owner is the person, whose ownership attributes outweighs those of any other person.41

Jurisdictions such as China have attempted to provide guidance on this vexed concept.42 A Chinese Circular43 essentially defines ‘beneficial owner’ as one who meets all the following four conditions:(1) a person has the right to own or dispose of the income and rights or property in the income; (2) a person who is usually engaged in a substantial business operation; (3) a person who is not an agent; and(4) a person who is not a conduit company.44

However, despite the opinions of experts and several court decisions, the meaning of beneficial owner has remained elusive.

IV. OECD meaning-revised discussion draft

The OECD released a revised discussion draft on October 19 2012. The OECD, after making additions and deletions to the first draft, arrived at the revised draft para 12.4 on meaning of ‘beneficial owner’ as below:

12.4 In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the recipient of the dividend is not the “beneficial owner” because that recipient’s right to use and enjoy the dividend 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 dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person. This type of obligation must be related to the payment received; it would therefore not include contractual or legal obligations unrelated to the payment received even if those obligations could effectively result in the recipient using the payment received to satisfy those obligations. Examples of such unrelated obligations are those 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 under the principles of paragraphs 6.8 to 6.34 of the Commentary on Article 1. Where the recipient of a dividend does have the right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person, the recipient is the “beneficial owner” of that dividend. It should also be noted that Article 10 refers to the beneficial owner of a dividend as opposed to the owner of the shares, which may be different in some cases.

The OECD in the revised draft has again given a negative definition of ‘beneficial owner’. However despite doing so, it has furnished an almost acceptable work. The revised draft states that the recipient of the dividend is not the “beneficial owner”, when the recipient’s right to use and enjoy the dividend is constrained by a contractual or legal obligation to pass on the received payment to another person. It has further clarified that the obligation can normally be ascertained from the legal documents and facts and circumstances, which show in substance that recipient does not have right to enjoy or use income unconstrained by obligation to pass on the payment.

Secondly, the obligation must relate to the payment received. Therefore, it would not include contractual or legal obligations unrelated to the payment received even if those obligations could effectively result in the recipient using the received payment to satisfy those obligations.

The OECD has placed the comments received on the discussion draft on its website. It might be interesting to peruse some of these comments. Avellum partners in their comments have stated that a fiduciary or administrator of income may be considered as a beneficial owner of such income, provided there is sound commercial reason for establishment of such entity. For example, entities established for public issuance of securities traded on recognised stock exchanges could be beneficial owners of income provided that operation of their establishment was required for access to the stock exchange for legal or regulatory considerations and not merely for tax economy purposes.46

Van Bladel has argued that to be a beneficial owner, the owner of an asset should also be its legal owner. Besides being a legal owner, it also should have sufficient degree of economic ownership. According to which,a legal owner will not be able to fully recover the value of its asset. In his opinion, this can be measured by the solvency rules of Basel II and Basel III, whereby, no beneficial ownership can be assumed if there is no solvency requirement. According to him, beneficial ownership can be assumed if there is a solvency requirement of 1.6 %, 8 % or 100 %. However, beneficial ownership will be debatable in the case of 0 % solvency.47

Regarding ‘facts and circumstances’ to be considered for ascertaining as to whether there is any contractual obligation or not, it is suggested that factors such as close dates of receipt and payments, similar amounts of receipt and payment, similar subject matter or same reference asset or currency,48 same counterparty of transactions, same or similar interest or rate of return, same duration of transactions, same amount or quantum of contracts etc should be considered.49 It is suggested further that the contractual obligation must exist before the receipt of payment and must be triggered only on receipt.50 Moreover, conduct and statements of the parties also should be taken in to account while considering ‘facts and circumstances’.51 As far as use of the word ‘substance’ is concerned, it is suggested that, it should be seen as ‘economic substance’ used in the anti-avoidance doctrine.52 It should also be examined as to whether recipient has gained risk and control over the payment.53

Maximum numbers of the comments are received on the use of word ‘related’ and ‘unrelated’. The commentators have found these words to be unclear and thus giving uncertainty to the proposed explanation of the concept. However, Vaan Raad in his comments has aptly explained these words by giving examples. He has stated that, normally a person (individual or company) receiving income also will have an obligation to make payments. For example, a salaried person may have contractual obligation to pay house rent. A bank receiving interest income on money lent by it is under contractual obligation to pay interest on money deposited with it. However, these obligations are independent of any particular receipt. This would be different if any particular receipt is earmarked by an obligation based on law or contract to be forwarded to another person.54

This can also be explained with the help of the concept of ‘diversion of income by overriding title’. The Indian Supreme Court explained this concept by holding that, Where by the obligation income is diverted before it reaches the assessee, it is deductible (being income diverted by overriding title) ; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law does not follow.55 (Words in the bracket are added). If this concept is applied to the ‘beneficial owner’, then it can be said that the recipient is not a ‘beneficial owner’ whose income is diverted because of the overriding (either legal or contractual) title. The payment made in consequence to such overriding title would be considered as a ‘related’ payment, whereas the payments of application of income would be considered as ‘unrelated’ payment.

The concerns of all would be adequately addressed if the OECD incorporated an explanation on ‘related’ and ‘unrelated’ payments on the above lines in its final version.

If we were to revisit the case law discussed here in light of the proposed clarification in the revised discussion draft, it may be seen that the decision of Indofood will hold good. However, the decision in the case of Bank of Scotland could generate discussion. This is because, the UK company RBS had already made upfront payment to a US company on acquisition of usufruct of shares of French subsidiary. Therefore, there was no legal or contractual obligation on RBS to make payment to the US company from receipt of dividend. Secondly, as mentioned earlier, this decision is rendered by following the doctrine of anti-avoidance and not considering attributes of beneficial ownership. In this case, beneficial-ownership test was not applied independently of the ‘abuse of law’ concept, but rather as a consequence of ‘abuse of law’ analysis.56 Further, RBS cannot be considered as an ‘agent ‘or ‘nominee’ or ‘conduit company’ of the US parent company. Yet, it is clear from the facts that, RBS cannot be considered ‘beneficial owner’ of the dividend.

Similarly, in Prevost shareholders had decided by agreement to distribute 80 % of profit. Other important facts of Prevost are that, the holding company in the Netherlands had minimum substance, and the directors in holding company and in the Canadian company were the same. Secondly, the intermediary company had only two shareholders; namely, Henleys and Volvo. Therefore, in substance, there is no difference between the company and shareholders, when shareholders had agreed to act in a particular way. Although the company is a different legal entity, it acts only according to the wishes of the shareholders. In these circumstances, the company is bound to follow the shareholder’s agreement. However, the Canadian court has not seen the facts this way. Probably because according to it, as expressed in the decision of Velcro, piercing of the corporate veil should be done as a the last resort.57

In Velcro 90 % of royalties were to be paid to the parent company within 30 days. The Canadian Court decided after elaborately discussing as to how the intermediary company was in ‘possession’, ‘use’ ‘risk’ and ‘control’of the payments and how it cannot be regarded as ‘agent’ or‘nominee’ or ‘conduit company’. Legally speaking, it is difficult to disagree with both the decisions. These decisions are also compatible with the revised draft as recipients’ right to use or enjoy is not constrained by obligation related to receipt. Most of the scholars and experts across the world find these decisions acceptable by following the legal approach. However, the ‘substance’ of the matter is quite different in both the cases.

This discussion highlights the apparent shortcoming of the revised draft as it does not explicitly address substance-over-form aspect, which is necessary to address the situation involving some of the tax–avoidance arrangements involving ‘beneficial owner’. The OECD addresses this aspect in para 12.4by stating that “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 dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person”.

Draft para 12.5 permits application of other approaches to counter anti-avoidance by stating that, “whilst the concept of “beneficial owner” deals with some forms of tax avoidance (i.e. those involving the interposition of a recipient who is obliged to pass on the dividend to someone else), it does not deal with other cases of treaty shopping and must not, therefore, be considered as restricting in any way the application of other approaches to addressing such cases.” However, it might be good if the OECD elaborates on such aspect for clarity and certainty.

V. India’s Law

Beneficial ownership is not a new concept in Indian law. It is used in the Income tax Act, 196158 and is also used in several non-tax laws such as the Companies Act 1956, Depositories Act 1996, Indian Trusts Act 1982 and Transfer of Property Act 1882.59

It may be noted thatthe concept of ‘beneficial owner’ in treaties is used with reference to the ownership of income and not with respect to the ownership of the underlying asset.60 Ownership of the underlying asset is not relevant for determining whether a person is a beneficial owner of income or not. However, Indian income tax law uses this concept with relation to the beneficial ownership of asset. Therefore, the majority of the disputes relate to issues in which formal legal ownership was not vested with the person because legal title was not yet registered in the official records in its name. In these circumstances, Court had to decide the dispute as to whether such person could be held as a beneficial owner or not for attributing income u/s. 2(22)(e) or granting depreciation or for taxing capital gain u/s. 2(45A).

The factors on which a person can be considered as ‘beneficial owner’ of the asset are different than whether a person can be considered as‘beneficial owner’ of income. Therefore, Indian domestic law is of no help in understanding the domestic law meaning of ‘beneficial owner’ of income. This is notwithstanding the position that the domestic law is not relevant for ascertaining the treaty meaning of ‘beneficial owner’.

A striking consequence emerges that a ‘beneficial owner’ may not be taxable under Indian tax treaties. This is because, presently, Indian income tax law u/s. 9 attributes income (interest and royalty for the purpose of beneficial ownership) to the non-resident recipient. However, the ‘beneficial owner’ remains out of the legal purview for its taxability. This can be explained with an example. Let us assume that entity X, resident of country ‘A’, advances a loan to an Indian entity through a conduit company, which is a resident of Country ‘B’, to access the more favourable India-Country B tax treaty. However, domestic law taxes interest payable by Indian residents to a conduit company but does not tax interest payable by conduit company to entity X in country A. As domestic law does not tax the beneficial owner, Indian tax authorities may not be in a position to invoke the India-Country ‘A’ tax treaty,with the result that India may have to tax only a conduit company and not the ‘beneficial owner’ because it is not taxable under domestic law. However, this position would work favourably for the taxpayer till the Income-tax Act is amended.

VI. India’s Tax Treaties

Most Indian tax treaties use the concept of beneficial owner to grant the benefit of reduced withholding taxes.61 Only the India-Australia tax treaty uses the expression ‘beneficial entitlement’. It is clear from the term ‘beneficial entitlement’ that it is a somewhat different concept than ‘beneficial owner’. The term ‘beneficial entitlement’ is concerned with the‘right to use and enjoy’ income and not concerned with its ownership.

Indian judicial decisions on beneficial ownership under domestic Income Tax law mainly pertain to beneficial ownership of shares and pertain to the ownership of an asset for eligibility of depreciation.In International taxation, the decisions are with respect to beneficial ownership of shares for taxing capital gains.62 In fact, Brian Arnold has questioned the application of the ‘beneficial ownership’ concept in the Indian cases on international taxation, when such a provision does not exist in the Article 13 of the tax treaty on Capital Gains.63

With regard to the nature of the Indian judicial decisions on beneficial ownership, Universal international Music BV was probably the first case in India, in which the issue of beneficial ownership was involved as provided in the tax treaty. The Courts had an opportunity to provide guidance on this difficult issue. However, that was not to be.

This article first appeared in the June, 2013 issue of Tax Planning International Review, published by Bloomberg BNA.

63Brian Arnold, Tax Treaty News, Bulletin for International Taxation, Vol 65(2011) no 2 PP 650-654. He has stated that “the taxpayer would likely argue that the absence of any express beneficial owner requirement in article 13 was intentional and it would, therefore, be inappropriate for a court to read such a requirement into article 13. It might be possible for a court to deny the benefit of article 13 of the tax treaty in these circumstances by applying a domestic anti-avoidance rule or by interpreting article 13 in accordance with paragraphs 7 to 12 of the OECD Commentary on Article 1 of the OECD Model (2010) to prevent abuse of the tax treaty. Both approaches are, however, problematic”.