On October 19, 2012, the Organisation for Economic Co-operation and Development ("OECD") released a revised discussion draft ("revised discussion draft") on the meaning of "beneficial owner" in Articles 10 (dividends), 11 (interest) and 12 (royalties) of the OECD Model Tax Convention on Income and Capital 1977 ("Model Tax Convention"). The revised discussion draft comes on the heels of the OECD's April 29, 2011 discussion draft ("2011 discussion draft") which was widely criticized by the tax community as being confusing and overly broad in its application. The OECD's revised commentary is an important development for multinational companies that are concerned about the taxation of cross-border payments of dividends, interest and royalties.
Under subsection 212 (1) of the Income Tax Act (Canada), a 25 percent withholding tax applies to various types of income (including dividends, certain kinds of interest and royalties) paid or credited, or deemed to be paid or credited to non-residents by a resident of Canada. Where a bilateral tax treaty is in force between Canada and the non-resident's country of residence, the 25 percent withholding tax rate may be reduced or eliminated.
Canada's bilateral tax treaties are based on the Model Tax Convention. The Model Tax Convention provides a lower rate of withholding tax on a payment made by a resident of one country to a resident of another country if the recipient is the "beneficial owner" of the dividend, interest or royalty. The term "beneficial owner", however, is not defined in the Model Tax Convention or in any of Canada's bilateral tax treaties. Furthermore, the Model Tax Convention does not specify whether a country should use its own domestic laws to interpret the term. This ambiguity has given rise to different interpretations by courts and tax administrations which can impact the tax effectiveness of certain transactions.
OECD Discussion Drafts
On April 29, 2011, the OECD released for public comment a discussion draft on the meaning of "beneficial owner" in Articles 10, 11 and 12 of the Model Tax Convention. In the 2011 discussion draft, the OECD stated that the recipient of a dividend is the "beneficial owner" of that dividend wherehe has the"full right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass the payment received to another person". It also stated that such an obligation will normally derive from the relevant legal documentation, but the facts and circumstances may also be relevant in showing that the recipient clearly does not have the full right to use and enjoy the income. The 2011 discussion draft was criticized as being far-reaching and adding further confusion and subjectivity to the interpretation of the concept of beneficial ownership.
In an attempt to address the concerns that were raised in response to the 2011 discussion draft, the OECD released a revised discussion draft on October 19, 2012.
Most of the comments received by the OECD on the 2011 discussion draft dealt the OECD's statement (quoted above) that the recipient of a dividend is a beneficial owner of that dividend where he has the "full right to use and enjoy the dividend…". A number of commentators suggested that the phrase could apply to a number of legitimate situations, such as the use of holding companies, the payment of a dividend by a subsidiary to its parent, the use income received to pay interest to a creditor and various financial products (e.g., repurchase or repo transactions and credit derivatives, including credit default swaps).
The revised discussion draft attempts to address some of the concerns raised in response to the 2011 discussion draft. For example, the "full right to use and enjoy" test has been amended to a "right to use and enjoy" test, as it was suggested that the use of the word "full" introduced uncertainty. The OECD, however, retained its statement that the recipient will not be a beneficial owner where he is "constrained by a contractual or legal obligation to pass on the payment received to another person". The OECD added that a contractual or legal obligation to pass the payment received to another person must be related to the payment received and would therefore not include contractual or legal obligations unrelated to the payment, such as obligations a recipient may have as a debtor or as a party to a financial transaction, or typical distribution obligations of pension schemes and of collective investment vehicles entitled to treaty benefits.
The revised discussion draft also retained the OECD's statement that an obligation may be found to exist on the basis of "facts and circumstances" which show "in substance" that the recipient does not have the right to use and enjoy the income.
Finally, the revised discussion draft addresses the OECD's statement in the 2011 discussion draft that the term "beneficial owner" should have "an autonomous treaty meaning" (in that it should not refer to any technical meaning that it could have under the domestic law of a particular country). The 2011 discussion draft noted that having an autonomous treaty meaning does not mean that the domestic law interpretation of "beneficial owner" is irrelevant for purposes of interpreting that term. This apparent contradiction created confusion and, in some cases, the perception that the commentary could be read as allowing a taxpayer to choose between the domestic law interpretation and the OECD interpretation. The revised discussion draft acknowledges the confusion that was created by this apparent contradiction and removes the statement that the meaning given to beneficial owner under the domestic law of a particular state could be considered.
Canadian Jurisprudence on "Beneficial Owner"
Recent Canadian jurisprudence on the meaning of "beneficial owner" provides guidance on the way in which Canadian courts have interpreted this concept. These decisions are important as they provide further clarification of the circumstances under which taxpayers may arrange for payments to be made to a company in a treaty jurisdiction without the loss of treaty relief for Canadian-sourced payments.
In The Queen v. Prévost Car Inc. ("Prévost Car"), the Canada Revenue Agency ("CRA") challenged the ability of a Netherlands holding company ("Holdco")to claim treaty benefits by arguing that Holdco was not the "beneficial owner" of dividends received from a Canadian corporation, thereby entitling the CRA to impose a 25% withholding tax rather than the Canada-Netherlands tax treaty rate of 5%.
The Tax Court of Canada ("TCC") and the Federal Court of Appeal ("FCA") ruled in favour of the taxpayer, finding that Holdco was the beneficial owner of the dividends. The TCC stated that the beneficial owner of dividends should be the person who receives the dividends for their own use and enjoyment and assumes the risk and control of the dividends received. Furthermore, the TCC stated that the corporate veil should not be pierced unless the corporation is merely a conduit for another person and has absolutely no discretion as to the use or application of funds that pass through it.
The TCC found that although Holdco had no physical office or employees, it was not a conduit and it was not in the position of having absolutely no discretion as to the use of funds. In affirming the conclusion of the TCC, the FCA noted the importance of using the OECD Commentaries as interpretative guides. However, while the FCA considered the meaning of beneficial owner in the 2003 OECD Commentary, the FCA noted that later OECD Commentaries should not be considered where they clearly conflict with the OECD Commentary in place at the time a treaty was negotiated or ratified.
The CRA was clearly not dissuaded by the decision in Prévost Car when it decided to pursue a similar line of arguments in the case of Velcro Canada Inc. v. The Queen("Velcro"). In the Velcro case, the CRA challenged whether a Dutch holding company ("VHBV") was the beneficial owner of royalties paid by a Canadian company, Velcro Canada Inc. ("Velcro Canada") A Dutch company ("VIBV") had assigned to VHBV the right to grant licenses to Velcro Canada in respect of VIBV-owned intellectual property immediately prior to VIBV becoming a resident of the Netherlands-Antilles. The issue at trial was whether VHBV was entitled to benefit from the treaty-reduced withholding tax rate under the Canada-Netherlands treaty.
At trial, the TCC referred to the meaning of "beneficial owner" of income that was adopted by the courts in the Prévost Car case as the person who receives the income for his or her own use and enjoyment and assumes the risk and control of the income he or she received. The TCC distilled four elements from Prévost Car to consider in determining where beneficial ownership lies: (a) possession; (b) use; (c) risk; and (d) control. The TCC also referred to the comments in Prévost Car that a court is not likely to pierce the corporate veil unless the corporation has "absolutely no discretion" with regard to the use and application of the funds.
The TCC concluded that the taxpayer demonstrated it was the beneficial owner of the royalties on each of the four elements. The TCC considered the following factors as relevant to this determination: the funds paid as royalties by Velcro Canada were deposited in an account owned by VHBV over which it had exclusive possession and control; VHBV had the legal right to receive the royalties from Velcro Canada; the funds were comingled with other monies in VHBV's accounts; VHBV converted the funds from Canadian to US dollars to pay VIBV; the money earned interest belonging to VHBV; VHBV did not have to seek instructions in dealing with the funds; and the amount of the royalty payments received from Velcro Canada differed from the amount paid by VHBV to VIBV. Applying the guidance found in the interpretations of the Model Tax Convention, the TCC then considered whether VHBV acted as an agent, nominee or conduit in respect of the royalties from Velcro Canada. The TCC concluded that VHBV did not have the capacity to affect the legal position of VIBV, and therefore was not its legal agent.
Fasken Martineau Commentary
The release of the OECD's revised discussion draft is an important development that multinational enterprises should be aware of. Since all of Canada's tax treaties limit access to the treaty-reduced withholding tax rates on dividends, interest and royalties to the beneficial owner of such payments, the revised discussion draft could affect the determination of the appropriate withholding tax rate on the payment of cross-border dividends, interest and royalties.
Unfortunately, the OECD has fallen short of providing sufficient clarification on the type of obligations that would mean that the recipient of a payment would not be considered to be a beneficial owner of that payment.
The revised discussion draft has retained the OECD's statement that the recipient will not be a beneficial owner where he is "constrained by a contractual or legal obligation to pass [on] the payment received to another person". This statement could, for example, impact the taxation of securities lending arrangements, which involve, on the one hand, the clear transfer of ownership of the securities to the borrower, but on the other hand, comprise an obligation for the borrower to re-deliver an equivalent amount of the same kind of securities to the lender (along with compensation for any yield which the securities have generated).
Furthermore, the OECD has retained the statement that an obligation to pass on the payment to another person may not only derive from the relevant legal documents but also from the "facts and circumstances" that show that the recipient does not have the full right to use and enjoy the payment. By stating that "facts and circumstances" should be taken into account, the discussion drafts diverge from the general prior understanding, and the conclusion of the Canadian courts in Prévost Car and Velcro, that the recipient corporation that is the legal owner is also the beneficial owner of the dividends unless it is a nominee, agent or conduit. This broader subjective interpretation could lead to tax authorities using the meaning of beneficial ownership as a tool to combat tax avoidance, allowing them to attack international holding companies in circumstances that appear abusive, and thereby introducing significant uncertainty for multinational enterprises.
Finally, the proposed new wording creates further confusion by introducing the concept of related and unrelated payments without an explanation of what it means for a payment to be related or unrelated. While the OECD provides a few examples of what might constitute an unrelated payment, the revised discussion draft does not explain what it means for a payment to be related or unrelated. International businesses would benefit from more specific guidance regarding what it means for a payment to be related or unrelated in order to structure transactions with confidence and certainty.
The OECD has invited the public to submit comments on the discussion draft before December 15, 2012, for review in February 2013. However, the OECD states that it is not seeking comments on the substance of its proposals but rather on drafting issues only. This likely means that any future changes as a result of the consultative process will be modest.