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Background

The concept of “beneficial ownership” (BO) plays a crucial role in determining whether a recipient of income qualifies for certain benefits under the Double Taxation Avoidance Agreement (‘DTAA’).

It is quite significant from international taxation perspective as a significant number of tax treaties adopt the condition of BO for granting concessional treatment to a resident of another country; in particular, when it comes to articles dealing with dividend, interest, royalties.

BO under tax treaties is a specific anti-abuse rule incorporated to target specific instances of tax treaty shopping involving the use of agents/ nominees/ conduits i.e. entities which act as mere administrators or fiduciaries of income and have no substance of their own.

From Indian perspective, the concept of BO has gained even more relevance with the abolishment of dividend distribution tax on companies whereby the dividend is now taxable in the hands of the investors with effect from 1 April 2020. The tax rate for a non-resident prescribed under section 115A of the Income-tax Act, 1961 (‘Act’) is 20% (plus applicable surcharge and health and education cess) while many India’s tax treaties typically provide a tax rate of 5-15% subject to BO and certain other shareholding related conditions. Thus, foreign investors exploring to avail benefit under the tax treaty would be required to fulfil the BO criteria.

To understand the methods for evaluating BO, it is imperative to first discuss the evolution of the concept in international tax arena.

Evolution of the concept of BO in tax treaties

The concept of BO was first envisaged in the US-Canada tax treaty of 1942 and has evolved over time.

The expression ‘beneficial owner’ has not been defined under the tax treaties or the Act and must therefore be interpreted based on general commercial understanding, tax commentaries and judicial precedents in this regard.

The Model Commentaries (MC) to the tax treaties and leading international tax lawyers have commented that the term has to be given a purposive interpretation (viz. prevention of tax avoidance) and persons not entitled to treaty protection are to be prevented from obtaining benefits there under by interposing entities between the ultimate beneficiary and the payer.

Further, in evaluating the concept of BO, one has to take cognizance of the ‘substance’ of the transaction and not its ‘form’ duly considering all relevant facts and circumstances. In other words, the meaning of the term “BO”, should be understood in a commercial or general parlance.

Definitions of beneficial owner

With regards to the term ‘beneficial owner’, as per Black’s Law Dictionary[1], the said term is defined as “one recognized in equity as the owner of something because use and title belongs to that person, even though legal title belongs to someone else.”

Law Lexicon defines ‘beneficial owner’ as “one who, though not having apparent legal

title, is in equity entitled to enjoy the advantage of ownership.”

As per Prof Klaus Vogel, among other factors, the issue of control is the most important factor in deciding the BO. Beneficial owner is the person who is free to decide:

• Whether or not the capital or other assets should be used or made available for use by others; or
• On how the yield there from should be used; or
• Both

Further, Klaus Vogel in his commentary[2] also states that “….even a one hundred per cent interest in a subsidiary does not preclude the latter’s ‘beneficial ownership’ in the assets held by it. There would have to be other indications of the fact that the subsidiary’s management is not in a position to make decisions differing from the will of the controlling shareholders. If it were so, the subsidiary’s power would be no more than formal and the subsidiary would, therefore, not qualify as a “beneficial owner” within the meaning of Arts. 10 to 12.”

Reference from treaty commentaries

The OECD MC[3], in relation to the ‘BO’ was substantially amended in 2014. The key highlights of the commentary in relation to BO are as under:

• The meaning of “beneficial owner” should be interpreted as not to refer to any technical meaning that it could have had under the domestic law of a specific country, but it must be understood in light of context and purpose of the tax treaty.
• In addition to agent and nominees, conduit companies do not satisfy the status of BO.
• It is considered that a direct recipient of income may not qualify as a “beneficial owner”, if from the very inception of his status, that recipient’s right to use and enjoy the income is constrained by a contractual or legal obligation to pass on the payment received to another person.
• Reference has been made to the “related” and “unrelated” obligations. In case where the recipient has specific obligation to pass on the income received, such factor is relevant to the BO test.
• The obligation may be inferred from legal documents or facts and circumstances of the case.
• The concept of BO and other forms of anti-avoidance principles are applicable simultaneously since BO addresses specific forms of tax avoidance.

Reference from domestic and international Judiciary

Key Indian judicial precedents/ circulars etc. in the context of BO are set out below:

Circular No. 789 dated 13 April 2000 issued by the Central Board of Direct Taxes (CBDT) in the context of the Treaty provides that a Tax Residency Certificate (TRC) issued by the tax authorities of a country would be regarded as conclusive evidence regarding residential status and BO of the income earned by Mauritian entities. The validity of the above Circular has been confirmed by the Supreme Court in its decision in the case of Union of India v Azadi Bachao Andolan[4].

In Bharti Airtel Limited[5], the issue before the Income Tax Appellate Tribunal (ITAT) was whether benefit of Article 11 of the India-Sweden tax treaty would be available when interest was paid to an ‘arranger’ of loan (ABN Amro Bank, Sweden) instead of the actual lender. The ITAT held that the provisions of Article 11 shall not be applicable since the arranger is a mere conduit for onward payment to the actual lenders. Even though the arranger produced a TRC to establish their residency in Sweden, the interest received by the arranger was not in its own right but merely as a facilitator and thus the arranger is not the beneficial owner of the interest income.

In HSBC Bank (Mauritius) Ltd.[6], in context of BO of interest income, the ITAT adjudicated the following:

“Considering the above, we infer that the ‘beneficial owner’ can be the one with the full right and the privilege to benefit directly from the interest income earned by the FII-Bank (Indo-food International Finance Ltd vs. J.P. Morgan Chase Bank NA London Branch [2006] EWCA case 158). The income must be attributable to the assessee for tax purposes and the same should not be aimed at transmitting to the third parties under any contractual agreement / understanding. The bank should not act as a conduit for any person, who in fact receives the benefits of the interest income concerned. The recipient of the interest income should be deemed as the ‘beneficial owner’ unless there is any evidence to suggest that the said interest income is for the benefit of third persons.”

• In the case of Golden Bella Holdings Ltd[7], ITAT held that the mere fact that the investment was funded using a portion of an interest free shareholder loan shall not deprive the Cyprus entity from enjoying the concessional rate of 10% withholding taxes as per Article 11 of India-Cyprus treaty. It was held that the Cyprus entity is not a conduit to be subject to tax at 42% but a beneficial owner of interest income.

Key international judicial precedents in the context of BO are mentioned below:

• The Canadian Court in the case of Prévost Car Inc. v The Queen[8]concluded that beneficial owner is the person who receives dividends for his own use and assumes the risk and control of the dividend and is not accountable to anyone for how he deals with it. However, where the person receiving the dividend is obligated to pass on such dividends to a third party, such a person would not be considered as a beneficial owner of the dividends.

This decision reaffirms the principle that while examining BO rule, the corporate veil of the entity earning income should be respected unless the corporation is a conduit and has no discretion to deal on its own with the property put through it as a conduit or is acting as an agent, trustee or nominee of its shareholders.

A similar view is taken by the Canadian Court in the case of Velcro Canada v The

Queen[9].

• The UK Court of Appeals in the case of Indofood International Finance Ltd. v JPMorgan Chase Bank NA, London Branch[10] held that an interposed entity between the beneficiary and the ultimate payer with a back-to-back debt obligation would not qualify as the beneficial owner of such interest income. The UK Court of Appeals arrived at its conclusion on the application of the ‘substance over form’ approach.
• The Federal Administrative Court of Switzerland[11]while determining the BO of dividend under DTAA between Switzerland and Denmark, held that the concept of BO as stated in double tax convention, has to be interpreted based on ‘substance over form’ approach. The beneficial owner is defined as a person who has broad discretion to decide how dividend shall be utilised. In the facts of the said case, the Federal Administrative Court observed that, although the taxpayer had a duty to compensate the counterparty of a total return swap for the appreciation of the underlying shares, including dividend payments distributed during the maturity of the derivative, the total return swap did not include any contractual obligation for the taxpayer to hedge its position with the acquisition of the underlying assets. The Court then observed that there was no factual obligation to transfer any dividend income to the counterparty, as the taxpayer was only obliged to pass on an amount equal to the dividend, irrespective of whether it had effectively received a dividend payment. Hence, the fact that the taxpayer, by hedging its exposure from the total return swaps, was able to use the dividends for other purposes played a crucial role in strengthening the BO. The Federal Administrative Court further clarified that the effective holding period of the shares has no impact on the BO.

However, it is pertinent to note that in respect of the above decision, on further

appeal by the Swiss Federal Tax Authority (SFTA), the Federal Supreme Court (FSC)[12] reversed the decision of the Federal Administrative Court and upheld the view of SFTA. The FSC observed that there also is an implicit BO requirement in treaties that do not explicitly mention BO. BO requires, as a first element, that at the time of receiving a dividend, the recipient of a dividend has an unconstrained right to use, enjoy and dispose of the dividend received. If the recipient has a (legal or factual) obligation to pass on the dividend received to a third party under a derivatives contract, BO is denied.

Furthermore, the beneficial owner must bear the economic risk of whether a dividend is distributed or not. Where such risk is passed on to a counter-party to a derivatives contract, BO is denied. The derivatives contracts entered into by the Danish banks were accurately matching their investment in the underlying, both in volume and timing. The derivatives were entered into when the underlying shares were acquired and were terminated when the shares were sold. At the time when the dividend was received by the Danish banks, they had an obligation to pass it on to third parties under the total return swap or futures contracts, so that both the risks and rewards of the investment in the Swiss shares were substantially with the third parties and not with the Danish banks, which made only a small profit from these transactions.

Factors for determining BO – The PURC Matrix

Based on the meanings and judicial decisions discussed above, the PURC (Possession, Use, Risk, Control) matrix is a widely regarded test of BO. The elements of the PURC matrix need to be cumulatively fulfilled in order to satisfy the BO condition.

A brief discussion on each element is tabulated below:

Possession

This refers to possession of income which is substantiated by factors like receipt of income, exercise of dominion over income and property and valid economic, commercial purpose for the transaction.

Further, the recipient should not be acting as a mere conduit, nominee or agent.

Legal ownership, ultimate control and holding period of shares are irrelevant factors for fulfilling this element

Use

The recipient must have full right to directly benefit from the income and must be free to decide the manner of using the income so earned i.e. there should not be any contractual/ legal obligation to pass the income so earned

An adverse factor denoting lack of use by the recipient is that the right to use and enjoy is constrained by interdependency between obtaining an income and an obligation to pass it on.

Risk

The recipient must bear the business risk of the income in order to satisfy this element of the matrix. The recipient must be the economic owner i.e. he must bear the consequences of loss as well as enjoy the fruits of income. Further, his liability towards creditors must not be affected by lack of receipt of the income.

Any contractual agreement to pass on the risk of bad debt, loss, exchange fluctuation is indicative of lack of risk of the recipient.

Control

The recipient must retain full control over the income. Even in absence of explicit contractual agreements, the Revenue Authorities have regarded common Board of Directors (between the recipient and the alleged beneficial owner) as a sufficient factor for determining that the recipient does not have control over the income.

However, merely because of a holding-subsidiary relationship, it should not be assumed that the subsidiary company does not retain control of the income.

Based on the above, it can be concluded that the evaluation of BO is a highly fact specific exercise and there is no one-size-fits-all approach for the evaluation.

Way forward – Is evaluating BO a Pandora’s box?

The evaluation of BO requires a careful study of the facts of the case and is an evolving matter in the courts of law. For instance, as discussed above, in some cases Revenue Authorities have held that merely having a common director leads to non-fulfilment of the ‘Control’ element; however, having common directors across group entities is a normal business practice and driven by commercial considerations – all of which are seldom considered by the Revenue Authorities.

Given the recent amendment on taxation of dividends in the hands of the investors, the BO test would be required to be fulfilled by foreign investors seeking to avail tax treaty benefits for such dividend income. Thus, litigation around the overall concept of BO may increase.

Also, the determination of BO will be a time-consuming activity, both for the Assessing Officer (in terms of understanding complex multinational group structures and applying the concept of BO) and the taxpayer (in terms of collating documentation). Similar to approach adopted under GAAR, the Indian Revenue Authorities should release a guidance on the BO to provide certainty on the matter.

Chartered Accountants are also required to issue certificate in Form 15CB certifying applicability of beneficial rate under DTAA which will include satisfying the BO test. CAs must ensure that there is adequate documentation on record to substantiate that the foreign investor is indeed fulfilling the BO test. Where BO has not been evaluated, it would be a worthwhile exercise to undertake the same before certifying applicability of beneficial rate under DTAA.

One can equate BO test as being akin to Pandora’s box – once it is opened i.e. BO is evaluated, it can bring upon unexpected troubles and hurdles to the taxpayer in the form of never-ending litigation. That being said, just like Pandora’s box, there does remain ‘hope’ – that the tax authorities are able to provide clarity around the issue to promote Ease of doing business in India instead of resorting to frivolous litigation!

Background

In order to implement the Base Erosion and Profit Shifting (BEPS) Action Plans, the Organisation for Economic Co-operation and Development (OECD) released the text of the Multilateral Instrument (MLI) in November 2016 to implement treaty related BEPS measures into more than 3000 existing treaties in a synchronised and swift manner.

India became a signatory to the MLI at the Paris conference on 7 June 2017 and deposited its ratified instrument with the OECD Depository on 25 June 2019, thus seeking to modify its Double Taxation Avoidance Agreements (DTAAs). The DTAA modified by the MLI is referred to as a Covered Tax Agreement (CTA).

It is pertinent to note that the MLI is not akin to a Protocol i.e. it does not directly amend the text of the CTA but has to be read alongside the existing CTAs. Further, the MLI does not modify all the CTAs in the same manner. Each MLI signatory is free to choose to apply provisions of the MLI (except minimum standards) and the list of each signatory’s position on each provision should be submitted with the OECD at the time of depositing the ratified instrument.

Need for synthesised text

As countries can choose the MLI provisions which they want to incorporate in their CTAs, one will need to consider the following documents while evaluating the impact of MLI on a specific provision of the CTA:

1. The text of the CTA along with the Protocol (if any);

2. The text of the provision(s) of the MLI; and

3. The list of notifications and reservations submitted by both the parties to the OECD.

For instance, to evaluate the impact of Article 8 of the MLI (dividends) on the existing India- Slovak Republic CTA, one will be broadly required to follow the below steps:

• Check whether India and Slovak Republic are signatories to the MLI
• Check whether India has notified Slovak Republic in its list of covered CTAs
• Check whether Slovak Republic has included India in its list of covered CTAs
• Refer India’s ratified instrument to check whether it has opted to apply Article 8 of MLI for its CTA with Slovak Republic
• Refer Slovak Republic’s ratified instrument to check whether it has opted to apply Article 8 of MLI for its CTA with India

Where the answer to all the above steps is in the affirmative, Article 10 of the India- Slovak Republic CTA will stand modified by Article 8 of the MLI.

Needless to say, to undertake the above exercise for each Article of each CTA is highly cumbersome and tedious and increases the risk of errors while determining taxability and rates. This gave birth to the need of a comprehensive document providing the existing CTA along with the modifications made by the MLI – a Synthesised Text.

Meaning of Synthesised Text

The dictionary meaning of the word synthesis is “the combination of components or elements to form a connected whole”. This is what the synthesised text of a CTA does – it combines articles of the CTA and the modification proposed by the articles of the MLI.

In the synthesised text, the provisions of the MLI that are applicable with respect to the provisions of the CTA are included within “boxes” throughout the text of the CTA in the context of the relevant provisions of the CTA.

On 14 November 2018, the OECD released a “Guidance for development of synthesised texts” to provide suggestions to MLI signatories for the development of synthesised texts in order to facilitate the interpretation and application of modification proposed by articles of the MLI to the respective CTAs.

To ensure clarity and ease of reference on application of MLI, it is imperative that the synthesised texts of each CTA are as consistent as possible. Thus, the OECD Guidance also suggests sample language that may be included while preparation of synthesised texts.

Key features of synthesised texts as per the OECD Guidance

1. Not a legal document

The purpose of synthesised texts is primarily intended to facilitate the understanding of the MLI. For legal purposes, the provisions of the MLI must be read alongside Covered Tax Agreements as they remain the only legal instruments to be applied.

The synthesised text does not constitute a source of law and cannot be construed as a legal document admissible in a court of law.

2. Form of synthesised text

To be prepared in the form of a single document or webpage, the synthesised text would reproduce (a) the text of CTA (including the texts of any amending protocols or similar instruments), and (b) the provisions of the MLI that will modify that CTA in the light of the interaction of the MLI positions both the parties have taken.

Synthesised texts would also include explanatory information, including information on the entry into effect of the relevant provisions of the MLI.

Synthesised texts would thereby make it much simpler to understand the effects of the MLI and the way it modifies each CTA.

3. Prepared qua each CTA

Before developing synthesised texts, each MLI signatory is encouraged to integrate the effects of any existing amending instruments or protocols into the CTA.

4. No legal obligations on countries to develop synthesised texts

MLI signatories are not legally obligated to prepare synthesised texts for each of their CTAs and such synthesised texts are not a pre-requisite for application of MLI to the CTA.

5. No legal obligation on countries to consult each other while preparing synthesised texts

While there is no pre-requisite for countries to consult each other for preparing synthesised texts, the OECD encourages countries to do so. This is a good administrative practice and will help to ensure a consistent interpretation of the application of the MLI’s provisions to each Covered Tax Agreement.

When a synthesised text is prepared in consultation with the CTA partner, the following text is added to the synthesised text of the CTA:

“This document was prepared jointly by the Competent Authorities of Country A and Country B and represents their shared understanding of the modifications made to the Agreement by the MLI.”

This does not dilute the fact that the synthesised text is for understanding purpose only and not the legal document. Thus, the legal value of a unilateral or a bilaterally prepared synthesised text remains the same i.e. Nil.

Issues in unilateral synthesised texts of India-Japan CTA

On 23 August 2019, the Japan Ministry of Finance released the unilateral synthesised text of the India- Japan CTA and subsequently, on 4 September 2019, India’s Cen Japan CTA.tral Board of Direct Taxes (CBDT) released their unilateral synthesised text of the India-

Given that India and Japan have prepared separate synthesised texts without consultation with each other, it has resulted in inconsistent interpretation of the compatibility clauses of two provisions by India and Japan. The analysis of the discrepancies is provided below:

1. Discrepancy in Article 12(1) of the MLI

12(1) – Dependent Agent PE [seeking to modify Article 5(7)(a) of the India- Japan CTA]

India has not deleted the text of Article 5(7)(a) of the India – Japan CTA and has stated that Article 12(1) applies to Article 5(7)(a).

Japan has deleted the text of Article 5(7)(a) of the India – Japan CTA and has stated that Article 12(1) replaces Article 5(7)(a).

A combined reading of the compatibility clause of Article 12(1) and Article 12(5) states that the MLI provision shall apply “in place of” the existing clause in the CTA i.e. Article 12(1) shall replace the Dependent Agent PE provision in the CTA

Japan’s interpretation on applicability of Article 12(1) seems to be the correct interpretation of the compatibility clause of Article 12(1) of the MLI provisions.

2. Discrepancy in Article 17(1) of the MLI

17(1) – Corresponding adjustment [seeking to modify Article 9(2) of the India- Japan CTA]

India has deleted the text of Article 9(2) of the India – Japan CTA and has stated that Article 17(1) replaces Article 9(2).

Japan has not deleted the text of Article 9(2) of the India – Japan CTA and has stated that Article 17(1) applies to Article 9(2).

Japan has notified Article 9(2) of the India- Japan CTA to be modified by the MLI whereas India has not notified Article 9(2) of the India- Japan CTA. In such a scenario, as per Article 17(4) of the MLI, Article 17(1) shall apply and supersede the existing Article 9(2) of the India- Japan CTA only to the extent such clause is incompatible with the MLI provision.

In light of the above, India’s interpretation that Article 17(1) shall replace Article 9(2) may not be the correct interpretation. Further, Japan’s interpretation that Article 17(1) applies to Article 9(2) also seems to be incomplete since the synthesised text does not mention that the changes proposed by MLI shall be applicable only to the extent of incompatibility.

One may note that the above discrepancies do not have any legal ramifications in absence of the synthesised text being a binding legal document.

Way forward

With effect from 1 April 2020, the impact of MLI is to be considered in some of India’s key tax treaties – with Singapore, United Kingdom, Japan, Netherlands, France etc. and the list will only increase in the years to come. While the synthesised text captures articles of the CTA and the modification proposed by the articles of the MLI in a single document, one cannot rely on it in the Courts since it is not a legally binding document.

Use of synthesised text can be regarded as akin to looking up a legal query on the Google search engine- while it is good as a reference point, one cannot merely rely on the results produced by the search engine to give a legal opinion.

Similarly, while evaluating the impact of MLI, the synthesised text can be a good starting point but should always be backed up by comprehensive reading of the text of the CTA, the protocol(s) to the CTA, the text of the MLI and the positions adopted by both the Contracting Jurisdictions to arrive at the accurate answer.