In six simultaneous decisions issued on 26 February 2019 which are relevant for any international group structure, the European Court of Justice (ECJ) has looked at the interpretation of the concept of beneficial ownership and the identification of abuse of law in the context of entitlement to exemption under the Interest and Royalties Directive (IRD) and the Parent Subsidiary Directive (PSD). The cases involved payments of dividends or interest to associated companies in EU member states which were ultimately owned by non-EU entities.
Entitlement to an exemption from withholding tax under the IRD will only be available where the beneficial owner of the interest paid is established in another member state. The PSD does not include an explicit beneficial ownership requirement but the referral to the ECJ raised similar concepts in respect of when an intermediate holding company can properly be regarded as having received a dividend from its subsidiary. If the conditions are not satisfied, a withholding tax obligation may arise, making the group structure ineffective in tax terms.
In considering entitlement under the IRD, the ECJ states that, to be the beneficial owner, the entity receiving the interest payment must actually benefit from the interest economically and must be able to freely determine the use to which it is put. The concept of beneficial ownership which appears in bilateral tax conventions based on the OECD Model and, importantly, in the successive amendments to that model and to the commentaries is relevant when interpreting the IRD. It follows from this that the OECD commentary in respect of conduit companies is relevant and that a mere conduit without economic ownership and control (as identified in the OECD commentary) will not meet the requirements for beneficial ownership.
The ECJ decisions represent quite a shift from the Opinions of Advocate General Kokott issued in March 2018 which had supported the taxpayer, particularly in terms of the discussion of beneficial ownership. These had suggested that the concept of beneficial ownership under EU law needed to be interpreted autonomously and independently of the interpretation offered in the OECD Model treaties and commentaries, suggesting scope, at least, for divergence of requirements. The ECJ’s decisions provide for much greater alignment. A group hoping that there is a lower hurdle when looking at claiming benefits under the EU Directives rather than a tax treaty is likely to be disappointed. Groups with income flows relying on an EU Directive for withholding tax exemption should review their structure to check it is BEPS and ECJ compliant.
Abuse of law: artificial arrangements
The ECJ also considered questions which go to whether the exemptions under the IRD and PSD should be denied on grounds of abuse of law. This requires an intention to obtain a tax advantage by artificially meeting the qualifying conditions under the Directive. Case law has previously acknowledged that the required level of intention can be present if the arrangement is put in place with the “essential aim” (not only the “sole aim”) of obtaining a tax advantage. The ECJ sets out the test as being that “the principle objective or one of the principle objectives” of the arrangement is to obtain the tax advantage. The concept of “one of the principle objectives” may allow for a broader interpretation of what constitutes abuse.
The decisions discuss artificiality and the use of conduits. Identification of artificial arrangements involving conduits is discussed specifically. In addition to a conduit company’s obligation (contractual or in substance) to pass the payment received on to a third party or it otherwise not having the right to use and enjoy those sums, a number of factors are identified as indicative that an entity is a mere conduit. These factors look to the absence of economic justification or activity and are familiar from discussions of substance in other areas of tax law. Factors identified by the ECJ as indicative of the absence of actual economic activity include: the management of company, its balance sheet, its costs and expenses, staffing and premises and equipment. It has generally been accepted that levels of staffing, premises and equipment may be low for a passive holding or financing company as long as it has sufficient substance to carry on its limited activities. The key questions for artificiality have focussed on whether the holding company has the right to enjoy and use the income received and to make key management decisions necessary for its activity. It is unclear whether these new ECJ decisions suggest that this should now be construed more broadly.
Establishing the abuse of rights
In order to establish the abuse of rights, the tax authority has to show that the company to whom the payment has been made is a mere conduit and is not the beneficial owner. The tax authority does not have to look up the chain to identify who the beneficial owner is and, in particular, does not need to establish whether or not the beneficial owner would have been entitled to treaty exemption (although evidence that it would benefit might suggest that the group’s structure is unconnected with abuse of rights).
Where does this leave us?
The requirement for substance is a theme running through a number of the OECD’s BEPS (Base Erosion and Profit Shifting) Actions and the decisions echo this. It is a particular focus of the final Action 6 report which looks at treaty abuse and introduces a number of new minimum standards designed to counter treaty shopping. These have already been adopted by many jurisdictions under the Multilateral Instrument and are being introduced bilaterally in other double tax treaties. Many asset holding or financing companies will be relying on treaty relief and will already be aware of these changes. The OECD’s work on transfer pricing also has a focus on establishing substance (or DEMPE functions) in order to support transfer pricing positions and so again, for many IP holding companies which have taken steps to reinforce their substance, these decisions will not impose any additional burdens. The key message seems to be that entities that would not meet the beneficial ownership requirements under the OECD Model treaty cannot be sure to obtain exemption under the IRD or PSD. Any residual hope that that the EU would permit a lower hurdle to be satisfied has evaporated.