January 2012 (117) – Combatting Double Non-taxation

Dear Reader

I trust that by the time you read our first Newsletter of the year, the Christmas excesses will be a distant memory and 2012 will have started in full earnest – with positive prospects in sight. For IFS, this is our 40th January and we are as keen to help our Clients in their international business development as when I first started in 1972.

By way of advanced warning in the form of ‘save the date’, we have three events currently in the planning process. The first is a golf day to be held in conjunction with Barclays Wealth on 17th May (very limited spaces available I’m afraid, but do let me know if you are a keen golfer).

The second is a week later in Geneva on 24th May which IFS will be hosting together with Memery Crystal LLP on alternative financing techniques available in London including listing possibilities on AIM and the main exchange, together with other techniques such as the use of Retail Bonds. And the announcement this week of London wishing to become the leading international centre for trading the yuan, China’s currency, could make the UK the gateway for Asian banking and investment in Europe, according to the Chancellor George Osborne. The presentation will also cover the relatively recent advantageous corporate tax regime for UK companies including the substantial shareholders’ exemption and the participation exemption for dividends. Please let me know if you would like an invitation to this.

The third event is in fact the Third Annual ITSAPT Conference which will be held on 8thNovember at the Landmark Hotel London (as for the last two years) and will be on the topic of Structuring International Real Estate Transactions. As always, speakers will be attending from all over the world including China, Singapore, India, Canada, the US, Brazil and many European countries. We will be reviewing specific case studies illustrating the problems and opportunities arising from real estate, whether it be the acquisition of private homes or the development of commercial and residential property. This conference will again be sponsored by Barclays Wealth and we are very privileged to have Kevin Gardiner (Managing Director and  Global Investment Strategist at Barclays Wealth) presenting a short session on property investment opportunities in Asia. More about this in subsequent newsletters.

Our international tax article this month is on a new initiative from the European Commission on tackling the perceived problem of double ‘non-taxation’. Over the past three decades, countries have tackled the issue of tax avoidance at source where the individual or corporate recipient is also able to avoid taxation through what these countries perceive as artificial structures. Nowhere is this a concern more than in the US, which has progressively tackled the problem of conduit companies and the requirement for beneficial ownership through Revenue Rulings and ‘Limitation of Benefits’ provisions incorporated into double tax treaties. Now the European Commission is advocating a more unified approach amongst EU countries to prevent what the EC terms as loopholes being exploited so that taxation is payable neither at source nor residence. Definitely a ‘watch this space’ subject but one that our readers need to know about to understand the scope of these new recommendations.

I wish you an enjoyable, successful and above all healthy 2012.

Roy Saunders


Readers of this newsletter have perhaps grown accustomed to hearing about double taxation. It is universally deemed undesirable — by States, which find that it hinders international trade, but also by taxpayers who are justified in not willing to pay a double amount of tax. What receives much less attention but remains nevertheless one of the key concepts shaping international tax policies is doublenon-taxation, that is, when a taxpayer pays no tax at all in respect of income and capital gains.

To illustrate this, a trust or foundation which is cash rich may wish to lend money to a related company for its trading activities. It does so by incorporating a company in a double tax treaty jurisdiction with the source State so that the relevant withholding tax on interest payable to such a foreign creditor is exempt under the treaty. The company is able to pay all or virtually all of its interest receivable to the trust or foundation without any further tax obligations. Thus there is double non-taxation.

Or the trust or foundation wants to invest in real estate in the source State by incorporating a company in a tax treaty jurisdiction which prevents the source State from taxing the potential capital gains on a sale of the company’s shares, and again there is no other tax obligations existing to prevent double non-taxation.

The European Commission has now addressed this issue in a communicationdated November 11th 2011 and also in this publication.. The Commission considers that both double taxation and double non-taxation contradict the very spirit of the Single Market and should be addressed through taking practical measures. The end result sought by the Commission is to remove real obstacles to a more competitive economy and make the EU easier to invest in and in which to conduct business. Regarding double taxation, the Commission acknowledged that it has already been addressed at the EU level, albeit insufficiently and not always effectively, and identified a number of possible remedies that it will seek to apply.

What yet remains uncertain, however, is what measures will be taken to address double non-taxation. The Commission merely indicated its intention to launch a fact-finding consultation procedure in order to establish the full scale of this phenomenon and to use its results to identify and develop the appropriate policy response. The outcome of the consultation may severely impact international tax planning opportunities available to taxpayers operating in the EU or dealing with EU-resident taxpayers. One may speculate on what direction the EU-wide measures will take by looking at how the US targets similar arrangements undertaken to avoid US taxation at source. We can look at two strategic anti-avoidance measures, the Conduit Financing Regulations and the Limitation of Benefits Provisions.

Conduit Financing Regulations

The standard US withholding tax rate on interest payable to US non-residents is 30%, unless minimised by double tax treaty provisions. For many years the IRS has targeted double non-taxation resulting from conduit finance arrangements that stem from the interposition of an entity in an appropriate double tax treaty regime which denies the right of the US to levy such withholding tax. For example, in the well-known Aikens Industries case, an intermediary Honduran recipient of interest was disregarded by the tax court as a result of lack of relevant ‘dominion and control’ over the income receivable. The courts stated that it is not sufficient merely to have an interest rate differential to validate the commerciality of an intermediary finance company, but that such companies should exist for commercial reasons other than the mere reduction of US withholding taxes.

Thus to enable a conduit entity to benefit from withholding tax exemption, or other US tax benefits, it should be established that there are sufficient business reasons for the existence of the company. Reasons put forward as acceptable are accessibility to foreign financial markets and shareholders’ funds, and the avoidance of burdensome regulatory requirements of US corporate or tax law.

Present conduit financing regulations against multi-party conduit financing arrangements were published by the IRS as long ago as August 1995. These final regulations serve to disregard treaty-based intermediary financing companies for US withholding tax purposes where the intermediary’s participation in the arrangement is pursuant to a plan of which one of the principal purposes is the avoidance of US withholding tax, and otherwise lacks a legitimate business purpose. However, the regulations are not as extensive as originally feared, as follows:

·      the intermediary must be related to the financing or financed entity, which means that the relevant parties must have more than 50 per cent ownership, directly or indirectly;

·      tax avoidance must be the motive, and this is generally indicated if the intermediary could not have funded the US recipient without the initial loan from the financing entity, and moreover if the intermediary requires interest receipts in order to meet its interest paying obligations to the financier. Tax avoidance will be deemed to exist where the receipt of funds in the intermediary and the onward transmission of these funds to the US company both take place within a relatively short period, considered 12 months in this instance;

·      tax avoidance will not be deemed to arise if the intermediary is engaged in an active business, or if it undertakes significant activities in respect of the financing arrangements, which will involve the intermediary in having employees in the country of its residence who perform significant activities.

Back-to-back arrangements or parent company guarantees to unrelated parties may also invoke the conduit financing regulations. What is noteworthy is that intermediaries engaged in active business will be exempt from the regulations. We have been advising clients for many years that any entity within a group structure has to have the relevant degree of substance required for its activities in order to benefit from double tax treaty provisions, and this is a criterion which the Commission may well adopt in its quest to judge the acceptability or otherwise of double non-taxation issues.

Limitation of Benefits provisions

Limitation of Benefits provisions (LOB) are another example of US anti-treaty shopping legislation, related to inward and outward investments. The first LOB clause was introduced into a renegotiated US/Netherlands double tax treaty in 1996 and will explain the US focus generally on preventing the use of double tax treaties to mitigate US tax revenue. Article 26 of that treaty, the LOB article, must be the longest article in the history of double tax treaties, extending to eight and a half A4 pages. In summary, it attacks the problem of treaty shopping through two principal tests: the Stock Ownership Test and the Base Erosion Test. There are also three alternative tests relating to publicly traded companies, active businesses and headquarters companies, but the two main tests are likely to be the most commonly applied tests, and unless both are satisfied the relevant double tax treaty will not apply to exempt US withholding taxes.

·                     The Stock Ownership test requires 50 per cent or more of the aggregate vote and value of a (Dutch) company’s shares to be owned directly or indirectly by “qualified persons” — in essence residents of the Netherlands as well as US citizens — or by certain “equivalent beneficiaries”, who may be subject to limitation regarding their numbers and shares’ ownership (a derivative test).

·                     The Base Erosion test stipulates that less than 50 per cent of the (Dutch) company’s gross income may be used directly or indirectly to make ‘deductible payments’ to persons who are not qualified persons, i.e. residents of the Netherlands or US citizens.

The use of Dutch companies as conduit vehicles for non-residents for the receipts of (specifically) interest and royalties from the US therefore no longer enables the 30 per cent US withholding taxes on interest and royalty payments to be avoided, unless both tests are satisfied. Their purpose is to combat tax evasion through what the US perceives as artificial structures, hence there are three alternative tests which are the exceptions to the general LOB provisions.

·                     The Publicly Traded tests allow public companies with a substantial presence in the US or the Netherlands whose shares are listed on a recognised stock exchange, and whose shares are substantially and regularly traded on such exchange, to fall outside of the LOB article. Alternatively, a Dutch subsidiary company which is owned more than 50 per cent by a maximum of five Dutch or publicly traded US companies may benefit from the treaty.

·                     The Active Business test permits treaty benefits to apply to a company engaged in the active conduct of a trade or business in one of the States (Netherlands) where the income from the other State (US) is derived “in connection with” that trade or business, or provided that the trade or business conducted in the Netherlands is “substantial” in relation to the same conducted in the US.

·                     The Headquarter company test allows treaty benefits to be granted to headquarters companies for multinational groups under certain conditions.

The US thus welcomes active bona fidebusinesses such as public companies, which have a purpose of their own — raising money from the capital markets and which generally have substantial management — and also active trading companies, which have their own function separate from merely avoiding US taxes, while being exempt from taxation in their home State. Nor will the LOB provisions apply where the true beneficial owner would be awarded reduced US withholding taxes on US-sourced income were it to receive such income direct, even if it may not pay any tax on such income in its country of residence.

Thus the LOB provisions work to deny treaty benefits in situations where inappropriate double non-taxation may occur. For example, where a passive holding, finance or licensing company may be interposed to avoid taxation at source and either to accumulate income without a tax charge or remit income to its real beneficial owner (e.g. a trust or offshore company), which will be also exempt from tax.

Whether the Commission will follow the US experience in combating double non-taxation through implementing provisions against conduit finance arrangements or awarding double tax treaty benefits only to “qualified persons” subject to limited exceptions remains to be seen. The active business test is likely to be a feature of any anti-avoidance measures introduced since the stated aim is to minimise any impediment to genuine competitive economic growth.

Previous newsletters have focused also on the issue of beneficial ownership [see xxx]and the over-riding requirement to have substance within any corporate entity within a group structure. Regardless of the precise regulations which the Commission will recommend, the Communication is a sobering warning to international tax practitioners of the move towards US style anti-avoidance legislation to be introduced into the tax arsenal of European Union countries.