In principle, from a policy perspective, countries impose withholding taxes on gross payments made to nonresidents often on passive income such as dividends, interest and royalties. Part 1 of this series analyzes the importance of being the beneficial owner of the income.
Cypriot companies have been widely used for investing in both Russia and Ukraine. This is due to the attractiveness of the low withholding tax provided in both treaties, namely Cyprus–Russia and Cyprus–Ukraine, and therefore, to a large extent, foreign direct investments have been routed to Russia and Ukraine through Cyprus.
Recently, however, Cyprus structures have been criticized by both the Russian and Ukraine tax authorities, because a Cyprus company might not be the beneficial owner of the income received, such as interest, dividends and royalties paid out from both Russia and Ukraine companies.
As a result, such tax authorities have denied the double tax treaty benefit, and therefore increased the tax burden for such companies. Yet the tax authorities have an additional weapon in their arsenal: a tax treaty general anti-abuse rule, namely the Principle Purpose Test ("PPT"), to challenge similar structures.
Inappropriate use of double tax treaties (“DTTs”) was high on the agenda of the Organization for Economic Co-operation and Development (“OECD”) with respect to the Base Erosion and Profit Shifting ("BEPS") project and for this reason BEPS Action 6: Prevent Treaty Abuse is included as a minimum standard.
Although the Beneficial Ownership Clause has been included in the passive income articles (Article 10 Dividends, Article 11 Interest and Article 12 Royalties of the OECD Model Tax Convention since 1977), the OECD decided to include an additional tax treaty General Anti-Avoidance Rule (“GAAR”), namely the PPT, to counter treaty shopping.
Such a tax treaty GAAR, from the perspective of the tax authorities, seems likely to work as a safety net in case the Beneficial Ownership Clause, or any other specific anti-avoidance provision, would seem unable to counter aggressive tax planning techniques with respect to, but not limited to, passive income.
In this context, following the introduction of the Russian de-offshorization law in 2015, as well as the new treaty signed between Cyprus and Ukraine that came into force in 2014, the beneficial ownership provision came into play to challenge Cyprus structures with respect to passive income paid out from both Russia and Ukraine to Cyprus companies.
Also, following the signing of the Multilateral Instrument (“MLI”) by Cyprus, Ukraine and Russia, such structures seem likely to be further challenged by tax authorities based on the PPT in the event that one of the principal purposes of the taxpayer was to take a tax advantage.
Beneficial Ownership Clause—A Specific Anti-abuse Provision
As noted above, the Beneficial Ownership Clause was first introduced by the OECD in 1977 (a similar clause is also found in the UN model, the U.S. model and the EU tax directives as regards to dividends, interest and royalties), and since then has been a controversial issue internationally.
In this context, investments through Cyprus have been challenged for not being the beneficial owner of the income; in particular holding, financing and IP structures have been challenged in this respect. Such structures have been challenged, to a large extent, by the Russian tax authorities and, to a lesser extent, by the Ukrainian tax authorities.
The main issue arising in such cases is whether a company, resident in one contracting state and receiving such income from another contracting state, is also to be considered the beneficial owner of such income.
For example, assume that Company A, resident in a country having a wide double tax treaty network such as Cyprus, borrows funds from Company B located in a tax haven (low or no tax jurisdiction), and the former lends the same funds to Company C resident in a country where the investments are located, such as Russia or Ukraine.
In this case, the tax authorities of the country where the investments are located (either Russia or Ukraine), may refuse the tax treaty benefit (reduced withholding tax rate imposed on interest payment to nonresidents according to the double tax treaty) claimed by Company C, on the gross interest paid to Company A, provided that Company A is not the beneficial owner of the interest received.
It is worth mentioning that the term “beneficial owner” does not mean the ultimate controlling person (owner of shares). Pursuant to the OECD MTC, any double tax treaty undefined terms shall have the internal law meaning “unless the context otherwise requires.” In this context, it is argued that the domestic law meaning could not suffice and therefore an international fiscal meaning should be provided to this term.
Consequently, following the Conduit Companies Report in 1986 that effectively amended the OECD Commentary, in general, the beneficial owner of the income would not be an agent, a nominee, or a conduit company. Instead, in general, it could be a person that has the actual “right to use and enjoy” the income “unconstrained by a contractual or legal obligation to pass on” the said income to another person.
In other words, the meaning of the Beneficial Ownership Clause is not whether a person is the owner of the company, but rather it emphasizes the authority and control of such a person with regards to the income flows of that company. Effectively, although this definition implies economic substance, it can be argued that it is a pass-through test rather than providing an economic substance meaning. Interestingly, one has to take into consideration legal documents and contractual restrictions in order to analyze whether the recipient of the income essentially has the right to use and enjoy such income.
Practical Application and Planning Points
For example, suppose that an multinational enterprise (“MNE”) has fully fledged offices with numerous employees in Cyprus and suppose that the Cyprus company enters into a back-to-back interest-bearing loan agreement (the Cyprus company is obliged under the back to back loan agreements to pass on the interest received to a company located in a tax haven) with its foreign subsidiary located in Russia.
Consequently, the Russian subsidiary will pay an interest expense in regard to the loan payable to the Cyprus holding company claiming treaty benefit, and therefore reducing the interest withholding tax to 0 percent pursuant to the Russia–Cyprus treaty.
In practice, however, it seems likely that the Russian tax authorities could challenge the structure that the Cyprus company is not the beneficial owner of the interest income since the Cyprus company is obliged to pass on the interest income to another company located in a non-treaty country.
Effectively, although the Cyprus company appears to have adequate substance in Cyprus (fully fledged offices with numerous employees in Cyprus), as noted above, the back-to-back loan arrangement appears to be the key point.
In this respect, it could be argued that the Cyprus company does not satisfy the pass-through test of the domestic law meaning of the Russian tax code (for example, the domestic law meaning in regard to beneficial owner of the income is the person who has the actual right to independently use and or dispose income received, and therefore account shall be taken of the functions which are performed and the risks which are assumed) nor of the OECD commentary definition as noted above. As a result, a 20 percent withholding tax could be imposed on the gross interest expense paid from the Russian subsidiary to the Cyprus holding company.
Equally, in practice, the Ukrainian tax authorities have also challenged similar structures in this respect.
In light of the above, it can be argued that use of the Beneficial Ownership Clause is limited to counter intermediary companies granting treaty benefits for another person. Notably, such a clause will not prevent other treaty anti-avoidance provisions to prevent treaty shopping cases such as the Principal Purpose Test.
Part 2 of this series looks at the new Principal Purpose Test.
Christos A. Theophilou is an International Tax & Transfer Pricing Consultant and Partner at Taxatelier, Cyprus.
The author may be contacted at: firstname.lastname@example.org