Effectiveness of the Beneficial Ownership Test in Conduit Company Cases

Abstract

Countries enter into double tax agreements with the economic objective of preventing double taxation of cross-border transactions. To achieve this objective, the contracting states agree reciprocally to restrict their substantive tax law. That is, a major policy of double tax agreements is to reduce double taxation of residents of states that are parties to the agreement. Residents of third states sometimes contrive to obtain treaty benefits typically by interposing a person or a conduit entity in one of the contracting states. In order to ensure that a resident of a contracting state who claims treaty benefits is entitled to them in substance, double tax agreements should be interpreted according to their substantive economic effect. Generally, double tax agreements follow the pattern of the OECD Model Tax Convention. The OECD Model Convention addresses the double taxation of dividends, interest and royalties, commonly collectively known as "passive income", in Articles 10, 11 and 12 respectively. These provisions usually operate by reducing withholding tax imposed by a source state on passive income that flows from the source state to a resident state. In order to prevent a resident of a third state from obtaining a source state withholding tax reduction by interposing a person or a conduit entity in the resident state, the OECD Model Convention requires the immediate recipient of passive income to be the "beneficial owner" of that income. That is, the OECD Model Convention requires the immediate recipient to be an owner in a substantive economic sense. Courts and commentators have difficulty in interpreting and applying the concept of beneficial ownership to conduit entities that are corporations, commonly referred to as "conduit companies". They have attributed the cause of the difficulty to the absence of a definition of the term "beneficial owner" in the OECD Model Convention. This thesis argues that the difficulty in applying the beneficial ownership concept to conduit companies has arisen not because of the absence of the meaning of the concept, but because logically and from an economic perspective the concept cannot be applied to companies in general, not to conduit companies in particular. The beneficial ownership test was meant to be a test of economic substance. From an economic perspective, the benefit or the burden of a contract entered by a company is economically enjoyed or borne by its shareholders. That is, in substance a company cannot be considered as owning income beneficially. From this consideration, it follows that conduit companies can never be considered entitled to treaty benefits. Nevertheless, the OECD Model Convention applies the beneficial ownership test to conduit companies pursuant to an assumption that at least in some cases conduit companies can be the beneficial owners of passive income. The Model Convention's assumption is based on the legal perspective that courts conventionally adopt. According to this legal perspective, companies hold income beneficially because they exist as separate legal entities from their shareholders. Courts find themselves battling these opposing perspectives when applying the beneficial ownership test to conduit companies. In order to make income tax law work efficiently, courts that are obliged to determine whether to honour claims to treaty benefits made by conduit companies have preferred to employ the legal perspective. Courts have justified this approach by adopting surrogate tests for the actual beneficial ownership test. Most of the surrogate tests do not relate to the concept of ownership at all. This thesis categorises the surrogate tests as "substantive business activity" and "dominion". By analysing reported cases, the thesis identifies deficiencies in these tests. One of the proposed outcomes of the thesis is to suggest an alternative approach for deciding conduit company cases. The thesis suggests that courts should consider an arrangement as a whole and investigate reasons for the existence of an immediate recipient of passive income in the specific corporate structure. The thesis also recommends amendments in the official commentary on Articles 10, 11 and 12 of the OECD Model convention in order to address the conceptual shortcomings inherent in those Articles.