The impact of diverging concepts of beneficial ownership on withholding tax reclaims

beneficial ownership impact

The concept of beneficial ownership is crucial in determining the withholding tax rates that apply to income from cross border investment within the European Union. The inconsistent interpretation of beneficial ownership between countries has posed difficulties for taxpayers attempting to recover over withheld tax. This article examines the influence of these diverging interpretations on the process of reclaiming over withheld tax (WHT). 

Any cross-border investment bears the inherent risk of double taxation: the country of residence of the investor is likely to tax the income from the cross-border investment, but so is the country of source of the investment. The latter is often referred to as withholding tax or source tax, as it is levied by means of withholding from the gross income in the country of source of the investment. To avoid or at least mitigate such double taxation, many countries have entered bilateral treaties for the avoidance of double taxation (“double tax treaties”) on cross border investment income. The bilateral tax treaties of most countries are based on the OECD model tax convention on income and capital, and its official Commentary (explaining treaty provisions and terms).

In practice, double tax treaties stipulate, among other things, that country A may reduce or even forfeit its right to levy a withholding tax on investment income paid to an investor country B, if country B will do the same for investment income paid to an investor in country A (based on the principle of reciprocity). In addition, the residence country of the investor may provide for a (partial) exemption from income tax on investment income, or a (partial) credit against such income tax for withholding tax paid in the source county.  

A standard condition for treaty benefits is for the recipient of the benefit to be a “tax treaty resident”. Being a tax treaty resident means being fully liable to tax in the country of residence. The rationale behind this standard condition is that if a person is not fully liable to tax in their country of residence, then there is no risk of double taxation and no need for the other country to reduce or forfeit its right to tax.  

Another standard condition for (most) treaty benefits is that the beneficiary of the treaty benefits is the “beneficial owner” of the income. The rationale behind the beneficial owner requirement is that if a person is not the beneficial owner of the income, that income is likely not included in its taxable basis, and therefore not liable to tax. So even if the person may be liable to tax in the country of residence, this income may still not be taxed, in which case there is still no risk of double taxation and no reason for the other country to reduce or forfeit its right to tax.  

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Being a beneficial owner under double tax treaties

Neither the OECD Model Convention nor the Commentary to the OECD Model Convention give an exhaustive definition of beneficial owner. Instead, it says that a person is not a beneficial owner if it is merely a conduit which has very narrow powers which render it a mere fiduciary or administrator. In its 2011 discussion draft, the OECD referred to the beneficial owner having the right to use and enjoy the income. 

If the recipient of investment income is not the beneficial owner, this does not necessarily mean that the source country is not held to reduce or forfeit its right to tax under the tax treaty. If the recipient of the investment income pays the investment income on to another person who is resident in the same country as the (direct) recipient of the investment income and the beneficial owner of the income, the treaty benefits of reduced or forfeited withholding tax should still be applied. If the recipient of the investment income pays the income on to a person who is resident in another country and beneficial owner of the income, the benefits of the tax treaty between the source country of the investment and the country of residence of the beneficial owner should be applicable. 

In practice, the condition of beneficial ownership is sometimes used by tax administrations as an anti-abuse measure, a reason not to apply treaty benefits. However, this is not why the condition of beneficial ownership was introduced in the OECD model convention. It was introduced in the OECD model convention to clarify to whom the investment income is considered paid for tax treaty purposes, as well as to clarify that treaty benefits do not have to be granted by the source country just because the direct recipient of the income is a resident of the other (treaty) country. Again, this does not mean that treaty benefits do not apply, period. It just means that treaty benefits may apply not by virtue of the direct recipient being a treaty resident but by virtue of the beneficial owner (the indirect recipient) being a treaty resident, or that the benefits of a treaty with a different country (the country of residence of the beneficial owner if this is a different country than the country of residence of the direct recipient) apply.  

While in practice most withholding tax reclaims and exemptions are based on bilateral tax treaties, they can also be based on other legal grounds such as the domestic tax laws of countries or the EU treaty or EU Directives. 

Beneficial ownership under domestic laws 

Many countries have a concept of beneficial ownership in their domestic tax laws, which may or may not align with the interpretation of the term in the OECD model convention and commentary. When a withholding tax reclaim or exemption is based on the domestic law of that country, then the concept of beneficial ownership as it applies in the country’s domestic law will clearly affect the applicability of the reclaim or exemption. However, in practice, when a reclaim or exemption is based on a bilateral tax treaty, tax administrations sometimes try to apply their diverging domestic law concept of beneficial ownership to deny the treaty benefits. Where this results in a situation where treaty benefits are denied where they would have been applicable under the bilateral tax treaty, this constitutes a tax treaty override and this should be challenged by taxpayers. 

For example, in France, the test for beneficial ownership is regarded as an objective test, with a focus on power to use and enjoy, business substance, and other economic factors. However, the French tax authority may still argue that a company is not the beneficial owner if its place in the structure is not justified by sound non-tax reasons. This stringent approach can make it difficult for investors to demonstrate their beneficial ownership and claim withholding tax exemptions.

In Germany, the beneficial ownership test is primarily applied in connection with dividend withholding taxes and requires the recipient to evidence substance, i.e. qualified personnel, business premises, and technical means of communication. The German tax authorities also do not generally look through to the actual beneficial owner, further complicating the reclaim process for investors.

In the Netherlands, the term beneficial owner has two different meanings for domestic law and tax treaty law, leading to potential discrepancies in claiming withholding tax exemptions.  

Beneficial ownership under EU law

The EU Court of Justice (CJEU) has played a significant and influential role in the interpretation of beneficial ownership within the framework of EU Directives. According to the CJEU, the beneficial owner of income is the person that benefits from the income economically and that has the power to freely determine the use to which it is put. The court also clarified that the beneficial owner concept should be interpreted considering the objective and purpose of the EU Directives, which is to prevent double taxation and tax avoidance. 

The CJEU’s guidance was based on its decisions in the Danish cases in 2019, which involved conduit arrangements where the recipients of interest and dividend payments were not considered to be the beneficial owners, as they were contractually or legally obliged to pass on the income to third parties. The CJEU held that such arrangements constituted an abuse of rights under EU law and that the withholding tax exemptions under the Interest and Royalties Directive and the Parent-Subsidiary Directive should be denied.

However, the CJEU did not provide a clear definition or criteria for identifying the beneficial owner in different scenarios, leaving room for interpretation by national courts and tax authorities. Moreover, some Member States have adopted their own domestic rules or guidance on beneficial ownership, which may deviate from or go beyond the CJEU’s approach. Some countries may apply a substance-over-form analysis, a look-through approach, or a main purpose test to determine the beneficial owner status.  

As is the situation with double tax treaties, this may result in situations where EU Treaty or Directive benefits are denied by member state tax administrations based on the interpretation of domestic concepts of beneficial ownership where they would have been applicable based on the interpretation of the beneficial owner concept under the EU Treaty or Directive.  

The inconsistent interpretation of beneficial ownership has created uncertainty for taxpayers attempting to reclaim over-withheld tax. The differing approaches to beneficial ownership and the lack of harmonization in national legislation have led to challenges in navigating the reclaim process, particularly in cases where the recipient of the income is deemed not to be the beneficial owner. Therefore, investors who are engaged in cross-border activities should be aware of the different approaches and requirements regarding beneficial ownership in each country, as well as the potential risks and challenges they may face when claiming withholding tax relief or exemption. The CJEU’s case law, national legislation, and the approach of national courts have all contributed to the complexities faced by taxpayers in navigating the reclaim process. As the EU continues to address the issue of beneficial ownership through initiatives such as the proposed Faster Directive, it is essential for taxpayers to stay informed about the evolving landscape of WHT reclaim processes in the EU. 

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