Historical Introduction to the Test of Dominion in the Context of Double Tax Treaties
S. Jain & J. Prebble, Historical Introduction to the Test of Dominion in the Context of Double Tax Treaties, 72 Bull. Intl. Taxn. 8 (2018), Journals IBFD
Posted: 21 Jun 2019
Date Written: June 26, 2018
Countries impose income tax on the basis of the source of income and the resident of a taxpayer. As a result, it is possible that cross-border transactions are taxed twice, both in the country of the source of income and the country of the resident of a taxpayer. This phenomenon is known as “double taxation”. In order to avoid double taxation, countries enter into double tax treaties, also known as double tax agreements.
Double tax agreements prevent double taxation by limiting the right to tax of either the source state or the resident state. In cases of dividends, interest and royalties, double tax agreements prevent double taxation by reducing withholding tax in the source state. Dividends, interest and royalties are also collectively known as “passive income”. Generally, double tax treaties are based on the OECD Model. The OECD Model deals with the taxation of dividends, interest and royalties under articles 10, 11 and 12.
Contracting states intend to restrict treaty benefits to their own residents. However, sometimes, residents of a non-contracting state try to obtain the benefit of a withholding tax reduction by interposing a company in a contracting state. The interposed company passes on the income to the residents of the non-contracting state. Consequently, the interposed company also passes on treaty benefits to residents of a third state. Such interposed companies are referred to as “conduit companies”.
In order to prevent residents of a third state from obtaining treaty benefits, the OECD Model restricts the benefit of a withholding tax reduction to a resident of a contracting state who derives income as the “beneficial owner” of that income. However, the problem is that as a matter of linguistic logic, of company law, and of economic analysis, the expression “beneficial owner” is not capable of fulfilling the anti-avoidance role that treaties assign to it.
From an economic perspective, companies are not capable of owning income beneficially. The object of a company is to make profits for the benefit of its shareholders. It is merely a vehicle through which shareholders derive income. Nevertheless, the traditional and formal legal view is that companies have separate legal personality and are therefore not only the legal but also the beneficial owners of their income. The official commentary on the OECD Model adopt the formal legal view. It follows that, legally speaking, conduit companies are the beneficial owners of income that they derive and are entitled to treaty benefits.
Courts appreciated that the beneficial ownership test was intended to frustrate conduit company arrangements. However, in the light of the traditional legalistic view of companies, courts seem to have decided that they were unable to apply the beneficial ownership test literally. As a result, in order to prevent residents of non-contracting states from obtaining treaty benefits by means of the interposition of conduit companies, courts adopted two surrogate tests in place of the literal beneficial ownership test: substantive business activity and dominion.
This article in the first in a series that focuses on the dominion test. All articles in this series use the term “dominion” to represent the right or freedom to decide how income from property shall be used. The OECD’s Conduit Companies Report is the first official document that explicitly recommends the use of the dominion criterion for determining whether a recipient company is the beneficial ownership of income in question. It transposes the dominion test from cases in which a tax authority argued that a recipient company acts in the capacity of a nominee or agent. A reason for the report to adopt this approach is a reference in the report to the official commentary on articles 10, 11 and 12 of the OECD Model of 1977, which presented a nominee or agent as an example of a conduit. The role of a nominee or agent is to pass income on to a principal. One result of this arrangement is that the nominee or agent does not have dominion over the income that it passes on. For this reason, the OECD Model regards a nominee or agent as not being the beneficial owner of income that it must pass on to the owner.
Keywords: Beneficial Ownership, Dominion, Treaty Shopping, Conduit Companies Report
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