• New U.K. Guidance on Treaty Relief for U.K. Source Income
  • October 26, 2006
  • Law Firm: Orrick, Herrington & Sutcliffe LLP - San Francisco Office
  • Anyone involved in securitisation or cross-border structured finance with a U.K. element will by now be aware of the Court of Appeal's decision earlier this year in Indofood International Finance Limited v. JPMorgan Chase Bank N.A.  Broadly, the Court of Appeal found that a special purpose vehicle ("SPV") that had been inserted into a cross-border loan structure and which was obliged to pass on all amounts received from the borrower to the ultimate lender was not the "beneficial owner" of those receipts for the purposes of the applicable double tax treaty ("DTT"). 

    HM Revenue & Customs ("HMRC") has now published draft guidance ("Guidance") on how it interprets the phrase "beneficial ownership" when used in DTTs in light of the Indofood decision.

    "International fiscal meaning" of "beneficial ownership"

    HMRC's view is that the decision is now part of U.K. law in relation to the meaning of "beneficial ownership" in the context of DTTs and that it is, in any case, fully consistent with HMRC's preexisting interpretation of the term in that context.

    HMRC's policy is that where there is treaty abuse (such as, say, "treaty shopping") a narrow technical interpretation of "beneficial ownership" would not give effect to the purpose and object of the DTT.  It would be contrary to the objects of the DTT to allow such treaty abuse.  Accordingly, where there is treaty abuse, "beneficial ownership" is to be given what the Court of Appeal called its "international fiscal meaning."

    In order to give "beneficial ownership" its "international fiscal meaning" it should be understood in its context and in light of the object and purposes of the DTT, including avoiding double taxation and the prevention of fiscal evasion and avoidance.  This interpretation, which was relied on by the Court of Appeal, is derived from the official Commentary on the OECD Model Convention on Income and on the Capital.

    HMRC's view is that even U.K. DTTs which do not have express "treaty shopping" or "conduit" Articles are effectively deemed to have such anti-avoidance provisions in relation to cross-border payments of interest, royalty and dividends.  This is achieved by interpreting the requirements of "beneficial ownership" by reference to its "international fiscal meaning" in any case where HMRC perceives potentially improper use of DTT relief.

    Impact on particular structures

    The Guidance explains how the "international fiscal meaning" is likely to be applied in relation to certain common cross-border financing structures and provides a non-exhaustive list of examples.

    HMRC's position is that securitisation SPVs will typically not satisfy the test of beneficial ownership when given its "international fiscal meaning."  This will be the case in any circumstances where an SPV is contractually bound to pass on income it receives from its asset portfolio to lenders/bondholders even where the SPV retains a spread to cover fees, etc.  The Guidance expressly recognises that this will include CDOs and CLOs that purchase loans to U.K. borrowers.

    The Guidance says that it is unlikely that a securitisation or fund SPV is able "to enjoy the full privilege to directly benefit from the income" where it has very narrow powers over that income and is obliged to pass on substantially all of it to the ultimate lenders.

    Where the SPV is reliant on DTT relief in order to receive gross payment on its U.K. portfolio assets the significant issue is whether the arrangements amount to an abuse of the DTT.  HMRC's position is that if no abuse of the DTT is intended, then the "international fiscal meaning" does not have to be applied to the interpretation of "beneficial ownership."

    Generally, HMRC would not expect there to be DTT abuse, and so the "international fiscal meaning" would not be applied in the following circumstances:

    1. Where the bondholders/ultimate lenders are resident in a state with which the United Kingdom has a DTT so that U.K. source income could in any case have been paid without withholding directly to them.

    2. Where the bonds issued by the SPV satisfy the U.K. definition of "Eurobonds" so that no withholding would have been due on interest payable in relation to the bonds if they had been issued out of the United Kingdom.

    3. Where a bank sub-participates a loan that it has previously made in the ordinary course of its banking business.  HMRC distinguishes such subsequent participation from a situation of DTT abuse where a lender who would not be entitled to treaty benefits arranges for a loan to be initiated by a bank lender in a treaty country.  In such conduit cases, the Guidance is that they would not be viewed as a normal commercial syndications nor as part of the ordinary course of banking business.

    Although the Guidance particularly focuses on SPVs, it also considers the example of a group finance company set up in, say, Luxembourg specifically to deal with intra-group loans and which is taxed on a small turn in Luxembourg.  Where the ultimate lender is located in a jurisdiction which does not have a DTT with the United Kingdom, HMRC would seek to apply the "international fiscal meaning" in order to deny relief on the basis that the Luxembourg finance company is a mere conduit.  This is distinguished from circumstances in which the ultimate lender is located in the United States or other country with which the United Kingdom has a DTT which provides for zero withholding.  In the latter case no abuse motive would be recognised and the "international fiscal meaning" would not be applied with the effect that treaty relief would be granted.


    In any case where the gross payment of U.K. source income is dependant on the availability of DTT relief, it is necessary to consider whether the recipient is truly the "beneficial owner" of the income payments. 

    Where the recipient has very narrow powers over the income and is obliged to pass substantially all of it on to the ultimate lenders, it will not be able to satisfy the "international fiscal meaning" of "beneficial owner".  However, it does not inevitably follow that DTT relief will be denied because the "international fiscal meaning" of "beneficial ownership" is only to be invoked in cases of treaty abuse. 

    Generally, HMRC will view a DTT claim as abusive where the U.K. would have applied a withholding had there been a direct relationship between the U.K. payer and the ultimate recipient of interest, royalties or, as the case may be, dividends. 

    The Guidance is to be welcomed in so far as it serves to allay fears that HMRC would seek to use the Indofood decision to challenge all DTT reliant securitisation structures.  However, this is achieved at the cost of implying "treaty shopping" or "anti-conduit" provisions into DTT's that were negotiated without the inclusion of such general anti-avoidance Articles.  HMRC would no doubt argue that they were not included because the "international fiscal meaning" of beneficial ownership made them unnecessary but if that is true why then have recent DTTs, most notably that with the United States, included express anti-abuse provisions?