- Federal Supreme Court of Switzerland denies treaty benefits in case of dividend paid on shares acquired for hedging derivative contracts.
- Court stated that due to the fully hedged nature of ownership, there was economic nexus and interdependency between two independent transactions and therefore, the "intermediary" bank did not have beneficial ownership over dividends received.
- Holds the beneficial ownership requirement to be applicable even though the treaty does not contain the requirement.
- The ruling is important for similar structures worldwide, including derivative structures hedged with Indian securities and also for back-to-back contracts between group entities for license of IP, subscription to debt instruments, etc.
The Swiss Federal Supreme Court recently gave an important decision denying treaty relief on dividend payouts in a derivative instrument structure.1 The case involved a Danish bank ("Bank") which had an entered into a total return swap arrangement with investors in various jurisdictions.
A total return swap can be used by an investor to invest notionally in a share or a basket of shares, a group of shares represented by an index or a basket of indices without in fact funding that investment. The investor pays LIBOR on the notional amount (as if it were borrowing) to a dealer. The dealer in turn agrees to pay an amount that is equal to the capital increase and dividends declared on the underlying shares during the relevant period (as if the investor directly invested in the shares). This becomes an interesting alternative to an investor who otherwise might have had to borrow funds for the investments. Such a structure also becomes useful in situations where the transaction costs per unit of share are prohibitive or if the regulations prohibit a 100% leveraged acquisition of the underlying shares. The dealer may buy the underlying shares to hedge the risk taken by it. The present fact situation is one such instance.
In an unexpected decision, the Swiss Supreme Court denied treaty relief on dividend payouts received by the Bank on hedged Swiss securities ("Shares') on the ground that the Bank was not the "beneficial owner" of the dividends received. The Court concluded that the beneficial owner was not the Bank but the investors outside Denmark who entered into swap contracts with the Bank.
The relevance of this ruling needs to be seen in light of the fact that 'beneficial ownership' is a pre-condition in several tax treaties (including Indian tax treaties) for availing relief from taxation in the source country in case of dividends, interest, royalties and fee for technical services. Further, in the Indian context, the 'beneficial ownership' requirement has also been considered in the context of capital gains, though tax treaties generally refer to such requirement.2 A beneficial owner is usually distinguished from the legal owner in terms of recognition as the owner in law versus enjoying benefits arising out of ownership. The beneficial owner usually retains the right to decide the manner in which the asset should be used and the manner in which the returns from the asset should be utilized. Therefore, this ruling could become important in the context of several situations in addition to derivative instrument structures, particularly, back-to-back contracts executed between group entities (for example, licensing and sub-licensing arrangements, back to back debt instruments with / without a margin being earned by the intermediate entity, outsourced technical services). However, it needs to be noted that there are several factual specifics on the basis of which the Swiss Supreme Court held that the Bank was not the 'beneficial owner' – particularly, the complete economic interdependency between the Bank's contract with the investors and the investment in the underlying shares (as reflected by exactly matching transactions).
- The Bank entered into total return swap contracts with various parties in England, Germany, France and United States. Pursuant to the Agreement the Bank agreed to pay an amount equal to the return on the Shares(earned as dividends and capital gains) in consideration for a fixed payment which consisted of a LIBOR based interest payment and a margin amount (which was a percentage of the total amount involved in the contract). ("TRS Agreement").
- The Bank subsequently hedged its obligations arising under the TRS Agreement by purchasing the Shares that formed the basis of the TRS Agreement.
- Dividends were paid by the Swiss companies to the Danish bank net of withholding tax.
- The Bank applied for refund of withholding tax in respect of dividends paid by the Swiss companies in light of the Swiss-Denmark tax treaty ("Treaty"). As per the Treaty, dividends distributed by a Swiss company to a shareholder in Denmark are not taxable in Switzerland.
- The Federal Tax Authority ("FTA")
rejected the claim for refund stating that the Bank merely acted as
an intermediary entity to pass on dividends to investors who were
not resident in Denmark. Consequently, refund was rejected on the
- Lack of beneficial ownership by the Bank: The FTA relied on the complete factual and economic interdependency of the two transactions; the swap arrangement and the purchase of the Shares to conclude that the Bank was not the beneficial owner of the Shares and was consequently not entitled to the refunds.3
- Abuse of treaty between Denmark and Switzerland: The FTA concluded that the Bank was only intermediated to take advantage of the Treaty and held that the structure had been utilized only to enable the investors from various jurisdictions to obtain benefits under the Treaty by using the Bank as an intermediary.
- Upon appeal, the Federal Appeals Court ("FAC") set aside FTA's order and held that beneficial ownership was not a pre-condition for granting benefits under the Treaty with respect to dividends. The FAC also held that the Bank was the beneficial owner of the Shares and any economic proceeds that arose out such ownership as the Bank had the discretion to decide how the dividends could be utilized and as the Bank was not under any contractual obligation to hedge its position with acquisition of the underlying asset.
Ruling of the Swiss Supreme Court
The Supreme Court held that the Bank did not qualify as the beneficial owner of the dividends. The Court observed that the concept of "beneficial owner" is designed to assess the decision-making powers with respect to use of the income and the recipient of an income will be treated as the beneficial owner if it is at least able to make certain decisions independently. Therefore, the Court held that greater the interdependence between the income and the obligation to pass it on, the weaker the beneficial ownership.
While the Bank was neither legally nor contractually obligated to hedge the swap agreements entered into, the Court found that there was high interdependence between the income earned from Shares and the obligation to make payment of an equivalent amount to investors based on the following:-
- Each time, the hedging transactions were carried out simultaneously with the swap agreement and to the same extent.
- It was the party entitled to the economic returns (and not the Bank) that solely bore the risk associated with the income in economic terms. The impact of any price loss or dividend loss on the underlying securities was borne by the party entitled to the economic returns.
- The Court rejected the argument that the Bank had to bear the risk if the party entitled to the economic returns did not fulfill its obligation to pay interest or fall in price as the margin compensated for the interest risk taken.
Hence, the Federal Supreme Court held that the flows of funds clearly proved the interdependency between the two transactions. Therefore, the court held that the Bank was not the beneficial owner of the dividends received and was not entitled to refund on withholding taxes paid.
Analysis and Key Takeaways
By focusing on economic inter-dependence, the ruling appears to be contrary to the established principles governing beneficial ownership, more so as the investors are unrelated to the Bank. It appears strange that the ruling recognizes the existence of business risk for the Bank in the event of default by the investors, but concludes that the Bank is not the beneficial owner of dividends received by taking a view that margin amount received from investors is sufficient to compensate for the business risk. The ruling also ignores that: (i) the investors would not be entitled to any right apart from the right to a receive an amount capturing the difference in price and dividends paid and other rights such as voting rights shall remain with the entity holding the underlying assets; (ii) in the event of default by the Bank, the investor can only claim damages for breach of contract as opposed to demanding that the income/gains from the underlying assets be passed on to it.
It may be noted that earlier instances where beneficial ownership was attributed to the party enjoying economic benefits have generally been limited to circumstances where the legal owner's right to take decisions with respect to the asset and/or the manner in which the returns from the asset should be utilized were curtailed.4
Indian courts have also dealt with the issue of beneficial ownership, though not specifically in the context of derivatives structures. For instance, in the case of Universal International Music BV.,5 a Dutch company that had acquired musical recording rights from its group companies in other jurisdictions and had subsequently granted license for commercial exploitation to an Indian company. The tribunal held that the Dutch company would be recognized as the beneficial owner of the royalties paid by the Indian company since the Dutch company had a valid tax residency certificate issued by the Netherlands tax authority stating that it was beneficial owner of royalty income received from the Indian company time to time.
Further, we may refer to the SEBI Master circular on AML/CFT6 for guidance, though it is not binding from a tax perspective:
"The beneficial owner is the natural person or persons who ultimately own, control or influence a client and/or persons on whose behalf a transaction is being conducted. It also incorporates those persons who exercise ultimate effective control over a legal person or arrangement."
We may also refer to Indian jurisprudence distinguishing between "application of income" and "diversion of income". The Supreme Court of India7 has held that an amount is considered to be diverted before it reaches a taxpayer and consequently not taxed as the income of a taxpayer only where the taxpayer is under an obligation of such a nature whereby the amount cannot be considered to be part of the income of the taxpayer. However, where an amount is required to be applied to discharge an obligation out of the income of the taxpayer, it is merely considered to be an application of income and the assesse is considered have earned the income.
Having said that, the ruling appears to reflect the growing global trend in favour of the substance-over-form approach and measures to prevent the treaty abuse, including the OECD's recently crystallized report on Base Erosion and Profit Shifting ("BEPS"). Such a trend becomes important in the Indian context as well, given that India has been actively participating in the BEPS project. Further, General Anti-Avoidance Rules ("GAAR") are slated to come into effect from financial year 2017-18. Under GAAR, tax authorities may exercise wide powers (including denial of treaty benefits) if the main purpose of an arrangement is to obtain a tax benefit and if the arrangement satisfies one or more of the following: (a) non-arm's length dealings; (b) misuse or abuse of the provisions of the domestic income tax provisions; (c) lack of commercial substance; and (d) arrangement similar to that employed for non-bona fide purposes.Therefore, it becomes important to clearly and consistently reflect the strategic and commercial objectives of any structure in various statutory filings, internal records, websites and other fora.
1.Case no. 2C_364/2012, Federal Tax Administration v. X.______Bank, (Judgment dated May 05, 2015)
2.In the case of Aditya Birla Nuvo v. DDIT [(2011) 200 Taxmann 437)], capital gains relief under the India Mauritius tax treaty was denied to a Mauritian entity as it had acted in its capacity of a 'permitted transferee' under a joint venture agreement and as the agreement clearly stated that the 'permitted transferee' would have no rights in shares and would only hold them on behalf of the party to the joint venture agreement, which was a US resident.
3.It may be noted that the Treaty did not have a 'beneficial ownership' requirement. However, the FTA held that the requirement is implicit in the Treaty.
4.For instance, in the case of CSX Corp v. Children's Fund Management (UK), the district court of New York held the party enjoying the economic benefits under a cash settled return swap could be deemed to be the "beneficial owner". In that case, the party enjoying economic benefits had control over disposal of underlying assets and the derivative counterparty was obligated to vote in accordance with their instructions.
5. (2011) 45 SOT 219
6. (SEBI Circular no CIR/ISD/AML/3/2010)
7.See: cases such as Dalmia Cement Limited v. CIT, AIR 1999 SC 2154; CIT v. Sitaldas Tirathdas,  4 ITR 367 (SC); Travancore Sugars & Chemical's case,  88 ITR 1 (SC)
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