The Court of Appeal held that a Dutch company (‘Newco’) interposed between the parent guarantor and the issuer of loan notes would not be the beneficial owner of the interest paid by the parent guarantor under the loan agreement, with the result that the provisions of art. 11(2) of the double tax convention between Indonesia and the Netherlands would not be satisfied and the obligation of the parent guarantor to account for withholding tax at a rate greater than ten per cent on that interest could not be avoided.

Facts

The claimant was a Mauritian company and the wholly owned subsidiary of an Indonesian company (‘the parent guarantor’). The claimant had been incorporated in order to issue certain loan notes. By a loan agreement the issuer undertook to provide the proceeds of the notes to the parent guarantor, and the parent guarantor undertook to pay interest to the issuer to enable it to fulfil its interest obligations under the notes. The defendant bank was trustee of the notes. When the notes were issued, Indonesia was a party to a double taxation agreement (DTA) with Mauritius. The effect of the DTA was to reduce the rate of withholding tax payable by the guarantor in respect of interest from 20 per cent to ten per cent.

The notes could be redeemed early if there was a material tax change which resulted in the guarantor having to pay a rate of withholding tax of more than ten per cent, unless that increased tax obligation could be avoided by the issuer taking reasonable measures available to it. The Indonesia/Mauritius DTA was terminated by the Government of Indonesia from 1 January 2005 so that the rate of withholding tax payable was increased from ten per cent to 20 per cent, thus increasing the burden in servicing the notes of the issuer and the parent guarantor.

The issuer asked the trustee to approve early redemption of the notes. When the trustee refused, the issuer commenced proceedings to establish its right to redeem. The trustee's case was that equivalent double taxation relief could be achieved by channelling the interest payable by the parent guarantor through an entity resident in another country, such as the Netherlands which had a DTA with Indonesia (the Netherlands DTA). If that could be done then, by virtue of the proviso to the material tax change provisions, the issuer would not be entitled to redeem. At the hearing, it was accepted that the only measure to be considered was the interposition of a company incorporated in the Netherlands (‘Newco’) between the issuer and the parent guarantor.

The High Court held ([2005] BTC 8,023) that, in deciding whether the proviso permitted the trustee to decline permission for the giving of notice to redeem the notes the UK court had to apply a ‘reasonable certainty’ test in coming to any conclusion as to the likely reaction of the Indonesian tax authorities to the putting into effect of the proposed restructuring. On the evidence the court could be reasonably certain that the proposed restructuring constituted reasonable measures within the proviso. If the proposed restructuring went ahead, the new Netherlands entity (‘Newco’) would be treated as resident in the Netherlands for tax purposes and not in Indonesia and would be the beneficial owner of the interest becoming due from the guarantor which would bring it within art. 11(2) of the Netherlands/Mauritius DTA.

The claimant appealed to the Court of Appeal, arguing, inter alia, that the judge was wrong to adopt that test but should have held that the burden was on the issuer to establish on a balance of probabilities that there were no reasonable measures available to the issuer or the parent guarantor to avoid the obligation to pay withholding tax at a rate in excess of ten percent.

Issue

Whether Newco would be the beneficial owner of the interest payable by the parent guarantor and whether Newco would be resident in Holland so that there were reasonable measures available to the issuer to void the increased tax obligation.

Decision

Sir Andrew Morritt C (Chadwick LJ and Sir Peter Gibson agreeing) (allowing the appeal) said that the question of whether there were any ‘measures available to’ the issuer or the parent guarantor by which the obligation to pay withholding tax at a rate in excess of ten per cent could be avoided had to be determined first and on a balance of probability. If it was established that such a measure did exist then the question would arise whether it was in all the circumstances reasonable to require the issuer and parent guarantor to take that measure.

The term ‘beneficial owner’ was to be given an international fiscal meaning not derived from the domestic laws of contracting states. The concept of beneficial ownership was incompatible with that of a formal owner who did not have the full privilege to directly benefit from the income. The legal, commercial and practical structure behind the loan notes was inconsistent with the concept that the issuer or, if interposed, Newco could enjoy any such privilege.

In determining the meaning to be given to the phrase ‘beneficial owner’ regard was to be had to the substance of the matter. In both commercial and practical terms the issuer was, and Newco would be, bound to pay on to the principal paying agent that which it received from the parent guarantor. The parent guarantor was bound to ensure that such an arrangement continued lest it was required to pay again under its guarantee to the noteholders contained in the trust deed. In practical terms it was impossible to conceive of any circumstances in which either the issuer or Newco could derive any direct benefit from the interest payable by the parent guarantor except by funding its liability to the principal paying agent or issuer respectively.

Such a conclusion was consistent with the evident purpose and obje\ct of the Mauritian DTA and the Dutch DTA. Their primary purpose was apparent from their respective titles. Accepting that the Dutch DTA also had as its object the encouragement of long-term foreign loans, none of those purposes was furthered by affording tax relief to the parent guarantor because it had a Mauritian or Dutch subsidiary when such relief would not have been afforded to the parent guarantor had the loan been made direct to it.

Finally, although the Indonesian tax authorities did not challenge the entitlement of the parent guarantor to deduct withholding tax from the interest payable to the issuer at the concessionary rate of ten per cent, that could not affect the legal position in Indonesia as tomisuse of the DTAs. They were likely to scrutinise arrangements such as this more closely in the future; and they would have ten years in which to do so. Accordingly, the interposition of Newco was not a measure available to the issuer or the parent guarantor whereby to avoid the obligation to pay withholding tax at a rate in excess of ten per cent. The issuer had discharged the onus of establishing that there were no available measures and was accordingly entitled to redeem.

It was not necessary to decide the residence issue.

Court of Appeal (Civil Division).

Judgment delivered 2 March 2006.