Implications of the Court of Appeal's Decision in Indofood

The case of Indofood International Finance and JPMorgan Chase Bank in 2006 came about because the Indonesian parent company (Indofood) wished to raise capital by issuing loan notes on the international market. It set up a special purpose funding vehicle in Mauritius to issue the loan notes in order to benefit from the reduced rate of withholding tax (10 per cent rather than 20 per cent) that was available under the Indonesia/Mauritius double tax agreement (DTA).

The issuer onlent the funds on back-to-back terms to Indofood, which also guaranteed the loan notes. One of the conditions under which the loan notes were issued was the provision that the notes could be redeemed earlier than the specified date if there was a change in Indonesian law which resulted in the withholding tax on interest paid by Indofood to the issuer exceeding 10 per cent.

On 24 June 2004, Indonesia gave notice to determine the Mauritian DTA with effect from 1 January 2005; on 24 August 2004, the issuer gave notice to the trustee of its intention to redeem the loan notes stating that there was no reasonable measure that the parent could take to avoid the liability to deduct a higher rate of withholding tax. The trustee (JPMorgan) refused to give its consent on the ground that reasonable steps could be taken to avoid this increased liability. In particular, it was suggested that a company could be incorporated in the Netherlands and interposed between the parent guarantor and the issuer; advantage could then be taken of the existing double tax treaty between Indonesia and the Netherlands and withholding tax would remain at 10 per cent or less.

The High Court judge found in favour of the trustee; the Court of Appeal reversed this decision and held that the interposition of a new Dutch company would not have prevented Indonesian withholding tax from being incurred at the higher rate. The Court of Appeal’s decision rested largely on the interpretation of ‘beneficial ownership’. In order for the double tax treaty with the Netherlands to apply, the proposed new company would have to be the ‘beneficial owner’ of the interest paid or payable by the parent. The judgment refers particularly to commentary provided by the OECD in relation to the OECD Model Tax Convention (and which states that ‘a conduit company cannot normally be regarded as the beneficial owner if, through the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties’. The Court of Appeal held that the position of the new company would equate to that ‘of an administrator of the income’, and noted that in practical terms it was impossible to conceive of any circumstances in which either the issuer or the new company could derive any ‘direct benefit’ from the interest payable by the parent guarantor.

Thus, the Court of Appeal went further than simply making a judgment on the basis of probability as to what view the Indonesian courts would have taken of the proposed restructuring and it was even suggested that the initial structure put in place by the parent was inadequate and incompatible with the beneficial ownership principles relied upon under the double tax treaty between Indonesia and Mauritius.

Much of the Court of Appeal judgment was given by Sir Andrew Morritt, who drew attention to relevant passages from the OECD commentary and observations made by Professor Baker, concluding that the term beneficial owner should be given “an international fiscal meaning not derived from the domestic laws of contracting states… the concept of beneficial ownership is incompatible with that of the formal owner who does not have ‘the full privilege to directly benefit from the income'”‘. No comment was made by the Court of Appeal about the UK’s settled domestic interpretation of ‘beneficial ownership’, and to what extent that might concur with or diverge from ‘an international fiscal meaning’.

Published opinions differ over the extent to which this judgment will affect the meaning of ‘beneficial ownership’ in the UK. While there appears to be a general consensus that the ‘beneficial ownership’ test as set out in the OECD Model Tax Convention is stricter than that under UK domestic law, it has yet to be seen whether HMRC will seek to rely on a more rigid interpretation of ‘beneficial ownership’ and look more closely at the actual benefits that the conduit vehicle is entitled to when considering the withholding tax implications of securitisations, and in particular special purpose vehicles (SPVs). It appears to be clear that HMRC view this decision as having potentially wide application.

Although this particular dispute did not involve either UK companies or UK tax liabilities, the case is likely to affect the way that HM Revenue and Customs (HMRC) approaches securitisation structures where the issuer is located offshore and the borrower or originator is based in the UK. There is nothing radical per se about the Court of Appeal’s judgment in Indofood; the idea that ‘beneficial ownership’ implies a degree of control over the income in question is a matter of common sense as much as a legal notion. The reason that this judgment has generated so much interest is the fact that it casts doubt on existing securitisation structures and other financial transactions that involve the use of offshore SPVs that receive income free of withholding tax due to reliance on a double tax treaty.

There is, however, a persuasive argument that the Court of Appeal’s conclusion regarding the ‘beneficial ownership’ point was a finding on a point of fact, and not a decision on a point of law: the only decision was a consideration of whether a particular proposed course of action was ‘reasonable’ or not and therefore any comments in Sir Andrew Morritt’s judgment regarding the ‘beneficial ownership’ point cannot therefore be regarded as ‘ratio decidendi’ that would be binding on any other court. Any comments made were made as an aside, in so far as they related to issues wider than the double tax treaty between the Netherlands and Indonesia and the case is not an authority for how the term ‘beneficial ownership’ is to be construed for the purposes of the UK’s own network of double tax treaties or, indeed, any domestic withholding tax exemption under UK law.

So, should companies be reviewing their existing securitisation structures (particularly back-to-back finance arrangements through offshore SPVs) in the light of the Indofood case? The answer, until further case law or HMRC guidance sheds more light on the matter, has to be yes. While it is unfortunate from a certainty point of view that the decision has not been appealed to the House of Lords, the potential implications of this judgment and any subsequent reaction from HMRC will have to be taken into account when any type of securitisation, previously regarded as standard, is proposed.