Beneficial owner: which tax treaty applies to passive flows?

I. Withholding tax and the beneficial owner of passive flows

A. Domestic withholding tax and its mitigation by treaty

Where a French enterprise pays certain income to a person that has no permanent professional installation in France, domestic law provides for a deduction at source designed to secure the taxation of these outbound flows. Royalties and income from industrial or commercial property fall within the withholding tax of article 182 B of the French General Tax Code (CGI), while dividends are subject to the withholding tax of article 119 bis, 2 of the same code. The domestic rate is high, in principle aligned with the standard corporate income tax rate, which makes the stake considerable for groups that move passive flows from France abroad.

Bilateral tax treaties mitigate, or even eliminate, this withholding, by reserving to the source State a reduced or nil right to tax royalties, interest and dividends. It is this mitigation that makes interposition arrangements attractive: by routing the flow through a company established in a State whose treaty with France is favourable, one hopes to benefit from a reduced rate, even though the final economic recipient resides elsewhere. Yet this strategy now collides head-on with the notion of beneficial owner, which is intended to neutralise the purely formal interposition of a relay company.

B. The beneficial owner, an economic anti-relay notion

The notion of beneficial owner (bénéficiaire effectif) designates the person that truly has the disposal of the income, who enjoys it and can freely dispose of it, as opposed to the mere apparent recipient who is only an intermediary bound to pass on the sums or devoid of any decision-making power over their use. Stemming from the OECD's work and inserted into most treaties concluded after 1977, this clause makes the grant of treaty benefits on dividends, interest and royalties conditional on the recipient's status as beneficial owner. It reflects an economic, not formal, approach to cross-border flows, which today permeates the whole of international tax law, from the OECD BEPS project to European Union directives.

Appearance does not make the law. A relay company that receives a royalty in order to pass it on, in whole or in part, to an entity of the same group, without being able to use it freely or enjoy it without an obligation to transfer it, is only the apparent beneficiary of the flow. The beneficial owner is the entity that designs the asset, bears its risks and ultimately receives its economic value. The burden of showing that the direct recipient truly has the disposal of the sums falls in practice on the taxpayer, who alone can establish the rights and obligations of the interposed company. Failing such proof, the authorities are entitled to set aside the treaty invoked and to seek the treaty applicable to the true beneficiary.

II. Applying the treaty of the beneficial owner's State

A. The principle: look beyond the apparent beneficiary

The Conseil d'État has laid down a principle of great practical reach: where income transits through an apparent beneficiary before reaching its beneficial owner, it is the tax treaty concluded between France, the source State, and the State of residence of the beneficial owner that applies, and not the one concluded with the State of the intermediary recipient. This solution, developed in relation to sub-distribution royalties paid successively to interposed companies before flowing back to the designer established in a third State, was confirmed in the second appeal closing the same case. It leads to a remarkable result: the authorities may apply a treaty with a third State that the taxpayer had not necessarily intended to invoke, as soon as that State is the State of the beneficial owner.

The lesson is twofold. On the one hand, interposing a relay company in a State with a favourable treaty produces no effect if that company is only the apparent beneficiary: the relay State's treaty is set aside. On the other hand, the treaty of the beneficial owner's State applies directly, which may lead to an intermediate withholding rate, neither nil as the arrangement hoped, nor at the full domestic rate. The recharacterisation of the flow, for instance as royalties rather than services, is carried out under both domestic and treaty law, the court analysing the real nature of the rights granted.

B. The conditions and limits of this reasoning

The requirement of a beneficial-owner clause. This mechanism presupposes that a beneficial-owner principle can be invoked in at least one applicable legal instrument, whether a provision of domestic law or a clause, explicit or implicit, of a tax treaty. For treaties subsequent to the 1977 OECD Model, the clause is most often present, at least implicitly, in relation to dividends, interest and royalties. In its absence, the reasoning loses its footing, which leaves situations where the analysis remains uncertain, in particular where the treaty at hand is old or differently worded.

The zones of uncertainty. Several questions remain open and call for caution. Identifying the applicable treaty may become complicated where no treaty has been concluded with the State of residence of the intermediary companies, or where the definitions of beneficial owner differ from one treaty to another. The question whether the court is under a duty to identify the applicable treaty of its own motion is not entirely settled. These uncertainties do not call the principle into question, but they require, for each flow, a fine analysis of the contractual chain and of the treaties in play, on pain of seeing the arrangement recharacterised in unforeseen conditions.

III. The lock of treaty residence and liability to tax

A. Liability to tax, not effective payment

The benefit of a treaty presupposes, even upstream of the beneficial-owner question, that the recipient qualifies as a treaty resident. Most treaties define a resident as any person who, under the law of a State, is liable to tax there by reason of domicile, residence, place of management or an analogous criterion. Recent case law brings a clarification favourable to the taxpayer, and heavy with practical consequences: the decisive criterion is liability to tax, not its effective payment. A company established in a jurisdiction applying a territoriality principle, not taxed locally on its foreign-source income, may nonetheless remain a treaty resident.

The case of territorial or dormant companies. A company established in a territorial-tax jurisdiction, structurally exempt on its foreign-source income, or even declared dormant for want of local activity, in principle retains the status of resident within the meaning of the treaty as soon as it falls within the scope of that State's tax, even at a nil rate on certain income. The mere fact of not paying tax, or of declaring nil income, does not establish the loss of tax residence. This analysis, based on a literal reading of treaty provisions, is not unanimously shared by the lower courts, and an appeal is expected on this point. Vigilance therefore remains warranted, all the more so since certain treaties expressly exclude from their benefit entities subject to an extraterritorial or offshore regime.

B. Practical recommendations: secure the flow chain

Map the contractual chain and identify the beneficial owner. Before putting in place a flow of royalties, interest or dividends transiting through one or more entities, one must establish precisely who designs the asset, who bears its risks and who receives its final economic value. This mapping determines the treaty actually applicable and the withholding rate that follows. An arrangement designed to benefit from the relay State's treaty must be re-examined in the light of the beneficial-owner principle, on pain of a recharacterisation producing a tax cost higher than anticipated.

Document the substance and rights of the intermediary company. Where interposing a company answers a real economic logic, it is necessary to show that this company truly has the disposal of the income, that it can use and enjoy it without an obligation to pass it on, and that it carries on an activity endowed with its own substance. Contracts reflecting real autonomy, evidence of the means employed, a certificate of tax residence and justification of liability to tax in the State of residence: all these must be gathered before payment, and not reconstructed at the time of an audit.

Verify the recipient's treaty residence. Because resident status conditions access to the treaty, it is necessary to ensure, for each entity in the chain, that it is indeed liable to tax in its State within the meaning of the applicable treaty, and that no exclusion clause targeting offshore or extraterritorial regimes is enforceable against it. In uncertain situations, in particular those subject to an as-yet-open judicial debate, a prudent approach consists in anticipating the least favourable position and securing the treatment through an advance ruling or a documented analysis.