Beneficial Owner

Beneficial Ownership Indian Issues
K R Sekar 20 March 2010
Contents
Meaning / Concept Indian Issues Carry forward and set off of losses Deemed Dividend Royalty Intermediary / Investment Company Jurisdiction Trust Way Forward
2010 Deloitte LLP. All rights reserved.
Concept
Concept of beneficial owner

Under common law, the term, beneficial owner, would exclude a legal owner who is trustee for another The terms beneficial owner, legal owner and registered owner have different implications
Legal owner: one who holds legal title to property Beneficial owner: one who ultimately enjoys the income on the asset and also controls such income receipts and the asset itself Registered owner: one in whose name the asset is registered e.g. registered shareholder. A registered owner may merely be holding the shares as a nominee for someone else (beneficial owner)
Blacks Law dictionary: A beneficial owner is one recognized in equity as the owner of something because use and title belongs to that person, even though legal title belongs to someone else. Law Lexicon defines beneficial owner as one who, though not having apparent legal title, is in equity entitled to enjoy the advantage of ownership.
4
Concept of beneficial owner Contd.

Resorted to by most countries to ensure that any tax incentive is availed only by the targeted tax payer
Beneficial owner should be made liable for taxes
Embedded as an anti-avoidance measure in the treaty law in respect of dividends (Art. 10), interest (Art. 11) and royalties (Art. 12) under OECD / UN models Technical explanations to US model convention: The beneficial owner of a dividend / payment of interest / royalty payment is understood generally to refer to any person resident in Contracting Sate to whom that State attributes the respective income for the purpose of its tax. As per Prof Klaus Vogel, the issue of control is the most important factor in deciding the beneficial ownership. Beneficial owner is the person who is free to decide
whether or not the capital or other assets should be used or made available for use by others; on how the yield therefrom should be used; or both
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Illustrative example of the concept

US Co
Loan USA TAX HAVEN Loan Tax Haven Co subject to 3% corporate income tax on spread
US Co
USA INDIA Interest
India Co
15% w/h tax
0% w/h tax [Tax Haven domestic tax law]
Tax Haven
Loan
INDIA
India Co
0% w/h tax [India/ Tax haven treaty]
Is Tax Haven Co the beneficial owner of the interest paid by India Co?
6
Beneficial Ownership & Domestic Tax Issues

The domestic tax issues arising out of the concept of beneficial ownership can be discussed under the following broad heads: Carry forward and set off of losses Deemed Dividend Royalty Investment Structures Trust
Carry forward and set off of losses
Section 79 Carry forward and set off of losses

Section 79(1)(a) of the Income Tax Act, 1961 (the Act) provides that:
Notwithstanding anything contained in this Chapter, where a change in shareholding has taken place in a previous year in the case of a company, not being a company in which the public are substantially interested, no loss incurred in any year prior to the previous year shall be carried forward and set off against the income of the previous year unless on the last day of the previous year the shares of the company carrying not less than 51% of the voting power were beneficially held by persons who beneficially held shares of the company carrying not less than 51% of the voting power on the last day of the year or years in which the loss was incurred.
Exception
Provided further that nothing contained in this section shall apply to any change in the shareholding of an Indian company which is a subsidiary of a foreign company as a result of amalgamation or demerger of a foreign company subject to the condition that 51% shareholders of the amalgamating or demerged foreign company continue to be the shareholders of the amalgamated or the resulting foreign company.
Rationale
To prevent trading in losses Not applicable to companies in which the public are substantially interested Genuine cases of reorganisation (as mentioned in proviso to Sec 79) excluded from the purview of Section 79 Earlier, there was a second condition attached to Sec 79 for the carry forward of losses i.e. the satisfaction of the Assessing Officer (AO) that the change in shareholding was not effected with a view to avoid or reduce any tax liability
However, there were controversies with regard to whether the conditions are cumulative or independent and the burden of proof, to show that the change in shareholding was effected with a view to avoid or reduce the tax liability, was on the AO or the assessee. This section was eventually deleted* to set at rest the controversies.
* omitted w.e.f 1 April 1989

10
Section 10A (9)

Earlier, Section 10A(9)* had provisions similar to Section 79
Where during any previous year, the ownership or the beneficial interest in the undertaking is transferred by any means, the deduction u/s 10A (1) shall not be allowed to the assessee for the assessment year relevant to such previous year (PY) and the subsequent years. For the purposes of this section, in the case of a company, where on the last day of the PY, the shares of the company carrying not less than 51% of the voting power are not beneficially held by persons who held the shares of the company carrying not less than 51% of the voting power on the last day of the year in which the undertaking was set up, the company shall be presumed to have transferred its ownership or the beneficial interest in the undertaking.
Introduced to prevent trading in incentives by shell companies formed only for that purpose However, not intended to cover cases of genuine business reorganisation while maintaining the major portion of ownership / beneficial interest with the same persons who were the owners of the business before such reorganisation. Different from Sec 79 as regards the date of comparison of holding of beneficial interest Section 79
Comparison of ownership between the year in which loss suffered and the year in which claim for set off of loss is made
* omitted w.e.f 1 April 2004
11
Section 10A (9)

Comparison of ownership between the year of setting up of the undertaking and the year in which deduction u/s 10A is claimed
Case Study 1
Outside India
Co 2 has brought forward losses

Co 1 Co 1 Co 3
Co 1 (100% holding company of Co 2) transfers the shares of Co 2 to Co 3 Will Co 2 be entitled to carry forward and set off of its losses incurred prior to the transfer even after the change in shareholding? Will the answer above change if Co 1 is a Company listed in an international stock exchange?
100%
India
100%
Co 2
Co 2
Pre-transfer
Post-transfer
12
Case Study 1 Contd.

Non-discrimination clause in a double tax avoidance treaty:
Enterprises of a Contracting State, the capital of which is wholly or partially owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned State, are or may be subjected [OECD model]. When an Indian subsidiary has an Indian parent company, shares of which are listed on any recognised stock exchange in India, the Indian subsidiary is treated as a company in which the public are substantially interested and hence, out of the scope of Sec 79. Therefore, when an Indian subsidiary has a parent company (outside India), shares of which are listed on any stock exchange in its domicile country, the Indian subsidiary, by virtue of the non-discrimination clause discussed above, should also be treated as a company in which the public are substantially interested. Hence, the disability on carry forward and set off of losses u/s 79 should not be extended to that Indian subsidiary of foreign parent Daimler Chrysler India Pvt Ltd v. DCIT*
* ITA No. 968/PN/03
13
Case Study 1 (a)

Outside India
Co 4 Co 4
55%
Co 4
Will the answer to Case Study 1 change if:

the change in shareholding of Co 2 is by reason of amalgamation of Co 1 with Co 3; and Co 4 holds 55% and 75% of Co 1 and Co 3 respectively?
55%
75%
75%
Co 1
Co 1
Merger
Co 3
Co 3
100%
100%
100%
India
Co 2
Co 2
Co 2
Will the answer to above change if Co 4 holds only 30% shares of Co 3?
Pre-transfer
Transfer
Post-transfer
14
Case Study 2
Till 2000
100% subsidiary 100% subsidiary
Co 1
Co 1
Co 3
Co 1
Co 3
Co 4
100%
55%
45%
6%
45%
49%
Co 2 Co 2 is a wholly owned subsidiary of ABL Co 2 had incurred losses prior to 2000
Co 2
Co 2
In 2000-01, Co 1 transferred 45% of holding in Co 2 to Co 3 (its wholly owned subsidiary)
In 2002-03, Co 1 transferred 49% holding in Co 2 to another company, Co 4
Is Co 2 allowed to carry forward and set off of its losses?
Is Co 2 now allowed to carry forward and set off of its losses after 49% shares are transferred to Co 4?
15
Case Study 2 Contd.

Under the first situation, as 51% shareholding of Co 2 remains with Co 1, Section 79 is not attracted and hence, Co 2 is entitled to the benefit of carry forward and set off of its losses incurred prior to the year of transfer Under the second situation, although Co 1 directly holds only 6% of the shares of Co 2, yet Co 3, being a 100% subsidiary of Co 1, it may need to be seen whether Co 1 continues to remain the beneficial owner of 51% shares in Co 2. This is also possible if the Board of Directors (BOD) of Co 3 is controlled by Co 1. (Section 79 does not talk about the ownership of the share A company is said to a subsidiary of a holding company also if the board of such company is controlled by the holding company). Similar was the AAR ruling in the case of Amco power Systems Limited*
The ITAT referred to the Companies Act which states that a subsidiary company is one in which its BOD is controlled by its holding company. Further, as per Companies Act, the BOD shall be deemed to be controlled by another company if that other company at its discretion can appoint or remove the holders of all or majority of the directorship. Because of the holding pattern, board decisions of APIL were controlled by ABL and accordingly ABL had control over the affairs of Amco Since the BOD of APIL is controlled by ABL, such voting power held by APIL was actually beneficially held by ABL. Thus there was no actual change in beneficial shareholding of Amco. Carry forward and Set-off allowed
* ITA No. 889/Bang/07
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Deemed Dividend
Deemed Dividend Section 2 (22) (e)

Section 2 (22) (e) of the Act provides that any payment made by a company in which the public are not substantially interested by way of advance or loan:
to a shareholder who is a beneficial owner of shares holding not less than 10% of the voting power; or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest; or any payment made by any such company on behalf, or for the individual benefit, of any such shareholder
to the extent to which the company in either case possesses accumulated profits would be deemed as dividend.
18
Rationale
Closely held companies, which are controlled by a group of members, even though the company has accumulated profits, would not distribute such profit as dividend because the same would be taxable in the hands of the shareholders. Instead, companies distribute them as loan or advances to shareholder or to concern in which such shareholders have substantial interest or make any payment on behalf of or for the individual benefit of such shareholder to avoid the same from being taxed in the hands of the shareholder. The intention behind the provisions of this section is to tax such dividend (in the form of loan or advance) in the hands of the shareholder.
19
Case Study 3
3 Trustees 5 beneficiaries
Shares were held in the name of 3 trustees for and on behalf of the Trust and there were 5 beneficiaries. The beneficial owners, in this case, are the beneficiaries of the trust Would the loan to Co 1 be taxable in the hands of Co 1 as deemed dividend? If a person is a registered shareholder but not the beneficial shareholder, then the provisions of section 2(22)(e) will not apply.
Trust
20%
10%
Co 1
Co 2
Loan
None of the trustees are beneficiaries of the trust
20
Case Study 3 (a)

Co 4 Co 2 grants a loan to Co 1 (in which the ultimate parent Co 4 has a substantial interest) Would such loan be taxed as deemed dividend in the hands of Co 4? Co 3
20% 100%
As per the provisions of Sec 2(22)(e), the loan has to be given to a shareholder (who is also a beneficial owner) or to a concern in which the shareholder has substantial interest In the instant case, Co 3 is a registered shareholder but the loan has not been granted to Co 3 The loan has been given to Co 1 in which Co 4 has substantial interest. However, although C 4 is the beneficial owner of the shares in Co 2, it is not the registered shareholder. If a person is a beneficial shareholder but not a registered shareholder, then also the provisions of section 2(22)(e) will not apply.
Co 1
Co 2
Loan
21
Case Study 3 (b)

Would the answer to Case Study 3 change if the common shareholder is a company (say Co 3) holds the shares of Co 1 as a beneficial owner?
Co 3
20% 10%
In that case, Co 3 would be both the registered shareholder and the beneficial owner of the shares in Co 2. Hence, the provisions of section 2(22)(e) will be applicable and the loan from Co 2 to Co 1 will be taxed in the hands of Co 3 by virtue of being the shareholder (both registered & beneficial owner).
Co 1
Co 2
Loan
22
Case Study 3 Contd.

It was held in the case of Bhaumik Colour (P) Ltd* that the expression shareholder referred to in Sec 2(22)(e) refers to both a registered shareholder and beneficial shareholder The requirement of holding of shares both as a legal registered owner and beneficial owner of such shares were not satisfied in the case of Bhaumik Colour. Therefore provisions of Sec 2(22)(e) were not applicable in the case of the Assessee. Deemed dividend can be assessed only in the hands of a person who is a shareholder of the lender company and not in the hands of a person other than a shareholder The Madras High Court in the case of Govindarajulu Naidu (G.R.) V.CIT** has held that it is not possible to construe that Section as importing two fictions i.e., one that the loan granted to the shareholder should be deemed to be a dividend and other that, the beneficial owner of the shares is deemed to be a registered shareholder of the Company. Hence, loan advanced to a shareholder would be deemed as dividend u/s 2(22)(e) only if the loan is advanced to a registered shareholder
* 27 SOT 270 (Mum, SB)
** 90 ITR 13 (Mad, HC)

23
Madura Coats (P) Ltd - AAR 274 ITR 609

A loan given by a step down subsidiary to another company, which is a subsidiary of the super parent not treated as deemed dividend u/s 2(22)(e)
Subsidiary
CHL
Subsidiary
CPL
Subsidiary
CFL
Borrower is not the direct shareholder of the lender company Hence, borrower is not the beneficial owner of the shares of the lender company
JPC
99.998%
Loan
MCPL
24
Royalty
Treaty definition of Royalty

Article
1
OECD Model
Royalties arising in a Contracting state and beneficially owned by a resident of the other contracting state shall be taxable only in that other State
UN Model
Royalties arising in a contracting state and paid to a resident of the other contracting state may be taxed in that other state
However royalties may also be taxed in the Contracting state in which they arise but if the beneficial owner of royalties is a resident of the Other Contracting State, the tax shall not exceed %
26
Concept of beneficial ownership Royalty

Article 12 of the Model Conventions: Treaty benefits on royalty available only if recipient is the beneficial owner of such payments The terms beneficial owner and economic owner can be equated in contrast to legal owner International Bureau of Fiscal Documentation Klaus Vogel on Double Taxation Conventions (1991)
Treaty benefits should not be granted with a view to formal title to royalties (or interest or dividend), but to the real title
The dispute of form versus substance should be decided in favour of substance 1986 OECD Conduit Companies Report
The test of beneficial ownership for tax treaty purposes must be an economic one, the beneficial owner must be the person that economically benefits from the assets
OECD Model Convention 2005 Commentary on Article 12

Requirement of beneficial ownership was introduced to clarify how Article 12 applies in relation to payment made to beneficial owners State of source is not obliged to give up taxing rights over royalty income Where income is received by a resident of a Contracting State acting in the capacity of an agent or nominee, it would be inconsistent with the object and purpose of the Convention for the State of Source to grant relief or exemption However the limitation of tax in the state of source remains available when an intermediary is interposed between the payer and the beneficial owner. States which wish to make this more explicit can do so in bilateral negotiations
27
Case Study - 4
Members of the consortium are the owners of the technology and the IPR; C, Canada acts as an agent for licensing the technology to potential licensees; C, Canada identifies potential licensees, grants the license, undertakes collection and remittance; C receives a commission / fee for its activities; Assume the case of an Indian licensee; In determining the tax implication, which DTAA would apply Indo-Canada; or The DTAA between Indian and the respective country of the owners of the IPR Whether C receives the royalty or licensee fee in his own right or as a mere agent?
F, France
G, Germany
J, Japan
C, Canada
Consortium
Licensee
Licensee
Licensee
Licensee
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Intermediary / Investment Company Jurisdiction
KSPG AAR Ruling

Facts Initially German company was the holding company of the Indian company. The shares of the Indian company were transferred to a Netherlands company in 2008 The Netherlands company had made major investments in the subsequent period Question before the AAR Whether the capital gain on sale of shares of Indian company to another non-resident is liable to tax in India? Assessees contention As per the Indo-Netherlands treaty the capital gain on alienation of shares of Indian company is liable to tax in Netherlands PG GmbH
Germany 100%
KSPGN
100% Netherlands India
PG India
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KSPG AAR Ruling Contd.

Revenue Authorities The beneficial owner of shares is the German company and therefore the IndoGerman Treaty should be applied Till 2008 the German company was the holding company and to avoid the capital gains tax, the intermediary holding company in Netherlands was incorporated AAR held Netherlands company is a different legal entity and having separate board of directors and management systems Netherland company also had made substantial investments in Indian company Netherland company is not a conduit company Transaction cannot be treated as device to avoid the capital gains
Capital gains is not liable to tax in India
31
E Trade Mauritius Limited Vs. ADIT (Int. Taxation)

E-Trade Fin Corp
USA E-Trade Mauritius is a limited company and a subsidiary of E-Trade Financial Corporation, a US based company. E-Trade Mauritius sold shares of an Indian company (IL&FS) Ltd to another Mauritius company, HSBC Violet Investments (Mauritius) Ltd and claimed capital gains exemption under Indo-Mauritius DTAA.
E-Trade Mauritius
Mauritius India
HSBC
Share transfer
IL&FS
Whether Mauritian based purchaser of shares of an Indian company is required to deduct tax at source while paying sale consideration to another Mauritian based subsidiary of US based company? Assessee company in Mauritius is just an instrument of the US parent company for routing investments into India. Therefore, Indo-USA Tax treaty is applicable and the purchasing company is liable to deduct tax at source while remitting consideration to the assessee.
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Apex Court Ruling - Azadi Bachao Andolan
Key takeaways
Key Takeaways
No clear definition available anywhere, either in the treaties or in the domestic tax law of any jurisdiction - Imminent need to have a commonly understood meaning across jurisdictions India to have a clear definition of beneficial ownership in its domestic tax laws which is in sync with the internationally accepted meaning thereof Similar provisions exist in the proposed Direct Tax Code but beneficial ownership has also not been defined therein. So, the present judicial precedents should hold good even thereafter Intermediary holding company structures and their status as beneficial owner of the investments: In what situation the corporate veil is to be lifted is based on the facts of the case
Every intermediary holding company needs to pass the substance test and establish its independence and authority to claim itself as the beneficial owner of the investments
In the advent of the landmark judgement of the apex court in the case of Azadi Bachao Andolan, it appears that inbound investments into India through treaty network may not be faced with many hurdles in claiming beneficial ownership and corresponding treaty benefits provided it is a legal transaction. However, outbound investments from India may need to establish the facts based on the interpretation of the law of the respective source countries, who may decide the availability of treaty benefits that can be claimed.
Undoubtedly, the ratio of Azadi Bachaos case is widely acknowledged internationally and hence, the decision should benefit even deserving outbound investors
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Beneficial Owner

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Beneficial Ownership Indian Issues

K R Sekar 20 March 2010

2010 Deloitte LLP. All rights reserved.

Concept of beneficial owner

Concept of beneficial owner Contd.

Illustrative example of the concept

0% w/h tax [Tax Haven domestic tax law]