Conduit companies and the Indofood case

The recent Court of Appeal judgement in the Indofood case, Indofood International Finance Ltd v JPMorgan Chase Bank N.A., London Branch (formerly J P Morgan Chase Bank, London Branch) caused a significant amount of concern to practitioners when handed down earlier this year.  While most of the excitement has died down, I think some interesting points emerge.

1. Facts

A key point is that this was not a tax case, but contractual litigation between Indofood International Finance Ltd (“Indofood”) and the bank “JPMorgan” in its capacity as trustee for some public bondholders. 

Indofood itself was a Mauritius subsidiary of an Indonesian company, PT Indofood Sukses Makmur TBK (“PTISM”), which in June 2002 wanted to raise debt in the international bond market.  As Indonesia had a 20% withholding tax in general, but only a 10% withholding tax on interest paid to Mauritius, Indofood was setup in Mauritius and issued US$ 280 million of 5 year bonds, guaranteed by PTISM, with a fixed interest rate of 10.375%, and lend the money so raised to PTISM. (PTISM was willing to accept the 10% withholding tax cost on interest paid to Indofood as part of the overall cost of the bond finance.)  Under the contractual arrangements, PTISM was required to pay interest on its loan from Indofood two days before Indofood was due to pay interest on its bonds.  Within one day after that, Indofood was obliged to transfer the cash received to JPMorgan as paying agent, to pay the bondholders.

Two years later, Indonesia gave notice that it was revoking its tax treaty with Mauritius, which would cause 20% withholding to apply on the Indofood/PTISM loan instead of 10%.  Under the contractual arrangements, this material tax change permitted Indofood to repay its public bonds at par.  However, by June 2004 the bonds were standing in the market well above par, due to changes in credit conditions, and the bondholders wanted to avoid the repayment at par taking place.

The contractual arrangements excluded repayment at par if there were “reasonable measures” that PTISM could take to avoid the impact of the tax change. JPMorgan contended that PTISM and Indofood could achieve this by incorporating a new Dutch special purpose vehicle (“SPV”) and then novating to it the bonds owed by Indofood, as well as assigning to the Dutch SPV the ownership of the debt owed by PTISM to Indofood.  PTISM rejected this as unlikely to be successful; given their clear commercial desire to repay the bonds at par, one is not surprised that PTISM held this view.  Litigation ensued.

2. Court Decisions

In the High Court, Justice Evans-Lombe found largely in favour of JPMorgan.  Accordingly Indofood appealed, while JPMorgan cross appealed on the point that had gone against them.  The Court of Appeal found unanimously for Indofood.  What matters is the extent to which the Court of Appeal decision has wider application.

Strictly the decision of the Court of Appeal was that, in the language of the contractual documents, there were no “reasonable measures” available to Indofood to avoid the extra Indonesian withholding tax cost arising from the Mauritius treaty being abrogated. 

To reach that conclusion, the Court of Appeal did not find itself considering an entire universe of alternative courses of action; the only one being put forward in argument was the use of a new Dutch SPV.  The leading judgement was given by the Chancellor of the High Court, Sir Andrew Morritt.  He focused on three questions under the Indonesian/Netherlands Double Tax Agreement (DTA).

(a) Would the Dutch SPV be the beneficial owner of the interest payable by PTISM?

At the High Court, Indofood had produced evidence from the Indonesian tax authorities.  They had been asked by PTISM whether they would regard Dutch SPV as the beneficial owner of the interest, and unsurprisingly answered in the negative.  It emerged during the litigation that Indofood’s expert witness on Indonesian tax law had assisted the Indonesian authorities in drafting their answer!

In addition to this evidence regarding the view of the Indonesian tax authorities, the Chancellor also considered the official commentary to the OECD Model Convention, written by Professor Philip Baker QC.  This explains the “beneficial ownership” limitation in the model agreement, and in particular “suggests that the term should be accorded an ‘international fiscal meaning’ not derived from the domestic laws of Contracting States.”

The Chancellor held that, on the facts in this case, the likelihood of the Indonesian tax authorities concluding that the Dutch SPV did not have beneficial ownership was sufficiently high that its interposition was not a “reasonable measure” available to PTISM.

(b) Whether Dutch SPV would be resident in Holland?

Article 4 of the Netherlands/Indonesia DTA has a “place of effective management” test for corporate residence.  The Chancellor concluded that the Dutch SPV would not be Dutch resident, as the key decisions relating to its setting up would be taken by PTISM in Indonesia.

(c) Whether the Dutch SPV could be interposed without the creation of  a new loan between Dutch SPV and PTISM?

This question mattered because the external bonds, and therefore the internal loan from Indofood/Dutch SPV to PTISM were due for repayment on 18 June 2007.  Accordingly, if there was a new loan its life (looked at when the issue became relevant in mid 2005) would be less than 2 years.  The Netherlands/ Indonesia DTA’s interest article was Article 11.  Under Article 11.2 the withholding tax rate was 10%, but this was reduced to zero if the period of the loan was more than two years. 

Furthermore, movements in interest and exchange rates between June 2002 (when the PTISM loan was first made) and mid 2005 meant that a new loan made on identical terms would not be made at market rates, and therefore infringe Article 11.9 of the DTA dealing with excessive interest arising from a special relationship.

JPMorgan contended that the existing Indofood/PTISM loan could be assigned to Dutch SPV without any form of novation which would constitute the making of a new loan.  On this point, the Chancellor found for JPMorgan.

However, as questions (a) and (b) had been decided for Indofood and the Chancellor considered (a) by itself to be decisive, he gave judgement in favour of Indofood.

The opinion given by Lord Justice Chadwick was much shorter than the Chancellor’s.  LJ Chadwick also analysed the beneficial ownership issue in some detail and concurred with the Chancellor that Dutch SPV would not be regarded by the Indonesian tax authorities as having beneficial ownership for treaty purposes of the interest paid by PTISM.  This was sufficient for him to decide the case in favour of Indofood.  LJ Chadwick stated that his provisional conclusion on residence differed from that of the Chancellor, but he considered detailed analysis unnecessary and preferred not to decide the point.

The third judge sitting was Sir Peter Gibson.  He concurred with the Chancellor on question (a), beneficial ownership, which was enough to decide the appeal in favour of Indofood.  Accordingly, he expressed no opinion on question (b), residence.

3. What is the significance of the case?

One needs to consider the two main issues separately.

(a) Beneficial Ownership

In my view, the judgement has no impact upon the meaning of “beneficial ownership” in UK law.  It is tolerably clear from the Chancellor’s judgement and his citation of Professor Philip Baker QC’s official commentary that the “beneficial ownership” test in the OECD Model Treaty is a more stringent test than asking whether the recipient of the interest is beneficial owner under UK law.

The essential point of the judgement is that while the proposed Dutch SPV would own the PTISM loan and be fully entitled to receive the interest, its subsequent lack of freedom regarding what to do with the interest once received was so great that it could not be regarded as the beneficial owner under the language of the DTA.  Despite my view that the case has no impact upon the UK domestic law meaning, I would not be surprised if HMRC sought to plead the case if challenging a purely domestic conduit agreement.

I do however expect the judgement to be applied widely in the interpretation of double tax treaties, subject to two qualifications.

(i) What are the facts?

This case was decided on its specific facts.  If one wanted to interpose a conduit SPV which did have beneficial ownership, the obvious approach would be to avoid all the constraints which had been placed on Indofood regarding what it could do with the interest monies when received.

(ii) Other anti-conduit provisions
 
Modern double tax treaties often contain additional provisions aimed at preventing the use of conduit companies.  For example, the relatively new UK/US treaty contains anti-conduit rules which were discussed in my article “The Anti-Conduit Provisions of the New UK/US Treaty” which was published in the September 2003 issue of Financial Instruments Tax and Accounting Review, and is attached to this posting.

(b) Corporate residence

I found the Chancellor’s comments and decision on corporate residence surprising. 

He did not cite a single case, and his views are clearly not consistent with the decision of the Court of Appeal in Wood v Holden given on 26 January 2006, before the hearing of Indofood.  I also note that LJ Chadwick and Sir Peter Gibson declined to reach any conclusion about residence.  Furthermore, the Chancellor was assessing what decision the Indonesian tax authorities would take regarding the residence of a hypothetical company that had not yet been set up.

Accordingly, while it seems “brave” to ignore a Court of Appeal decision, in my view the case gives no guidance for the UK law on corporate residence.

My views on the case differ from some representatives of the US, Canadian and UK tax authorities who discussed the case in March at an international tax conference in Washington. I was not at the conference, and the comments below are based upon a news story on the Tax Analysts service.

Patricia Brown, US Treasury Deputy International Tax Counsel found problematic the ruling that beneficial ownership has an international meaning. She commented that she often came across definitions of “beneficial owner” that she disagreed with, for example in the context of mutual funds. She was concerned that the term was being used against taxpayers to deny treaty benefits inappropriately. I largely share her concerns.

Brian Ernewein, Director of Tax Legislation for Canada’s Department of Finance found the ruling on residence particularly significant, which is at variance with my view above.

Diane Hay, Deputy Director of Revenue Policy, International at Her Majesty’s Revenue and Customs describe the ruling as “not just one Christmas present but two” for HMRC. She disagreed with other panellists who considered Indofood to be a narrow contract law case, and stated that “This is now English law.” As indicated above, I would differ on with regard to residence. I do think that the comments on beneficial ownership in the context of tax treaties would be followed by other UK courts, although there may be scope for future litigants to argue that strictly the Court of Appeal did not need to reach its own view on beneficial ownership under the Netherlands/Indonesia DTA; it merely needed to decide what the likely decision of the Indonesian tax authorities would have been if Dutch SPV had been set up.

However, given the views expressed at the conference, which can be expected to circulate widely within the respective tax administrations, taxpayers can expect that in the future tax authorities will frequently cite Indofood against them.

Mohammed Amin