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In a widely-watched and much-anticipated decision, Prevost Car Inc. v. Her Majesty the Queen, issued April 22, 2008, the Canadian Tax Court determined, for purposes of the Canada-Netherlands Income Tax Treaty (the “Treaty”), that a Dutch holding company was the “beneficial owner” of dividends it received from its Canadian operating subsidiary, even though it promptly paid dividends in the same amounts to its two shareholders. The Honorable Gerald J. Rip, Associate Chief Justice, addressed a persistent conundrum in tax treaty practice: Aside from “limitation on benefits” provisions, in what circumstances should a corporation's receipt of dividends be “disregarded” for dividend withholding tax purposes under a treaty? The opinion is of significant interest to international tax practitioners outside Canada and the Netherlands, e.g., in places like the United States. As of this writing, it is not known whether the decision will be appealed.

Prevost Car (Canco) was a Canadian operating company. It was 100%-owned by Prevost Holding BV (BV), which in turn was owned 51% by Volvo, a Swedish company, and 49% by Henlys, a U.K. company. BV was formed as the corporate holding vehicle for a business joint venture between its two shareholders “to pursue multiple North American projects.” The first project was the investment in Canco and the second was to have been an investment in a Mexican company (which never occurred). The evidence established that, in choosing a Dutch holding company, tax was a consideration, “but not an overriding consideration.” Volvo did not want an English company, and Henlys did not want a Swedish company. Both wanted a European entity that was not too expensive to operate and where business could be conducted in English. The choices considered by the parties were Switzerland, Luxembourg, Belgium, and Holland (a list well known to most practitioners).

Volvo and Henlys, but not Canco or BV, entered into a shareholders' agreement providing for regular distribution of the profits of Canco to BV, and by BV to its two shareholders, by way of dividends, return of capital, or loans. The Court noted that for some of the years the Canco shareholders' meeting was attended by representatives of Volvo and Henlys, not of BV. Said Justice Rip, “This is at least sloppy maintenance of corporate records but also could be an indication of something more significant.” (Some judges might have written “more sinister”.)

BV's registered office was in the offices of an “international management” company affiliated with BV's banker, Citco Bank. BV had no employees in the Netherlands, nor any investments other than the shares of Canco. In today's common parlance, some might say that BV was “an empty box.”

From 1996 to 2001, Canco paid dividends of $90 million, representing 80% of its profits for the period. Canco withheld 5% Canadian tax under the Treaty. The Canada Revenue Agency (CRA) claimed that BV was not the “beneficial owner” of the dividends, and on that theory assessed tax at 15% under the Canada-Sweden treaty on that portion of the dividends it claimed was beneficially owned by Volvo, and 10% under the Canada-U.K. treaty on the dividends beneficially owned by Henlys. Justice Rip noted that “[CRA had said,] facetiously, I might add, [that] fortunately for the appellant, the Minister applied the reduced rates of taxation of 15 and 10% … even though the [Sweden and U.K.] treaties had no application.”

The issue in the case was the meaning of the words “beneficial owner” and “beneficiare effective” (and the Dutch equivalent) under Article 10(2) of the Treaty. Article 3(2) required looking to the law of the state imposing the tax at issue--the source country (in this case Canada)--in order to determine the meaning of the words.

At this point, note that the current U.S.-Canada treaty has a similar provision, also found in Article 3(2): “As regards the application of the Convention by a Contracting State any term not defined therein shall, unless the context otherwise requires and subject to the provisions of Article XXVI (Mutual Agreement Procedure), have the meaning which it has under the law of that State concerning the taxes to which the Convention applies.” This principle is consistent with the 2006 U.S. Model Income Tax Convention, Article 10(2)--to wit, “The term 'beneficial owner’ is not defined in the Convention, and is, therefore, defined as under the internal law of the country imposing tax (i.e., the source country).” (The 1996 U.S. Model Income Tax Convention is to the contrary--to wit, “The 'beneficial owner’ of a dividend is understood generally to refer to any person resident in [a] Contracting State to whom that State attributes the dividend for purposes of its tax.”)

Despite Article 3(2) of the Treaty, Canco introduced expert witness testimony that BV was the “beneficial owner” of the dividends under Dutch law, and CRA predictably disagreed with this proposition. Interestingly, Canco had sought Competent Authority relief on the beneficial ownership issue, but when the two governments differed, CRA terminated the proceeding. Canco's expert also stated, however, that if BV had been legally obligated to pass on the dividends to its shareholders, then Dutch law would not have considered BV to be the beneficial owner.

Getting to the heart of the matter, the parties agreed that BV was not an “agent, trustee or nominee” for its two shareholders. Rather, CRA argued that BV was “acting as a mere conduit or funnel” in favor of its shareholders upon receiving the dividends from Canco.

Justice Rip opined:

… In my view the “beneficial owner” of dividends is the person who received the dividend for his or her own use and enjoyment and assumes the risk and control of the dividend he or she received. The person who is beneficial owner of the dividend is the person who enjoys and assumes all the attributes of ownership. In short the dividend is for the owner's own benefit and this person is not accountable to anyone for how he or she deals with the dividend income… .When corporate entities are concerned, one does not pierce the corporate veil unless the corporation is a conduit for another person and has absolutely no discretion as to the use or application of funds put through it as a conduit, or has agreed to act on someone else's behalf pursuant to that person's instructions without any right to do other than what that person instructs it, for example, a stockbroker who is the registered owner of the shares it holds for clients. This is not the relationship between [BV] and its shareholders.

The Justice found that the references in Canco's minute books to Henlys and Volvo were errors that were “not fatal” to the taxpayer. “Minute books do contain errors.” And he found no evidence that BV was a “conduit”: Even though there was no physical office or employees in the Netherlands, “there is no evidence that the dividends … were ab initio destined for Volvo and Henlys, with BV as a funnel.…” Critical in this respect, BV was not a party to the shareholders' agreement to distribute Canco's profts. And there could be no legal action against BV, if that shareholders' agreement had not been honored by Volvo or Henlys.

In my view, Prevost Car is consistent with the two U.S. judicial opinions most closely relevant, both dealing with interest rather than dividends. (Thank you, Canada!) In Aiken Industries, Inc. v. Comr., 56 T.C. 925 (1971), the U.S. Tax Court held that interest had not been “received by” a Honduran corporation from its related U.S. corporation under the withholding tax provision of the U.S.-Honduras treaty. The Honduran corporation earned no profit (spread) and was “merely a conduit” for transmittal of the interest to a third party. And in Northern Indiana Public Service Company v. Comr., 115 F.3d 506 (7^th Cir. 1997), the taxpayer succeeded in applying the old U.S.-Netherlands treaty (as extended to the Netherlands Antilles). That treaty required that the interest be “derived by” a resident of the other Contracting State, and the intermediary resident company earned a 1% spread.

Thus, the view of this Canadian court is generally in line with the few U.S. precedents. And Prevost Car reminds us that business purpose is important and that corporate formalities (like minute books) should be given appropriate attention. The case doesn't tell us to hire employees and rent space in the Netherlands, but, of course, we already know we should do that.

This commentary also will appear in the July 11, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Levine and Miller, 936 T.M., U.S. Income Tax Treaties -- The Limitation on Benefits Article, and in Tax Practice Series, see ¶7140, U.S. Income Tax Treaties.