When establishing a hedge fund it is vital to structure it tax efficiently by seeking to eliminate or reduce tax at the fund and investor level. This often requires the use of double taxation agreements (DTA). Hedge funds are generally domiciled in low tax jurisdictions, such as the BVI and the Cayman Islands, to ensure that the hedge fund does not suffer tax on the increased value of the portfolio each year. But low tax jurisdictions typically do not conclude DTAs and this could create tax inefficiencies for structuring the underlying fund investments.
One structuring technique available to avoid or minimise tax leakage at the fund investment level is for a hedge fund to establish an intermediate holding company (SPV) that is based in a jurisdiction that has the benefit of preferential DTA rates with the country, or countries, where the underlying investments are to be held. The investments would then be acquired by the SPV. For such a structure to work effectively, the SPV must suffer minimal corporate tax and should be able to repatriate its profits to the hedge fund, in the form of dividends or interest, without the deduction of withholding taxes.
The use of an SPV in this manner is often referred to as “treaty shopping” and tax authorities around the world may attempt to deny the SPV the benefit of a DTA on the basis that the SPV is not the “beneficial owner” of the relevant income stream. “Beneficial owner” is one of the most important concepts used in DTAs and its application generally aims to restrict the benefit of any DTA-reduced withholding taxes on dividends, interest and royalties to the recipients who are the “beneficial owner” of such income. If an SPV is merely a conduit company established to access beneficial rates of withholding tax on source income, it would not be regarded as the beneficial owner and may be denied DTA access, which could lead to increased taxation and diminished investment returns within the hedge fund. Although the term “beneficial owner” has been incorporated into the majority of the DTAs that follow the OECD Model Tax Convention, it is not generally defined in DTAs. This means that the term has to be given the meaning that it has under there levant domestic law (general or tax law).
As the term “beneficial owner” is a DTA concept and generally has no defined meaning under the domestic tax law of most countries, this creates uncertainty as to how the term is likely to be interpreted by domestic courts if a tax authority asserts that the SPV is not the beneficial owner. The Organisation for Economic Cooperation and Development (OECD) does not provide…
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