Spain's Supreme Court applies beneficial-owner requirement to deny reduced rate under double taxation agreements

The Supreme Court, in its ruling of 12 January, considered that, if the recipient of a cross-border royalty is not its beneficial owner, the primacy of European Union law prevents the reduced rate of the bilateral agreement from being applied.

Cross-border regulatory framework

When a royalty payment is made between entities located in different EU member states, legal double taxation may occur, given that this income can generally be taxed both in the jurisdiction of the payer and in that of the recipient. Directive 2003/49/EC aims to avoid this situation without having to resort in each case to the double taxation agreements (DTAs) signed between the member states concerned.

The directive establishes that interest or royalty payments between associated entities from a member state shall be exempt from taxation in that state of origin, provided that the beneficial owner is a company from another member state.

A company will be considered the beneficial owner only if it receives such payments for its own benefit and not as a mere intermediary, agent or representative (for example, when it transfers them in full or in part to another entity outside the EU or does not have the right to dispose of them freely).

Spanish legislation on Non-Resident Income Tax (article 14.1.m) transposes this exemption into domestic law, requiring that the recipient company receive the payments for its own benefit and not as a mere intermediary.

At the same time, most DTAs establish reduced withholding rates in the payer's state when royalties are paid to a resident of the other contracting State.

Therefore, in general, in the absence of the application of the benefits of European legislation – which takes precedence – the tax benefits provided for in the corresponding DTA may be applicable.

The facts of the case

Velcro Europe, a company resident in Spain, was part of a US-owned multinational group whose parent company Velcro Industries was incorporated in the Netherlands but resident for tax purposes in Curaçao, formally the Netherlands Antilles, and owner of the group's trademarks and intellectual property (IP) rights.

Velcro Holdings, which was domiciled in the Netherlands, acted as a sub-holding company responsible for managing and collecting royalties generated by the group's IP. Initially, it did so through a contract for the management and exploitation of royalties in Europe and, subsequently, through a licence agreement with Velcro Industries, which allowed it to sub-licence those rights to other subsidiaries of the group including Vesa.

Vesa entered into contracts whereby it paid royalties derived from the exploitation of IP directly to Velcro Holding. Initially, these payments were subject to the 6% withholding tax established in the DTA between Spain and the Netherlands. However, from 2014 onwards, Vesa ceased to apply withholding tax, considering that the exemption provided for in article 14.1.m of the Non-Resident Income Tax Law, which transposes the exemption provided for in the European directive, was applicable.

The Spanish tax authorities regularised Vesa's situation after considering that Velcro Holding was not the beneficial owner of the royalties but rather Velcro Industries, which was resident in Curaçao. It therefore denied both the exemption under Spanish law and the reduced rate under the Spain-Netherlands DTA, requiring the 24.75% withholding tax provided for in the domestic Non-Resident Income Tax regulations.

Legal dispute before the Supreme Court

The dispute centred on determining how the royalties paid by Vesa to Velcro Holding should have been treated for tax purposes. Specifically, once the applicability of the exemption under article 14.1.m of the Non-Resident Income Tax has been ruled out and given that there is a DTA that provides for a reduced rate of 6%, the question wa whether this reduced rate should be applied or the 24.75% withholding tax established in domestic legislation.

Position of the Supreme Court

The Supreme Court understood that European legislation takes precedence over bilateral agreements on withholding tax and that – when a transaction is subject to the Interest and Royalty Directive but is not eligible for the exemption because the recipient of the payment is not the true beneficiary – the reduced rate under the bilateral agreement cannot be applied either. In such cases, the Supreme Court considers that the withholding tax provided for in Spanish legislation, which faithfully reflects the provisions of the directive, should be applied directly, thus superseding the application of the DTA.

The court's reasoning was based on the fact that Spain has fully incorporated the rules of the European directive, creating a comprehensive regulatory framework that takes precedence for interest and royalty transfers between related companies in member states. Therefore, once the exemption under the directive had been ruled out because the recipient does not meet the condition of beneficial owner, the reduced rates established in the DTA cannot be applied either.

For practical purposes, this means extending the beneficial-owner requirement to also enjoy the tax benefits of the DTA, even when this is not expressly provided for, as in the case under review (Spain-Netherlands DTA).

In the case analysed, the specific result is that the withholding tax under Spanish law (24.75% in the year under review) must be applied, ruling out both the European exemption and the reduced rate of 6% under the bilateral agreement.

Osborne Clarke comment

This ruling may represent a significant change in how the relationship between European law and bilateral agreements are interpreted. The main conclusion is that European regulations not only prevail when they allow tax benefits to be enjoyed but their scope may also be extended to prevent the application of the advantages of bilateral agreements when the requirements of the directive are not met; in particular that of being the beneficial owner. This conclusion is debatable, as it does not appear that the objective of the directive is to condition the application of benefits provided for in other conventional regulations whose purpose is to avoid double taxation.

This criterion may have significant practical consequences. Companies with international operations involving royalty or interest payments between entities in different member states should carefully review their structures to ensure that the recipient of the payment is indeed the beneficial owner. Otherwise, in the event of a tax inspection, they may be forced to apply withholding rates that are much higher than those provided for in bilateral agreements.