Shadow directors

Individuals commonly referred to as „shadow directors,” that is persons who effectively manage and oversee the operations of a company without holding formal positions on the management body, such as a „board of directors” in a one-tier or unitary board system, or a „management board” in a two-tier board structure. I am seeking to develop a rationale for applying Article 16 of the OECD Model Convention and Article 16(1) of the UN Model Convention to „shadow directors”.

This perspective is typically not shared by existing commentaries on the Model Convention or double taxation treaties, which are available and known to the author.

Concept of a shadow director

The concept of a shadow director was introduced in common law countries to attribute potential liability for mismanagement errors or breaches of fiduciary duties to individuals who assume directorial responsibilities without being formally recognized or appointed to the board.

It is understood that the concept of a „shadow director” was introduced to hold these de facto directors accountable for the company’s affairs in a similar manner to formally appointed directors. This approach prevents a scenario in which individuals who are actually responsible for managing the company delegate all responsibility for running the company’s affairs to „straw men” or nominees who are formally appointed directors but do not actually act in that capacity.

While the deployment of shadow directors may sometimes indicate an intent to conceal the true identity of ultimate beneficial owners exceeding beyond legally accepted norms or to transfer responsibility for questionable activities, it would be premature to conclude that the mere existence of shadow directors indicates a mala fidae situation that warrants penalization or inferior treatment of such directors.

Classification of fees paid to shadow directors under double taxation treaties

There are two important arguments to support the application of Article 16 OECD MC and Article 16(1) UN MC not only to directors formally appointment to management organ of company but also to shadow directors, despite the commonly held contrary view.

Substance-over-Form Argument

First one is the substance over form doctrine, which is generally accepted in tax systems all around the world, allowing tax authorities to disregard the legal form of an arrangement and instead focus on its actual substance. This principle, when applied to directors, could be interpreted that if an individual acts in the capacity of a director, then the provisions of double taxation agreements applicable to directors should apply, even if they were not formally appointed to the position. While the doctrine was established with the goal of preventing the use of artificial structures to avoid paying taxes, its meaning is broad and general, and there is no reason to one-sidedly limit its applicability to situations where it could increase the tax burden. On the contrary, the „in dubio pro tributario” rules signify that taxpayers should have the possibility of applying the substance over form doctrine for their benefit, no less than the taxman.

The situation becomes particularly evident and self-explanatory when applying the provisions of Article 16 of the OECD Model Convention and Article 16(1) of the UN Model Convention in a legal environment where a formal „board of directors” with executive and non-executive directors does not exist at all. We can observe how legislators in such countries are grappling with the translation of this provision pertaining to the board of directors into diverse legal terminology, particularly when a double taxation treaty is concluded between two countries that do not adhere to a monistic governance model. Such agreements related sometime to “directors’ fees or top level managerial officials” (DTA between Poland and Armenia), or “board of directors or another similar organ” (DTA between Poland and Finland), or “an official in a top level managerial position of a company” (DTA between Poland and Egypt).

In each instance, these provisions are far from perfect and are subject to disputes, as there is uncertainty surrounding the practical interpretation of terms such as „any similar organ of a company” or „another similar organ”. It raises questions about why there is a difference in terminology between different Double Taxation Agreements – are 'any similar organs’ and 'another similar organs’ referring to the same entities within a group or are they distinct, and if they are the same, why the inconsistency in terminology. Similarly, there is a lack of clarity regarding the definitions of „top-level managerial position of the company” and „top-level managerial officials”.

Things become interesting and entertaining when we examine the 1974 Double Taxation Agreement between Poland and Pakistan. In this agreement, the board of directors from the Model Convention was interpreted by legislators in the Polish version of the DTA as a „supervisory board”. It is evident that there is a significant „lost in translation” issue, as non-executive directors would be entitled to apply Article 16 (as non-executive directors are essentially equivalent to a supervisory board in a dualistic governance model), while executive directors would not be able to utilize this provision.

There is another, related issue here. What if a certain individual was formally appointed to the „board of directors or a similar organ” of a company, but later, his appointment was deemed invalid due to procedural issues? Should his fees be considered „director’s fees” under Article 16 of the OECD Model Convention and Article 16(1) of the UN Model Convention, or not? Should it really matter for tax purposes? Should we allow tax authorities to weaponize such mistakes against taxpayers? With these questions, we can observe how jurisprudence has went astray from the plain and simple ratio legis of this provision.

The most efficient way to untangle this Gordian knot is by using Occam’s Razor

The most efficient way to untangle this Gordian knot is by using Occam’s Razor. The simplest solutions are often the most perfect. The idea behind Article 16 of the OECD MC and Article 16(1) of the UN MC is to regulate the avoidance of double taxation for individuals managing a company, who are entrusted with various statutory duties and fiduciary responsibilities towards the company.

By applying the Substance-over-Form Argument, which allows courts to disregard the formalities of a disguised transaction and look at its true nature, we can conclude that we cannot discern their status if they are members of a „board of directors” (despite the absence of such a structure in certain countries’ legal systems), a Management Board, or if they are top-level managerial officials essentially acting as directors, assuming the responsibilities of directors with all its legal consequences but without formal appointment (referred to as shadow directors).

In the quest for interpretation meeting the criteria of justice and fariness

General rules of law fairness dictate that we should avoid situations in which individuals, such as shadow directors in this case, are obligated to bear the responsibilities associated with the position of director but are unable to enjoy the corresponding benefits.

If we choose to impose the burdens and obligations of a director onto shadow directors, even though they have not been formally appointed, we should not prohibit them from reaping the profits associated with acting in the capacity of a director, despite their lack of formal appointment.

Lack of precedent

In conclusion, further exploration of practical cases from legal systems around the world could provide valuable insights and guidance regarding the utilization of Article 16 of the OECD Model Convention and Article 16(1) of the UN Model Convention in the context of „shadow directors.” This issue seems to have been somewhat neglected and interpreted with a certain level of automatic repetition of theses that were formed before the concept of legal responsibility of shadow directors for running company affairs was widely accepted.

The illustration was generated by me with the gracious assistance of Artificial Intelligence.