Tax Treaty Series

ITQ T-

010

August 23, 2019

Question

XCO is a company which is resident in country X. XCO has a “fixed place of business” PE in country Y. The PE carries on an IP licensing business – it licenses IP to customers in various countries, in return for royalties. One of those customers is ZCO, which is a company resident in country Z. XCO is the beneficial owner of the royalties, and it does not have a PE in country Z. The X/Y, X/Z and Y/Z double tax treaties are identical to the 2014 OECD model treaty (with Art. 23B), except that the source country tax on royalties is limited by Art. 12 in each of the 3 treaties to : 15% (X/Y); 5% (X/Z); and 10% (Y/Z). The MLI does not apply to any of those 3 treaties. Under the domestic tax law of each of the 3 countries : (i) the corporate income tax rate is 30%; (ii) the worldwide income of residents, and the domestic source income of non-residents, is taxed; (iii) a foreign tax credit regime applies, but only to residents; and (iv) the royalty withholding tax rate is 20%. In calculating foreign tax credits in each of the 3 countries, please disregard the allocation of deductions or (notional expenses) against foreign source income. If $100 of royalties are paid by ZCO to the PE, what amount of tax will be levied on that $100 in each of the 3 countries?

Answer

Z tax: $5 : Art. 12, X/Z treaty.

Y tax:

Prima facie tax, before applying Art. 24(3), would be $30 : Art. 7(1), 2nd sentence, X/Y treaty.

24(3), X/Y treaty, requires that : “The taxation on a [PE] which an enterprise of [X] has in [Y] shall not be less favourably levied in [Y] than the taxation on enterprises of [Y] carrying on the same activities”

Imagine a hypothetical enterprise of Y (“YCO”) which carries on the same activities as the PE. YCO would be subject to 30% corporate income tax on its profits from those activities (same as the PE), and it would be entitled to a credit for the Z tax under Y domestic law and under Art. 23B(1) of the Y/Z treaty (not the same as the PE : the non-residence status of the PE means that it does not satisfy the conditions for credit under Y domestic law and that it does not satisfy the residence condition in Art. 1 of the Y/Z treaty). YCO’s credit would reflect the 10% tax rate on royalties under the Y/Z treaty, not the actual 5% tax imposed under the X/Z treaty. Thus, hypothetically, the Y tax levied on YCO in regard to the royalties paid by ZCO would be $30 - $10 = $20.

Thus, the Y tax levied on the PE would be $20.

Apart from the issue of credit for Z tax, consider whether the taxable profits of the PE (determined under the Y domestic law and Art. 7(2), X/Y treaty) and the taxable profits of the hypothetical YCO (determined under Y domestic law) would be calculated as the same amount. To the extent that the taxable profits of the PE would be greater than the taxable profits of YCO, the resulting amount of excess Y tax would also generally (with some exceptions) trigger Art. 24(3), causing a reduction in the Y tax on the PE. This issue is not further considered here.

X tax:

X must grant a credit of $5 under Art. 23B(1) of X/Z treaty, and a credit of $20 under Art. 23B(1) of X/Y

treaty.

Thus, X tax = $30 - $5 - $20 = $5

Total tax : $5 (Z) + $20 (Y) + $5 (X) = $30

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