Tax Treaty Series

ITQ T-

012

September 6, 2019

Question

XCO is a company which is resident in country X. XCO owns 100% of the shares in YCO, which is a company resident in country Y. XCO is a pure holding company; its only assets are the shares in YCO. YCO has a “fixed place of business” PE in country Z, from which it derives profits. YCO also derives profits from its business operations in country Y. The X/Y, X/Z, and Y/Z treaties are identical to the 2011 UN model treaty (with the rate in Art. 10(2)(a) being 10%), and the MLI does not apply to those treaties. YCO pays a dividend to XCO. That dividend is subject to country Z tax, at the rate of 30% (the country Z corporate income tax rate) on a “net” basis – i.e., after subtracting allowable deductions. YCO has no collection obligations, under country Z law, in regard to that dividend; instead, XCO is required to report the dividend by filing a country Z corporate income tax return. The dividend is also subject to 20% dividend withholding tax under the country Y law. XCO is the beneficial owner of the dividend, and XCO does not have a PE in either country Y or country Z. Can the country Z tax and the country Y tax on the dividend be reduced or eliminated under a treaty?

Answer

Country Y tax:

Domestic law: 20% on gross dividend.
Treaty limitation: 10% on gross dividend: Art. 10(2)(a), X/Y treaty.

Country Z tax:

1. Domestic law: 30% on “net” dividend.

2. X/Z treaty:

10(2) and Art. 10(5) do not apply, as the dividend-paying company (YCO) is not a resident of a Contracting State.
If Art. 7 applies, XCO would be exempt under Art. 7(1).
However, a country Z court might take the view that Art. 7 does not apply, on the basis that XCO can be viewed as engaged in only a passive investment activity, which does not qualify as an “enterprise” (this term is not defined in the treaty – if it has a meaning under country Z law, it would probably take that meaning: Art. 3(2)).
If Art. 7 does not apply, Art. 21 is relevant. The default position is Art. 21(1), which would provide exemption from country Z tax. The critical issue is whether the dividend is “arising in [country Z]”, in which case Art. 21(3) would allow unlimited country Z tax. According to the UN Commentary, the “arising” issue is to be determined under the country Z domestic law – which would mean that there is a significant risk that a country Z court would conclude that Art. 21(3) applies.

3. Y/Z treaty:

Subject to (ii) & (iii) below, Art. 10(5) would apply to prevent country Z tax.
On the facts, it appears that the dividend is paid from a common profit pool, consisting of profits derived from the country Z PE and the country Y operations. The exemption in Art. 10(5) should not be reduced to the extent that the dividend is paid from profits from the country Y operations.
But can XCO, which is not a resident of country Y or Z, claim the benefit of Art. 10(5) of the Y/Z treaty? Art. 1 would indicate that it cannot. However, numerous academic articles and books have stated that Art. 10(5) would apply in this situation, regardless of Art. 1. For example, see: Madeira & Neves, “Exploring the Boundaries of the Application of Article 10(5) of the OECD Model”, Intertax, Vol. 35 (2007), Vol. 8/9.

4. What would happen if (a) Art. 21(3) of the X/Z treaty (country Z may tax), and (b) Art. 10(5) of the Y/Z treaty (country Z must exempt), BOTH apply? In my opinion, the exemption should prevail.

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