Tax Treaty Series

ITQ T-

017

October 11, 2019

Question

XCO is a company resident in country X.

XCO places money on a term deposit with an unrelated Bank, which is resident in country Y.

The deposit carries a fixed negative interest rate – i.e., XCO pays interest to the Bank.

The X/Y treaty is identical to the 2014 OECD model treaty. Assume that the Bank is the beneficial owner of the interest, and that it does not have a PE in country X.

Question 1: What is the treatment of the interest (which is paid by XCO to the Bank) under the X/Y treaty?

Due to further negative movements in market interest rates, the Bank decides to terminate the deposit before its maturity date. This triggers a penalty fee (imposed on the Bank) under the terms of the deposit.

Question 2: What is the treatment of the penalty fee (which is paid by the Bank to XCO) under the X/Y treaty?

Answer

Question 1:

There is no guidance on this issue from the OECD, either in the Commentary or elsewhere. Moreover, although there is some guidance from country tax authorities on aspects of the tax treatment of negative interest (e.g., tax deductibility), there is very little on the characterisation of negative interest for treaty purposes.
The relevant part of the definition of “interest” in Art. 11(3) is “income from debt-claims of every kind”. This suggests that the income must flow from an asset (being a debt-claim) of the income recipient, and not from a liability. Also, unsurprisingly, the OECD Commentary on Art. 11(3) is written on the assumption that the interest is paid by the debtor to the creditor. The reference to “negative interest” in paragraph 20 of the Commentary refers to bonds which are issued at a premium, which is arguably a different topic from negative coupon interest.
It has been suggested that negative interest should be characterised, not as interest, but as a fee charged by the debtor.
At present, the better view is that the negative interest is not “interest” as defined in Art. 11(3).
As the creditor is a bank, Art. 7(1) should apply to provide an exemption from X tax.

Question 2:

The penalty fee is paid by debtor to creditor, and thus the issue considered above does not arise here.
But, nevertheless, the question remains: is the penalty fee “income from debt-claims of every kind” (Art. 11(3) definition of “interest”)?
Again, there is no OECD guidance on this topic, and arguments can be made for and against.
If it is “interest”, then Y may tax the fee up to a limit of 10% on gross (assuming XCO satisfies the conditions in Art. 11(2) & (4)). X must then provide a credit for the Y tax: Art. 23A(2) or Art. 23B(1).
If it is not “interest”, then the fee should be exempt in Y (assuming XCO does not have a PE in Y), under either Art. 7(1) or Art. 21(1).

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