Tax Treaty Series

ITQ T-

025

December 13, 2019

Question

ACO is a company resident in country A.

3 years ago, ACO purchased, from an unrelated party, a “special security” which had been issued by Entity B, which was formed under country B law. Entity B is a “qualifying cooperative foundation” (QCF), a legal form which is found in country B law, but not in country A law. Under country A law, the only legal forms which exist are individuals, companies and partnerships.

Several other parties own “special securities” issued by Entity B.

During the last 3 years, Entity B has derived significant profits from business operations in country B. However, during that period, it has made only a series of relatively small payments to ACO.

Under country A tax law, ACO is taxable on global profits, although an exemption is given for foreign source dividends. Country A has no CFC or similar rules, no entity characterisation rules, and no instrument characterisation rules. Partnerships are tax-transparent. There is no double tax treaty between countries A and B.

In calculating ACO’s country A income tax liability: (i) should ACO be taxable on the series of relatively small payments made to ACO by Entity B?; and (ii) should ACO be taxable on all or part of the profits derived by Entity B?

Answer

This question raises 2 characterisation issues: (1) what is the characterisation of Entity B?; and (2) what is the characterisation of the "special security"?

Regarding (1):

As country A law recognises only 3 legal forms (individuals, companies and partnerships), it is necessary to characterise Entity B as one of those 3 forms. In the absence of specific rules, most countries adopt a so-called "similarity approach" – i.e., identify the rights and obligations of the foreign entity under the law where it is formed, and then (based on those rights and obligations) identify the local country legal form which it most closely resembles (see: OECD Report: "The Application of the OECD Model Tax Convention to Partnerships", 1999).

Based on this approach, Entity B would be characterised as either a company or a partnership for country A tax law purposes.

Regarding (2):

As country A tax law has no instrument characterisation rules, a "similarity approach" would probably also be used: based on the rights and obligations of the "special security" under country B law, what characterisation would be given to the “special security”?

The 2 likely alternatives are: an ownership interest (either shares in a company or a partner's interest in a partnership) or a debt interest.

Thus:

The possibilities are: (a) company + shares (no country A tax); (b) company + debt (country A tax on payments received, on basis that they are "interest"); and (c) partnership (country A tax on Entity B's profits; possibly 2 taxable items, if “special security” is characterised as debt).

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