Tax Treaty Series

ITQ T-

026

December 20, 2019

Question

XCO is a company resident in country X.

XCO owns 100% of the shares in YCO, a company resident in country Y.

XCO has made an interest-bearing loan to YCO. Assume that the interest rate satisfies the arm’s length principle.

Country Y tax law includes a thin capitalisation rule, which uses a 2:1 non-resident related party debt to equity limit. XCO’s loan to YCO exceeds that 2:1 limit. Accordingly, under the thin capitalisation rule, the interest on the excess amount of loan is disallowed as a deduction for YCO. However, the disallowed interest retains its character as interest for withholding tax purposes.

Country Y levies a 25% withholding tax on outbound dividends, and a 15% withholding tax on outbound interest.

Country X taxes resident companies on global income.

The X/Y double tax treaty is identical to the 2014 OECD model treaty.

Based on these facts, what is the tax treatment of each of XCO and YCO in countries X and Y?

Answer

The question does not indicate the maximum ratio of related party debt to equity which would satisfy the arm’s length principle ("ALP ratio").

We need to compare 3 ratios: (i) ALP ratio, (ii) Y's 2:1 thin cap ratio, and (iii) actual XCO / YCO debt to equity ratio ("actual ratio").

YCO's interest deductions:

If ALP ratio > actual ratio > 2:1 thin cap ratio, then YCO's deductions are allowable under Art. 24(4) (non-discrimination)
If actual ratio > ALP ratio > 2:1 thin cap ratio, then YCO’s deductions are disallowed under thin cap rule, to extent that actual ratio exceeds ALP ratio: Art. 24(4)

Interest withholding tax:

10%, under Art. 11(2) (regardless of the extent to which YCO's deductions are disallowed)
Note that Y law does not recharacterize disallowed interest as dividends
Note also that Art. 11(6) is not applicable, as the interest rate satisfies the arm's length principle ("the amount of the interest, having regard to the debt-claim for which it is paid, exceeds …")
X must give credit to XCO for the Y withholding tax: Art. 23A(2) / 23B(1)

ITQ Disclaimer

This International Tax Quiz (ITQ) contains general information only, and none of International Insights Pte Ltd, its employees or directors is, by means of this ITQ, rendering professional advice or services. You use the content of this ITQ strictly at your own risk. You should not rely on all or any part of the content of this ITQ in making decisions to take action (including inaction) in regard to tax or other matters. Before making any decision or taking any action (including inaction) that may affect your tax position, your finances or your business, you should consult a qualified professional advisor. None of International Insights Pte Ltd, its employees or directors shall be responsible for any loss whatsoever sustained by any person who relies on the content of this ITQ.