Tax Treaty Series

ITQ T-

039

April 17, 2020

Question

XCo, a company resident in X, owns 100% of the shares in YCo, a company resident in Y.

YCo derives a significant amount of profits, but it does not pay any Y tax on those profits (as it is in a tax holiday period in Y). YCo does not pay any dividends to XCo.

The X tax law includes CFC rules. Under those rules:

YCo is a CFC.
YCo’s total amount of profits is deemed to be paid as a dividend to XCo on the last day of the current tax year, and therefore that amount is included in XCo’s taxable profits for that year.

Q1: The X/Y treaty is identical to the 2014 OECD model treaty. Does the treaty prevent X from applying its CFC rules in regard to YCo’s profits?

Q2: Would your answer be different if the X/Y treaty were identical to the 2017 OECD model treaty?

Answer

Q1:

There are conflicting court decisions:

The Schneider case (France) and several Brazilian cases held that CFC rules conflict with a treaty and are therefore not applicable
Whereas, the Bricom case (UK) and several Japanese cases held, subject to conditions, that CFC rules do not conflict with a treaty and are therefore applicable

The 2014 OECD Comm. dismisses "pro-conflict" arguments which are based on Art. 7(1) (i.e., that YCo's profits cannot be taxed in X, as YCo does not have a PE in X) and Art. 10(5) (i.e., if YCo's profits are derived from X). The Comm. also, in regard to Art. 1, supports the position that there is no conflict. Five OECD members have registered their disagreement or reservations.

X's CFC rules operate by deeming a dividend paid by YCo to XCo. If Art. 23 in the X/Y treaty requires X to exempt dividends paid by YCo, the question would arise whether X's CFC rules conflict with the treaty: see para. 38, OECD Comm. on Art. 10.

Conclusion: depends on the views of X's courts on the above issues.

Q2:

Art. 1(3): the treaty cannot affect X's taxation of XCo (a resident of X). The 2017 OECD Comm. makes clear that Art. 1(3) applies to CFC rules.

Conclusion: CFC rules apply

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