Tax Treaty Series

ITQ T-

042

May 15, 2020

Question

ACo (a company resident in A) and BCo (a company resident in B) are sister subsidiaries in the global XYZ group.

ACo is the group’s in-house finance company and BCo carries on a manufacturing business.

ACo lends money to BCo at an interest rate of 4% per annum.

The B tax authorities determine that the arm’s length interest rate is 3% p.a. (please assume that that is the correct determination).

Under B domestic law, a final withholding tax of 20% (on gross) is levied on outbound payments of dividends, interest and royalties. The corporate income tax rate in B is 25%.

The A/B treaty is identical to the 2014 OECD model treaty.

What actions does the treaty permit the B tax authorities to take in regard to the 1% of excessive interest?

Answer

BCo’s interest deduction:
- Art. 9(1) permits the B tax authorities to use domestic law TP rules to disallow a deduction for the 1% excessive interest.
ACo’s interest income:
- Art. 11(6) applies to the 1% excessive interest – with three effects: (i) Art. 11(2) 10% limit on B tax does not apply to the 1%; (ii) the 1% “shall remain taxable according to the laws of each Contracting State”; and (iii) “due regard being had to the other provisions of this Convention”.
- Effect (ii) indicates that the 1% would be subject to 20% B tax.
- However, what is the impact of effect (iii)? Unless the B tax authorities make a secondary adjustment (see below), it seems that Art. 7(1) should apply to the 1% - in which case, the 1% would be exempt from B tax (assuming that ACo does not have a PE in B).
Secondary adjustment:
- According to the OECD Comm., Art. 9 does not prevent B from applying a secondary adjustment, if permitted to do so under its tax law.
- 2017 OECD TPG, paras. 4.68 – 4.78: A secondary adjustment might take the form of a deemed dividend (which would trigger dividend withholding tax) or a deemed loan to ACo (with deemed arm’s length interest). If a deemed dividend, then the fact that ACo and BCo are sister subsidiaries might cause hypothetical dividends and capital contributions up and down the ownership chain. Alternatively, the B law might allow ACo a time period in which to repay the cash to BCo.

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