Tax Treaty Series

ITQ T-

043

May 22, 2020

Question

XCo, a company resident in X, carries on a business of manufacturing and selling goods. XCo is considering establishing a manufacturing plant in a developing country in order to benefit from lower manufacturing costs.

XCo identifies possible locations in 3 countries, all of which provide a 10-year tax holiday and impose 20% withholding tax on outbound dividends (DWT).

The only material difference between the 3 countries is that Y has entered into a double tax treaty with X, and the other 2 countries have not. The X/Y treaty is identical to the 2017 OECD model treaty.

Based on that difference, XCo decides that Y will be the location. XCo forms a 100% Y-resident subsidiary (YCo) and it subscribes for significant share capital in YCo (due to the tax holiday in Y, XCo structures its funding in the form of 100% equity). YCo has no other funding. YCo builds and operates the plant. Some years later, YCo pays dividends to XCo. Under X domestic law, resident companies are taxable on global profits; however, dividends received from YCo are exempt under a participation exemption.

Q1: Under the X/Y treaty, what rate of DWT is Y permitted to levy on YCo's dividends?

Q2: Does the X/Y treaty permit the X tax authorities to deny the exemption for XCo's dividend income?

Answer

Q1:

5%: Art. 10(2)(a).

Art. 29(9) (PPT) should not apply to deny the benefit of Art. 10(2)(a), because:

Example C in the OECD Comm., para. 182 (on which this question is based) indicates that the PPT should not apply.
The PPT's second limb (i.e., "unless it is established…") should be satisfied, due to the construction and operation of the manufacturing plant in Y. (Despite the statement in OECD Comm., para. 182, it is arguable that the PPT's first limb is also satisfied.)
As a practical matter, it would be surprising if the Y tax authorities were to assert the PPT in this case (which involves a substantial inbound investment into Y).

Q2:

Art. 23A or 23B requires X to grant a credit to XCo for Y DWT. The credit is limited to the amount of X tax on the dividend income from YCo – thus, if the domestic law participation exemption applies, the credit will be nil.

YCo is "thickly capitalised" – it has no debt. It is possible that the X tax authorities would use the X transfer pricing rules or anti-avoidance rules to recharacterize part of YCo's equity as an interest-bearing loan. The X/Y treaty would not prevent such action: Art. 1(3).

If the X tax authorities impute interest income to XCo, it should obtain a credit for the DWT under Art. 23A or 23B, subject to the limitation described above.

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