Tax Treaty Series

ITQ T-

054

August 21, 2020

Question

XCo, a company resident in X, owned a building in Y which it purchased for $1 million.

XCo derived rent from leasing the building to an unrelated lessee.

Some years later, XCo sold the building, to an unrelated purchaser, for $1.5 million.

Under X law, XCo was subject to tax on the rental income, but was able to claim deductions for tax depreciation on the building. The tax depreciation aggregated to $0.3 million over the years of ownership. When XCo sold the building for $1.5 million, it derived a capital gain of $0.8 million (i.e., $1.5 million minus the reduced cost base of $0.7 million).

Under Y law, XCo was subject to tax on the rental income, but was not entitled to any tax depreciation. When XCo sold the building for $1.5 million, it derived a capital gain of $0.5 million (i.e., $1.5 million minus cost base of $1 million).

Both capital gains are subject to corporate income tax (at the same rate as ordinary income) under the domestic tax laws in X and Y.

The X/Y treaty is identical to the 2017 OECD model treaty, with Art. 23A.

Both X and Y use the same currency.

What will be the tax treatment of XCo, in each of X and Y, in regard to the sale of the building?

Answer

Art. 13(1) permits Y to impose tax on XCo’s "gain", which is not defined – its computation is left to Y law: para. 12, OECD Comm. on Art. 13.

Under Y law, XCo's capital gain of $0.5 million is subject to income tax.

XCo's capital gain of $0.8 million will, prima facie, be subject to income tax. However, X must provide relief under Art. 23A.

Art. 23A(1): "Where a resident of [X] derives income…which may be taxed in [Y] in accordance with the provisions of this Convention…,[X] shall…exempt such income…from tax."

What amount will be exempt: $0.5 million or $0.8 million?

These facts are similar to the situation described in paras. 14 & 15, OECD Comm. on Art. 13. The only difference is that, in the situation in those paragraphs, the treatment of the $0.3 million is described as "the depreciation allowances granted earlier may be recovered", whereas (in our facts) XCo's cost base is reduced to $0.7 million. As capital gains are subject to corporate income tax at the same rate as ordinary income, the 2 treatments of the $0.3 million have the same tax effect. Thus, it would be logical to apply the same approach – i.e., $0.5 million would be exempt.

IMHO: $0.5 million will be exempt, and $0.3 million will be taxed.

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