Tax Treaty Series

ITQ T-

055

August 28, 2020

Question

ACo, a company resident in A, makes an interest-free loan to BCo, a related loss-making company resident in B.

The A tax authorities decide not to impute interest on the loan, because they take the view that the loan is quasi-equity under A's TP rules.

However, the B tax authorities impute interest on the loan under B's TP rules, and claim that ACo is liable for 10% interest withholding tax (IWT) on the imputed interest (the B domestic law IWT rate is 25% on gross, but Art. 11 of the A/B treaty limits the B tax to 10% on gross). The A/B treaty is identical to the 2017 UN model treaty.

Does the A/B treaty permit B to impose tax on the imputed interest? If so, at what rate?

Answer

MAP:

MAP under Art. 25 might result in no imputed interest in B.

However, I will assume that MAP is not initiated or does not result in that outcome.

Art. 11:

Art. 11(2) allows B to impose 10% tax on "such interest", i.e., the interest described in Art. 11(1).

Art. 11(1) describes interest "arising" in a Contracting State (B) and "paid to" a resident of the other Contracting State (A).

The term, "paid", is not defined in the treaty. UN Comm. : "paid" has a very wide meaning – the concept of payment means the fulfilment of the obligation to put funds at the disposal of the creditor in the manner required by law or by custom.

Art. 11(5) defines "arising", by using terms such as "payer", "the person paying the interest", "the indebtedness on which the interest is paid was incurred", "such interest is borne by such [PE]".

Art. 3(2) allows a domestic law meaning of "paid" to be used, if B law contains such a meaning and if the context does not otherwise require.

IMHO:

Art. 11(5) assumes that there is an actual amount of interest. It provides a context for Art. 11(1), which then prevents a domestic law meaning of "paid" (assuming one exists) from being used.
Art. 11(1) is not satisfied, and thus Art. 11(2) does not apply.

Art. 21(3):

Art. 21(3) should generally not apply, as the imputed interest is "dealt with" in Art. 7 (see below).

The term, "arising", as used in Art. 21(3), is not defined. The UN Comm. says that it should take its meaning under domestic law. Thus, it is possible that the "arising" condition in Art. 21(3) is satisfied here. Nevertheless, if Art. 7 applies (see below), Art. 21(3) will not.

Art. 7:

If ACo has no PE in B, then the imputed interest should be exempt under Art. 7(1).

However, if ACo is a special purpose company with only one asset (the loan to BCo), the B tax authorities might argue that ACo does not carry on an enterprise and thus Art. 7 does not apply – in which case, Art. 21(3) becomes relevant.

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