Tax Treaty Series

ITQ T-

057

September 18, 2020

Question

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

YCo carries on a manufacturing business in Y.

XCo makes a loan to YCo, for use in its business. The loan carries an arm's length interest rate. Under Y tax law, the interest is fully deductible for YCo. The Y corporate income tax rate is 30%.

Under X tax law, YCo is treated as a branch of XCo.

YCo is therefore a hybrid entity: it’s treated as a taxable entity (a resident company) in Y, and as a transparent entity (a branch) in X.

Under domestic law, Y imposes a final withholding tax of 20% on gross outbound interest payments.

Neither X nor Y has introduced hybrid mismatch rules into domestic law.

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

What tax treatment does the X/Y treaty permit or require, in each of X and Y, in regard to the interest payments from YCo to XCo?

Answer

Y tax

The key issue is whether Art. 1(2) applies:

YCo is "an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State"
However, the interest is not "derived by or through" YCo – it’s derived by XCo, and paid by YCo
Thus, Art. 1(2) should not apply

Art. 11(2) would therefore apply: 10% Y tax would be imposed.

X tax

Art. 23A(2) requires X to allow XCo a credit for the Y tax: see the discussion on "conflicts of qualification" in the OECD Comm. on Art. 23A/B.

However, by virtue of the second sentence in Art. 23A(2), the amount of the credit is limited to the amount of the X tax on the interest income. If the interest income is not recognised under X tax law (because YCo is treated as a branch of XCo), then that amount of X tax is nil.

Thus, no credit.

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