Tax Treaty Series

ITQ T-

061

October 16, 2020

Question

XCo, a company resident in X, has a branch in Y.

The branch conducts a manufacturing business in Y.

Excess cash generated by the branch is "deposited", on a short term basis, with the XCo head office in X. When the cash is needed by the branch, it is "repaid" by the head office to the branch.

The branch's financial statements and income tax return do not recognise any interest income on these "deposits".

The Y tax authorities impute arm's length interest income to the branch under the Y domestic law transfer pricing rules. Those rules apply to "transactions" between a branch and head office, where one is located in Y and the other is located in another country. Those rules do not apply if the branch and head office are both located in Y.

The X/Y treaty, which was signed and entered into force in 2009, is identical to the 2008 OECD model treaty.

Does the treaty permit the Y tax authorities to impute arm's length interest income to the branch?

Answer

The Y branch is a PE under the treaty.

Under Art. 7(2), and the 2-step approach described in the OECD Comm., it is likely that the "deposit" would be characterised as a loan from the PE to the head office in X, and that arm's length interest may be imputed by the Y tax authorities under an analogous application of Art. 9(1).

However, Art. 7(2) is subject to Art. 7(3). In the OECD Comm. on Art. 7(3), it is stated that (except for financial enterprises such as banks) "internal interest" on "internal loans" between head office and PE need not be recognised. However, those statements refer to the situation where the "internal loan" is from the head office to the PE, and the "internal interest" is sought to be deducted by the PE under Art. 7(2). That is also the situation which is addressed in Art. 7(3) itself. Neither Art. 7(3), nor the OECD Comm. on Art. 7(3), is directed towards the alternative situation where the "internal loan" is from the PE to the head office.

The OECD Comm. on Art. 7(3) reflects a qualification on the full implementation of the OECD PE Reports (2008 & 2010). However, if Art. 7(3) does not apply to "internal loans" from the PE to the head office, that qualification is not relevant.

Thus, in my view, Art. 7(2) should allow the imputation of arm's length interest by the Y tax authorities.

Note that the Y law allows the imputation of interest between a branch and head office, but these rules do not apply if the branch and head office are both located in Y. Is that a breach of Art. 24(3)? No – the OECD Comm. states that Art. 24(3) is subject to the PE profit attribution rules in Art. 7(2).

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