Tax Treaty Series

ITQ T-

069

December 11, 2020

Question

Under the X domestic tax law, a resident company which makes income tax deductible payments to a related company which is resident in a designated low-tax jurisdiction, is subject to an adjustment. The adjustment is in the form of deemed income, calculated by a formula which has regard to the amount of deductible payments to the related company. The designation of a jurisdiction as low-tax is made annually in respect of a particular MNE Group, based on the effective tax rate (in that year) of the Group's members which are resident in that jurisdiction.

XCo, a company resident in X, makes income tax deductible payments to YCo, a company resident in Y. Both XCo and YCo are members of an MNE Group. For the relevant year, Y is designated as a low-tax jurisdiction in regard to the MNE Group. Accordingly, an amount of deemed income is included in XCo's taxable profits for that year.

The X/Y treaty is identical to the 2017 OECD model treaty.

Does the treaty permit the inclusion of the deemed income in XCo's taxable profits?

Answer

This question raises issues under Art. 24 (non-discrimination). Although XCo is a resident of X, Art. 24 can apply to restrict X's taxation of XCo: Art. 1(3).

I should note that I'm assuming that the amount of the payments satisfy the arm's length principle.

If the X law operated to disallow XCo income tax deductions for the payments to YCo, then (IMHO) Art. 24(4) would likely be breached. The disallowance of the deductions would be because the payments are made to YCo, a resident of Y – and the deductions would not be disallowed if the recipient were not a resident of Y. That would seem to me to be a clear breach of Art. 24(4).

However, such a provision in the X tax law would be based on the undertaxed payments rule (UTPR) in Pillar Two, in the context where the adjustment is in the form of disallowance of deductions. The Pillar Two blueprint report surprisingly concludes that there would be no breach of Art. 24(4), because the disallowance is not based on the residence of the recipient (YCo), but instead on the designation of YCo's residence jurisdiction (Y) as low-tax. IMHO: that view has no basis in either the text of Art. 24(4) or the OECD Comm.

But, in our question, the form of the adjustment is deemed income, not disallowance of deductions. Does that make a difference? Art. 24(4) requires that "disbursements…shall, for the purpose of determining the taxable profits…, be deductible under the same conditions…". That would seem not to cover deemed income, although (in our question) the deemed income is calculated by a formula which has regard to the amount of deductible payments to the related company.

The link provided by that formula might be sufficient for a court in X to conclude, particularly having regard to the requirement of "good faith" in the Vienna Convention on the Law of Treaties, that the deemed income is a breach of Art. 24(4). However, on balance, I think that the deemed income form is probably sufficient to avoid the application of Art. 24(4).

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