Tax Treaty Series

ITQ T-

070

December 18, 2020

Question

ACo, a company resident in A, conducts a manufacturing business in A, using patents and knowhow which ACo owns.

ACo wants to sell its goods in the B market. However, due to customs duties which are imposed on imports into B, ACo is planning to start a manufacturing operation in B, with the finished goods being sold to consumers in B.

ACo would like your advice on whether the B manufacturing operation should be structured as a B-resident subsidiary of ACo or as a branch of ACo.

ACo has told you the following:

ACo currently has significant tax losses in A. These losses are available for indefinite carry-forward.
ACo plans to use its existing cash resources to finance the B manufacturing operation – i.e., no borrowing will be done.
ACo wants to minimise B tax.
ACo wants to retain, in A, the legal and economic ownership of its IP.
The B market does not discriminate against branches of companies incorporated in A.

The B corporate income tax law levies the same rate (25%) on resident companies and branches of non-resident companies.

B does not impose tax on outbound dividends or on branch profit remittances. However, B imposes a 10% withholding tax on the gross amount of outbound interest and royalties.

The B tax law does not recognise intra-entity "transactions".

The A/B treaty is identical to the 2017 OECD model treaty, except that Arts. 11 & 12 allow 10% source country tax (on gross payments) to be levied.

What is your advice?

Answer

1. The amount of B income tax on profits should be the same for both subsidiary and branch:

The same rate is applied to both.
In regard to tax base, the profits attributable to the PE (i.e., branch) under Art. 7 should be the same as for a subsidiary, after deducting notional interest and royalty expenses. Although the B tax law does not recognise intra-entity "transactions", such deductions for the branch should be available by virtue of Art. 7 (i.e., by application of the "separate and independent enterprise" assumption). Also, Art. 24(3) will require that outcome.

2. No B tax is imposed on profit remittances by both subsidiary and branch.

3. 10% B withholding tax will apply to actual payments of interest and royalties in the subsidiary scenario, but no corresponding withholding tax will apply in the branch scenario: this is because the B tax law does not recognise intra-entity "transactions", and the "separate and independent enterprise" assumption in Art. 7 has no effect on Arts. 11 & 12 or on expanding ACo’s tax liabilities under B law.

4. ACo's A tax losses might be reduced by dividends paid by a subsidiary or by current profits derived by a branch. It is possible that the impact on ACo’s A tax losses would not be the same for both subsidiary and branch.

IMHO: I would choose a branch, in order to achieve the savings in B withholding tax (cash and book tax benefit). However, the possibility that a branch might reduce ACo’s A tax losses to a greater extent than a subsidiary, should be assessed.

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