Tax Treaty Series

ITQ T-

078

March 5, 2021

Question

XCo, a company resident in X, owns some redeemable preference shares in YCo, a company resident in Y. The shares carry a preference right to a 5% per annum dividend and a preference right to a return of the face value of the shares (in a liquidation scenario), but they do not otherwise participate in YCo's profit distributions or surplus assets.

YCo has paid-up share capital of $10 million, a share premium reserve of $90 million, and retained earnings of $50 million.

Of the $10 million of paid-up share capital, $4 million represents the par value of common shares issued to numerous shareholders (not including XCo). The remaining $6 million represents the par value of the redeemable preference shares issued to XCo.

Under Y law, withholding tax of 25% is levied on outbound dividends, interest and royalties.

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

Does the X/Y treaty permit Y to levy tax on YCo's dividends paid to XCo? If yes, at what rate?

Answer

Threshold issue: are the dividends treated as "dividends" or "interest" under Arts. 10 & 11 of the treaty? They will be "dividends" if the redeemable preference shares (RPS) are "shares" (not defined), and they will be "interest" if the RPS are "debt-claims" (not defined). Using Art. 3(2), the characterisation of the RPS under Y domestic tax law will probably determine their characterisation for treaty purposes. See also the OECD Comm. on Arts. 23A & 23B: "conflicts of qualification".

If the RPS dividends are "interest": Y may levy tax of 10% on gross: Art. 11(2).

If the RPS dividends are "dividends": Y may levy tax of 5% on gross: Art. 10(2)(a). Para. (a) applies if XCo holds directly at least 25% of the capital of YCo. According to the OECD Comm., "capital" in para. (a) means the par value of all shares (whether ordinary, preference or otherwise) – it does not include reserves. Thus, XCo holds directly 60% of YCo's capital.

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