Tax Treaty Series

ITQ T-

082

April 9, 2021

Question

ACo is a company which is incorporated in A, a tax haven. ACo carries on business in B through a branch.

The B income tax law is a territorial system: only income which is derived from a source in B is taxable. Under the B income tax law, there is therefore no concept of residence.

ACo invests some of its funds in interest-bearing corporate bonds issued by CCo, an unrelated company resident in C. Under the C tax law, outbound interest payments are subject to 20% withholding tax.

The B/C treaty is identical to the 2017 OECD model treaty. There is no A/C treaty.

Does the B/C treaty permit C to levy withholding tax on the interest paid by CCo to ACo? If so, at what rate?

Answer

Key issue: does ACo satisfy the definition of "resident of [B]" in Art. 4(1)?

The fact that the B tax law is a territorial tax system does not trigger the second sentence in Art. 4(1): para. 8.3 of OECD Comm.

The first sentence in Art. 4(1) asks whether, under a Contracting State’s tax law, a person is (i) "liable to tax", (ii) "by reason of…domicile, residence, place of management or any other criterion of a similar nature".

According to the OECD Comm., the “liable to tax” test refers to persons who are subject to a comprehensive liability to tax (a "full tax liability") in a Contracting State. Under the B tax law's territorial principle, "comprehensive liability to tax" arguably extends no further than tax levied on B-sourced profits. If that is the case, then what difference does it make that ACo is not incorporated in B?

In regard to (ii) (the "by reason of" leg), ACo's branch in B could be described as a "place of management".

A similar situation occurred in the Crown Forest case in Canada (1995). The court held that Art. 4(1) in the Canada / US treaty was not satisfied by a Bahamian company which had an office in the US. However, there was a major difference in that case: the US did not operate a territorial system.

This is a difficult question to answer, because, although my immediate reaction is to think that Art. 4(1) could not possibly be satisfied, it is difficult to pinpoint a reason for that conclusion in either the treaty or the Comm. My best attempt is this: if B were to change its law to replace the territorial principle with global taxation, ACo would probably not be subject to global taxation (under orthodox global tax systems). But that’s conjecture – and, in any event, Art. 4(1) requires the test to be applied to the actual B tax law.

Not surprisingly, jurisdictions with territorial systems (e.g., Hong Kong) usually don't use Art. 4(1) from the OECD model!

If it is concluded that ACo is a resident of B under the B/C treaty, it would be entitled to the 10% limit on C tax in Art. 11. If not, the full 20% domestic law rate would apply.

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