Tax Treaty Series

ITQ T-

088

May 28, 2021

Question

ACo, a company resident in A, wants to make a loan to a related company, BCo, resident in B.

However, B domestic law imposes a 30% withholding tax on outbound interest, and there is no A/B treaty.

ACo therefore forms a new 100% subsidiary, CCo, in C. CCo is resident in C, but it has very little substance.

ACo injects share capital into CCo, which makes an interest-bearing loan to BCo (the interest rate is an arm's length rate).

The B/C treaty is identical to the 2017 OECD model treaty, with the PPT (Art. 29(9)) but not the LOB.

The C corporate income tax rate is 15%.

There is no A/C treaty. The A corporate income tax rate is 25%.

After applying the B/C treaty, what will be the aggregate tax liability on the interest paid by BCo to CCo?

Answer

Art. 11(2) will allow B to tax the interest. However, the benefit of the 10% tax rate limit in Art. 11(2) should not be given to CCo, due to the applicability of Art. 29(9) (PPT). Thus, 30% B tax should apply.

The C tax rate is 15%. Prima facie, CCo would be entitled to a credit for the B tax under Art. 23A/B.

However, does Art. 29(9) apply to the credit? If the plan had worked, the B tax would have been limited to 10% (Art. 11(2)) and a credit for that 10% would be available (Art. 23A/B), leaving a net 5% C tax. It is possible that CCo would not obtain a credit for the B tax under C domestic law (i.e., in the absence of the treaty) – e.g., if the C domestic law does not provide a credit for tax paid in a treaty jurisdiction. If that is the case, then arguably obtaining of the credit under Art. 23A/B is "one of the principal purposes" of the plan. Nevertheless, I think the 2nd limb in Art. 29(9) should apply: it is the "object and purpose" of Art. 23A/B to provide a credit for B tax which is imposed in accordance with the treaty, even if that is part of a tax plan. On balance, I think the credit should be available – thus, the net C tax should be nil.

Would A be able to levy tax on the interest income? I will assume that there are no CFC rules in A. But what about transfer pricing? CCo has very little substance: let's assume that it has no employees who are able to decide to raise the share capital and make the loan to BCo – all decisions are made by ACo. If A's domestic law TP rules apply the 2017 OECD TPG [footnote], then these facts would indicate that CCo would be entitled to no more than a risk-free return, and ACo would be allocated the balance. To the extent that the interest income is allocated to ACo, the A 25% tax rate would apply. As ACo does not incur the B tax, ACo would likely not qualify for a credit under A domestic law foreign tax credit rules.

Thus, potentially, the aggregate ETR would be 30% on the full amount of interest, plus 25% on the amount of interest allocated to ACo.

Footnote: See para. 10.25 of Transfer Pricing Guidance on Financial Transactions (published by the OECD on 11 February 2020), to be included in the next edition of the OECD TPG.

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