Tax Treaty Series

ITQ T-

091

June 18, 2021

Question

XCo, a company resident in X, owns 100% of the shares in YCo, a company resident in Y.

YCo manufactures goods in Y and sells them to customers in Y and in other countries.

In Z, YCo's goods are distributed by ZCo, which is unrelated to XCo and YCo. ZCo is an independent sales agent, which acts on behalf of many non-resident vendors. ZCo habitually exercises an authority to conclude sales contracts, with customers in Z, on behalf of (and legally binding on) YCo. YCo pays ZCo an arm's length fee for its services. YCo is not a relatively substantial client for ZCo.

Under Z domestic law, YCo is treated as deriving profits from a source in Z, due to its use of ZCo as its sales agent. The Z-sourced profits are determined on a formulaic basis: 40% of YCo's gross profits (from sales to customers in Z) are deemed to be derived from a Z source.

YCo pays large dividends to XCo.

All 3 treaties (X/Y, X/Z and Y/Z) are identical to the 2017 OECD model treaty.

After applying the relevant treaties, is Z permitted to levy income tax on (1) YCo's profits or (2) YCo's dividends?

In regard to (2), please assume that Z levies its tax on the dividend-recipient (XCo).

Answer

YCo's profits (Y/Z treaty)
1. Although ZCo's actions would satisfy Art. 5(5), the exception in Art. 5(6) should apply to exclude a contract-concluding agency PE.
2. In the absence of a PE in Z, YCo's profits would be exempt from Z tax under Art. 7(1).
YCo's dividends (Y/Z treaty)
1. Art. 10(1)&(2) do not apply, as the dividend-payer (YCo) is not a resident of Z.
2. Art. 10(5) is apparently satisfied: YCo (a company resident in Y) derives profits from Z – thus, Z is prevented from taxing the dividends, subject to 2 exceptions (neither of which is relevant here). But the dividends are the income of XCo, and XCo is not a resident of either Y or Z. Can the benefit of Art. 10(5) of the Y/Z treaty be claimed by a taxpayer which is not a resident of either Y or Z?
3. Art. 1(1) would indicate that XCo cannot claim the benefit of Art. 10(5) of the Y/Z treaty. However, several academic articles and books have stated that Art. 10(5) would apply in this situation, regardless of Art. 1(1). For example, see: Madeira & Neves, "Exploring the Boundaries of the Application of Article 10(5) of the OECD Model", Intertax, Vol. 35 (2007), Vol. 8/9.
4. This point is not directly addressed in the OECD Comm. However, in the course of discussing the interaction between Art. 10(5) and CFC rules, the OECD Comm says that Art. 10(5) "concerns only the taxation of the company and not that of the shareholder".
5. IMHO: To conclude that Art. 10(5) is an exception to Art. 1(1) requires express words to that effect in either the OECD model or the OECD Comm. In the absence of such express words, my conclusion is that, based on Art. 1(1), Art. 10(5) does not apply to prevent Z tax on YCo's dividends.
YCo's dividends (X/Z treaty)
1. Art. 10(1)&(2), and Art. 10(5), do not apply, as the dividend-payer (YCo) is not a resident of Z.
2. Either Art. 7(1) or Art. 21(1) applies to provide an exemption for XCo.

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