Tax Treaty Series

ITQ T-

094

July 16, 2021

Question

ACo is a publicly listed bank which is resident in A. ACo has a branch in B. The branch constitutes a PE under the A/B treaty.

A small percentage of ACo's shares are indirectly listed on the B stock exchange in the form of B Depositary Receipts (BDRs). The BDRs are structured in this way: (1) some shares in ACo are owned by CCo, an unrelated bank resident in C, on bare trust (i.e., as nominee) for the B branch of ACo; and (2) the B branch of ACo issues BDRs (negotiable instruments listed on the B stock exchange), with the ACo shares held by CCo as the relevant underlying property.

Some of the BDRs are acquired by DCo, an investment company resident in D.

ACo pays dividends on its shares. In regard to the shares held by CCo, the dividends are received by CCo, which transfers the cash (less its expenses and fees) to the B branch of ACo, which in turn transfers the cash (less its expenses and fees) to the holders of the BDRs (including DCo).

Under the domestic law of each of A and B, a 20% withholding tax is imposed on outbound dividends and on outbound "dividend equivalent payments" under Depositary Receipts.

All 6 bilateral treaties (i.e., A/B, A/C, A/D, B/C, B/D and C/D) are identical to the 2017 UN model treaty.

After applying those treaties, will ACo or DCo have an income tax liability in A or B on the dividends and the resulting flow of cash?

Answer

(1) ACo's A tax liability:

Under A domestic law, a liability for A dividend withholding tax would probably not arise, due to mutuality.

Nevertheless, the profit (if any) derived by ACo's B branch on the BDRs might be taxable under A domestic law (regardless of mutuality), unless that law exempts profits of foreign branches.

(2) ACo's B tax liability:

Art. 7 of the A/B treaty would likely allow a profit to be recognised (and taxed) on the BDRs, based on the "separate enterprise" assumption.

The actual profit (if any) derived by ACO’s B branch might be taxable under B domestic law (regardless of mutuality).

(3) DCo's A tax liability:

Under domestic law, A imposes a 20% withholding tax on outbound dividends and "dividend equivalent payments" under Depositary Receipts.

Thus, under domestic law, the cash paid to DCo should be subject to 20% A tax, as either a dividend or a dividend equivalent payment.

Under the A/D treaty, if the cash retains the character as a dividend, Art. 10 should apply to permit A to levy tax according to the rate specified in Art. 10 – i.e., if the cash is a dividend, DCo should be the beneficial owner of the dividend.

However, if, under the A/D treaty, the cash does not retain its character as a dividend, then Art. 10 would not apply. Instead, Art. 7 should apply to exempt the cash (in the absence of a PE in A). There would be a risk that the A tax authorities would claim that Art. 7 does not apply, because DCo is a passive investor – and that Art. 21(3) would allow A tax (without limit).

(4) DCo's B tax liability:

Art. 10 does not apply, because the company paying the dividend is not a resident of B.

Art. 7 should apply to exempt the cash (in the absence of a PE in B). There would be a risk that the B tax authorities would claim that Art. 7 does not apply, because DCo is a passive investor – and that Art. 21(3) would allow B tax (without limit).

(5) Double tax relief in D:

Thus, it is possible that the cash is taxed in both A and B (in A, under Art. 10 or Art. 21(3); in B, under Art. 21(3)). In addition, the cash might be taxable under D domestic law. If the D tax authorities accept the applicability of the A and B tax in the 2 treaties, then D would be required to provide relief from double taxation under Art. 23A/B of the 2 treaties.

Note: The facts are based on the 2021 decision of the Mumbai ITAT in the Morgan Stanley case.

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