Tax Treaty Series

ITQ T-

100

September 3, 2021

Question

XCo, a company resident in X, sells goods to YCo, a related company resident in Y.

The income tax rates are 25% (in X) and 20% (in Y).

The X/Y treaty is identical to the 2011 UN model treaty. In a particular year, XCo derived $100 million of revenue from sales to YCo.

Under the Y transfer pricing rules, the Y tax authorities reduced YCo's aggregate consideration for purchases in that year from XCo to $80 million – i.e., a reduction of $20 million. The Y tax authorities therefore issued an assessment to YCo for tax of $4 million (i.e., $20 million x 20%). In addition, the Y tax authorities imposed a 50% "gross negligence" penalty of $2 million on YCo (i.e., $4 million x 50%). Thus, in total, YCo is required to pay $6 million in additional Y tax and penalties.

Will the X/Y treaty allow the group to obtain any relief in X for that $6 million?

Answer

Art. 9(2):

Ignoring for the moment Art. 9(3) (see below), Art. 9(2) would require the X tax authorities to make a corresponding adjustment only if, and to the extent, they agree with the primary adjustment made by the Y tax authorities – i.e., the reduction of $20 million in the purchase price. Therefore, a preliminary issue is: do the X tax authorities agree with that $20 million reduction? If they don't agree with all or part that reduction, then economic double taxation will be the result, unless (i) YCo can achieve a more favourable assessment in Y, via the appeals process; and/or (ii) an agreement between the 2 competent authorities is achieved under Art. 25.

If the X tax authorities do agree with the primary adjustment, then Art. 9(2) would require them to "make an appropriate adjustment to the amount of [X] tax charged … on [the $20 million]". That adjustment might occur under Art. 9(2) itself – i.e., XCo's taxable profits would be reduced by $20 million, which (ironically) would cause a reduction of $5 million in X tax (cf. YCo's $4 million increase in Y tax). Under this mechanism, there would be no adjustment in X in regard to the $2 million penalty.

The OECD & UN Commentaries on Art. 9(2) suggest that an alternative mechanism for the "appropriate adjustment" would be for X to provide XCo with relief from double taxation under Art. 23. Again, under this mechanism, there would be no adjustment in X in regard to the $2 million penalty.

Art. 9(3):

However, according to Art. 9(3), Art. 9(2) shall not apply where "judicial, administrative or other legal proceedings have resulted in a final ruling" that YCo is liable to a penalty with respect to, inter alia, gross negligence.

In that situation, not only is there no corresponding adjustment in X for the $2 million penalty in Y, there would also be no requirement for X to provide a corresponding adjustment for Y's $20 million reduction of the purchase price – i.e., the full $6 million would not be relieved in X.

An open issue would be whether, in this present case, the "judicial, administrative or other legal proceedings have resulted in a final ruling" in regard to the penalty. If, for example, YCo still has time to appeal in regard to the penalty, the X tax authorities would probably wait for that appeal process to be completed or time-barred, so that they know whether Art. 9(3) will be triggered.

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