Tax Treaty Series

ITQ T-

101

September 10, 2021

Question

ACo, a company resident in A, purchased 60% of the shares in BCo, a company resident in B.

ACo's purchase price was $6 million, and its purchase was from an unrelated party.

During ACo's ownership of the BCo shares, BCo paid no dividends or other distributions to its shareholders.

Several years later, ACo sold all of its BCo shares to another unrelated party, for a price of $2 million. ACo therefore incurred a loss of $4 million on the sale of the BCo shares.

Under the B domestic tax law, capital gains derived by non-residents on the sale of shares in B-resident companies are subject to income tax at a 25% rate. In computing such capital gains, the actual purchase price is ignored; instead, a capital gain equal to 20% of the sale price is deemed to be derived by the non-resident seller. Thus, in ACo's case, ACo is deemed to derive a capital gain of $400,000 (i.e., $2 million x 20%), and is therefore liable for B income tax of $100,000 (i.e., $400,000 x 25%).

The A/B treaty is identical to the 2017 UN model treaty. The percentage in Art. 13(5) is 10%.

Does the A/B treaty permit B to levy $100,000 income tax on ACo in regard to its sale of shares in BCo?

Answer

Note

This question is based on the Indonesian capital gains tax rules.

Art. 13(5)

Art. 13(5) permits B to levy tax on "gains … derived by [ACo] from the alienation of shares [in BCo]". Does ACo have a "gain derived", in the situation where it has incurred a loss of $4 million on the sale of the shares in BCo?

Para. 12 of the OECD Comm. on Art. 13 (which is incorporated in the UN Comm.) states:

"The Article does not specify how to compute a capital gain, this being left to the domestic law applicable. As a rule, capital gains are calculated by deducting the cost from the selling price. … Some tax laws prescribe another base instead of cost, e.g. the value previously reported by the alienator of the asset for capital tax purposes."

Although it does not specifically refer to the calculation method used by B, the Comm. is quite clear that the calculation of a capital gain is solely a domestic law matter. Therefore, based on the Comm., I would conclude that Art. 13(5) permits B to levy $100,000 tax on ACo.

Art. 2

A possible issue arises under Art. 2: is B's tax on ACo's deemed "capital gain" a tax on income or a tax on capital? The argument in favour of it being a tax on capital is that ACo has actually derived a loss (not income). If it is a tax on capital, then Art. 22 would apply, instead of Art. 13: Art. 22 would not permit B to levy tax (i.e., there is no equivalent to Art. 13(5) in Art. 22).

However, B's taxation of ACo's deemed "capital gain" is part of B's income tax, which we can assume (according to its predominant character) is clearly a tax on income. Although the position might be different if B's taxation of ACo's deemed "capital gain" were pursuant to a separate tax, it is not: it is part of B's income tax. Therefore, IMHO: Art. 2 does not cause Art. 22 to apply, instead of Art. 13.

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