Article 10 of the OECD Model Tax Convention covers taxation rights of the States.
In this post, we will cover the following:
- What is the dividend?
- Who has the right to tax dividends?
- Explain the term dividend as per Article 10
- When not to apply Paragraphs 1 and 2 of Article 10?
- What is extra-territorial taxation of dividends?
What is the dividend?
Cambridge English Dictionary states ‘dividend’ is a part of the profit of a company that is paid to the people who own shares in it.
The dividend is a distribution of profits to the shareholders by companies limited by shares, limited partnerships with share capital, limited liability companies, or other joint-stock companies. Such companies have a distinct identity from all its shareholders.
In the above definition, the partnership is not treated as a company, as they do not have a separate juridical identity under many countries’ tax law. Hence few states treat the partnership as a transparent entity, and partners derive profits as their business profits and are taxed on that individually.
How is the shareholder different from a partner?
A shareholder is a participant in the company’s capital, but the profits of the company are not his own and cannot be attributed to him. He is liable to pay tax on the profits distributed to him by the company. For shareholders, the dividend earned by them is the income on the capital.
Who has the right to tax dividends?
Article 10 gives both states the right to tax the dividend. Taxation of the dividend exclusive either in the State of Source or the State of Residence is not acceptable as a general rule. It is imperative to note, many states do not tax the dividend paid to non-residents, but all countries tax their residents for the dividend earned in any part of the globe.
State of Residence of the recipient of the dividend
Paragraph 1 of Article 10 states that the dividend paid to the resident of another state would be taxable at that other State. That is the right to tax the dividend to the country of residence of the taxpayer.
The term ‘paid’ has a broad meaning since the concept of payment of dividend means the fulfillment of the obligations to put funds at the disposal of the shareholder in the manner required by contract or custom.
Paragraph 1 of Article 10 deals with the payment of dividend by the company resident of one State to the resident of another state; it will not cover the payment of dividend by any third state.
When the dividend is received by a Permanent establishment of an enterprise in another state, the same will be taxable under Paragraph 1 of Article 7.
LQ Ltd is a company, and ABC Enterprise is an entity in State A. ABC Enterprise has a permanent establishment in State B. LQ Ltd paid dividend attributable to the Permanent establishment of ABC Enterprise. How will State A and State B tax the transaction?
State A is the State of Source will tax the transaction under Paragraph 2 of article 10.
State B being the recipient, State of residence, will tax the transaction under Paragraph 1 of Article 7.
ABC enterprise will seek relief under Article 23A and 23B.
State of Source
Paragraph 2 of article 10 reserves the limited right to tax dividends to the country of Source, i.e., the country where the company paying a dividend is the resident. The State of Source may also choose not to tax the dividend income paid to non-residents. Paragraph 2 of Article 10 limits the right to tax to the State of Source of the dividend:
Subparagraph a to Paragraph 2 of Article 10, states the tax on dividend shall not exceed 5% when
- the dividend is paid by a company to the beneficial owner, which is a company, resident of another State,
- Directly holding at least 25% of the capital of the company paying a dividend
- throughout the period of 365 days that includes the date of payment of dividends.
For computing the 365 days period stated above, no account will be taken of changes of ownership that would directly result from a corporate reorganization like a merger or divisive reorganization of the company that holds the shares or that pays the dividend).
The rationale behind the above subparagraph is for the payment of dividends by the subsidiary company to its foreign holding company to facilitate cross border investments by taxing dividends less heavily.
For interpreting the subparagraph a of Paragraph 2 of Article 10, we need to understand the following terms used in the subparagraph:
The term ‘beneficial owner’ is used in the subparagraph to clarify the term ‘ paid to .. a resident’ used in Paragraph 1 of Article 10. It attempts to curb the treaty shopping practice, as the State of Source need not give up its taxing rights, because the income was paid directly to the resident of the other State if the arrangements are made by the resident only to use the treaty entered by the State. The term ‘beneficial owner’ is not to be interpreted based upon the domestic law of the country, but to accentuate the term ‘paid to ..resident.’ the meaning of the term ‘beneficial owner’ is to be distinguished from the definition provided for the term in the context of other instruments that concern the determination of persons, typically individuals, that exercise ultimate control over entities or assets.
State A and State B have adopted the OECD Model tax treaty. State C and State B have a preferential treaty where any amount paid by State B to State C will not be taxed. And State A and State C do not have any tax treaty.
A Ltd, resident of State A, pays a dividend to Locust Enterprise, a tax resident of State B. Locust Enterprise is the agent, and the beneficial owner of the capital of A Ltd is Mr. Locust, a tax resident of State C.
In the given scenario, State A may choose not to apply the tax treaty between State A and State B, as the beneficial owner of the dividend is a resident of State C with which there is no tax treaty.
Agent, nominee, conduit companies do not become the beneficial owner as they do not have the right to use and enjoy the dividend received by them. The direct recipient of the income in this situation qualifies as a resident, but no potential double taxation arises as a consequence of that status since the recipient is not treated as the owner of the income for tax purposes in the State of residence.
The term ‘capital’ in the context of subparagraph b of Paragraph 2 of Article 10, implies it should be used in the sense in which it is used for the purpose of distribution to the shareholder (the parent company):
- Capital is to be understood as provided in the company law. Reserves are not to be taken into account
- Capital should be indicated in terms of the par value of shares.
- No account needs to take of difference due to the different classes of shares issued (ordinary shares, preference shares, plural voting shares, etc.)as such difference relates more to the nature of the shareholder rights than to the extent of ownership of capital.
- Loans or contribution to the company does not strictly speak income as capital under the company law but when on the basis of the domestic laws relating to the thin capitalization or assimilation of loan to capital; the income derived in respect thereof is treated as a dividend under Article 10, the value of such loan or contribution is also to be taken as capital.
- In case a body corporate does not have a capital, for the purpose of subparagraph a of Paragraph 2 of Article 10, capital would be total of all contributions to the body which are taken in to account for the purpose of distributing profits.
Subparagraph b of Paragraph 2 of Article 10 limits the rate to tax dividend at 15% for all other cases. The limit of 15% is justified as the State of Source will tax the profit of the company declaring a dividend in its State.
Paragraph 2 of Article 10 does not impact the taxation of the company with respect to profits out of which dividend is paid.
ABC Services is a partnership firm resident to State A. State A treats partnership firm as a body corporate and not fiscally transparent entity. ABC Services have held 30% capital of the AB Ltd registered, and resident of State B. AB Ltd declared dividend during its annual general meeting. Assuming State A and State B have adopted the OECD model tax treaty, at what rate will the State B tax dividend paid to ABC Services.
As ABC services are treated as a body corporate in its State of residence, it qualifies as Company under the definition provided under subparagraph b of paragraph 1 of Article 3. Hence the given scenario satisfies the conditions provided under subparagraph a of paragraph 2 of Article 10, i.e., ABC services hold more than 25% capital of the AB Ltd for the period 365 days. State B will tax the dividend paid to ABC Services at 5%.
Subparagraph b of Paragraph 1 of Article 3 defines the term ‘company’ as any body corporate or any entity that is treated as a body corporate for tax purposes.
Article 10 does not cover the procedural aspects; hence the State of Source is free to apply its law and levy the tax as a deduction or individual assessment.
Explain the term dividend as per Article 10.
Due to the varied laws of the countries, it is difficult to fully and exhaustively define the term dividend. As per Paragraph 3 of Article 10, dividend means income from shares of the company. Shares could be of any type meaning “joissance” shares, “joissance” rights, mining shares, founders shares, or other rights. It does not include rights derived through debt claims. The term shares include all securities issued by companies that carry a right to participate in the companies which take a right to participate in the company’s profits without being debt claims.
Article 10 covers interest on loans, on so far as the lender effectively shares the risk run by the company, i.e. when repayment depends mostly on the success or other of the enterprise business.
How to identify when the lender shares the risks run by the enterprise?
Following factors hint towards the possibility that the lender shares the risks run by the enterprise:
- The loan very heavily outweighs any other contribution to their enterprise’s capital and is substantially unmatched by redeemable assets.
- The creditors will share in any profits of the company
- The repayment of the loan is subordinated to claims of other creditors or the payment of dividend
- The level of payments of interest would depend upon the profits of the company
- The loan contract contains no fixed provisions for repayment by a definite date.
Many states treat the profits distributed by the cooperative societies as a dividend.
Distribution of profits by the partnership is not dividend unless the partnerships are subject in the State where their place of effective management is situated to a fiscal treatment substantially similar to that applies to companies limited by shares. Dividend payments include distribution of profit through the issue of bonus shares, bonuses, earnings on liquidation or redemption of shares, and disguised distribution of profits. The relief provided in the article applies so long as the State of which the paying company is a resident taxes such benefits as a dividend.
Payments having the effects of reducing the rights (like reimbursement of capital) in any form will not be treated as capital.
When not to apply Paragraphs 1 and 2 of Article 10?
Paragraph 4 of Article 10 places emphasis on non-applicability of Paragraph 1 and 2 of aRticle 10, when the company pays the dividend to a company registered in another State if:
- The beneficial owner of the dividend has a permanent establishment in the State where the company paying a dividend is resident
- The dividend is attributable to the Permanent establishment of the beneficial owner.
In such cases, the dividend will be taxed as the income of the Permanent Establishment under Article 7(1)
What is extra-territorial taxation of dividends?
Paragraph 5 of Article 10 rules out the extra-territorial taxation of dividends, i.e., the practice by which States tax dividends distributed by a non-resident company solely because of the corporate profits from which the distributions are made originated in their territory. The country of the Source has no right to tax the dividend when the non-resident company derives the profits or income from its states if:
- When the company is a non-resident
- The shareholders receiving the dividend are also non-residents.