Interest is commonly known as the income earned on the movable capital. Unlike dividends, interest does not suffer the economic double taxation and is not taxed both at the hands of the debtor and the creditor. The payer of the interest gets the deduction, whereas the recipient has to discharge taxes. Article 11 of the OECD Model Tax Convention covers the taxation of interest income.
In this post, we will answer the following questions?
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What is interest as per Article 11?
Paragraph 3 of Article 11 defines the term ‘interest’ as:
“The term ‘interest’ as used in this Article means income from debt claims of every kind, whether or not secured by the mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article.”
The paragraph mentioned above has provided an exhaustive and broad definition of the term ‘interest’ to reduce the ambiguity arising due to the domestic laws of the countries.
The term interest includes income from every kind of debt-claims, irrespective of whether it is secured or unsecured by a mortgage or guarantee and whether or not it provides any right to participate in the debtor’s profits. The debt claims include cash deposits and security in the form of money. Government securities, bonds, and debentures are covered explicitly as debt claims, due to their peculiar nature. Mortgage interest is treated as income from immovable property in a few countries, but for the OECD model tax convention, the same will be exclusively covered under Article 11.
The definition provided in Article 11 is exhaustive, and it is preferable not to include any subsidiary reference to the domestic laws based upon the following considerations:
- The definition covers all kinds of income which are regarded as interest in the various domestic laws
- The formula employed offers greater security from the legal point of view, and the conventions would not be affected by the future changes in the domestic law
- In the Model Convention, references to domestic laws should be avoided as much as possible.
Like dividends and royalty, on payment of interest tax is deducted at source.
Certain countries do not allow interest paid to be deducted for the payer’s tax unless the recipient also resides in the same State or is taxable in that State. Otherwise, they forbid the deduction. Paragraph 4 of Article 24 clarifies allowance of deduction when a resident of a Contracting State pays the interest to a non-resident.
Are interest from participating bonds be treated as interest or dividend?
Participating bonds are the bonds that are entitled to share in additional distributions of profits of the company along with its common stocks. This is over and above the interest payments received by them. Interest in participating bonds and convertible bonds will be treated as interest till they are converted to shares unless the loans effectively share the risks run by the debtor company.
For identifying the creditor sharing risks run by the debtor company, each case has to be analyzed with its specific circumstances as follow:
- Whether the loan very heavily outweighs any other contribution to the enterprise’s capital (or was taken out to replace a substantial proportion of capital which has been lost) and is substantially unmatched by redeemable assets;
- Whether the creditor will share in any profits of the company
- Whether repayment of the loan is subordinated to claims of other creditors or the payment of dividends
- Whether the level or payment of interest would depend on the profits of the company
- Whether the loan contract contains no fixed provisions for repayment by a definite date.
For avoiding overlap between the dividends and interest, it is to be noted that the term ‘interest’ as used in Article 11 does not include items of income which are dealt with under Article 10.
Which country has the right to tax the ‘interest’?
Paragraph 1 and 2 of Article 11 provides taxation rights on interest to both the State of residence and the State of Source.
A formula reserving the exclusive taxation of interest to one State, either the State of residence or the State of source, could not be sure of receiving the general approval. Therefore, Article 11 provides the right to tax interest to the State of residence but leaves the right to tax interest to the State of Source if its domestic law provides so. It is implicit that the State of Source is free to give up the right to tax the interest paid to the non-residents.
The State of Source’s right to tax interest is limited by the ceiling rate of 10% or as agreed by the Countries while agreeing.
Article 11 provides the right to tax the interest on the State of residence of the recipient. Although paragraph 2 of Article 11 bestows the State of source, the option of taxing the interest but within a limit of 10%.
State of Residence:
Paragraph 1 of Article 11, the interest paid by a resident of a contracting state to the resident of another Contracting State, may be taxed by the other State. It does not provide the exclusive right to the State of residence.
The Article deals only with interest arising in the Contracting State and does not apply to the interest arising in the third State.
State of Source:
Paragraph 2 of Article 11 bestows the limited right to tax the interest to the State of source with a ceiling of 10%. This rate is considered to be a reasonable limit as the State of Source has the right to tax profits or income produced on its territory by investments financed out of borrowed capital. The countries entering into agreement are free to choose the lower rate as a ceiling limit or an exclusive right to tax on interests to the State of residence.
Many countries believe, the State of Source’s right to tax interest forms an obstacle to international trade. The major problem that arises to the lender is the taxation of interest is on the gross amount without any deduction on the expenses incurred in order to earn such interest. In order to avoid this burden, many creditors tend to shift the burden of tax levied by the State of Source to the debtors, which increases the cost of borrowed funds to the debtors.
Double taxation avoidance agreements many countries may consist of variation or exemption on the following points:
- Interest paid to a State, its political subdivisions and to central banks
- Interest paid by a State or its political subdivisions
- Interest paid pursuant to export financing programs
- Interest paid to financial institutions
- Interest on sales on credit
- Interest paid to tax-exempt entities
What is the impact of premium paid on bonds and debenture while taxing the ‘interest’?
Interest yielded on the security includes what the institution pays over and above the amount paid by the subscriber, that is, the interest accruing plus any premium paid at the redemption or issue.
If a bond or a debenture has been issued at a premium, the excess amount paid by the subscriber over that repaid to him may constitute adverse interest, which should be deducted from the stated interest in determining the taxable interest.
It is important to note that the interest does not include any profit or loss that cannot be attributed to a difference between what the issuer received and paid.
Does Article 11 applies to ‘interest rate swaps’?
The definition of interest does not apply to payments made under certain kinds of nontraditional financial instruments where there are no underlying debts. Hence for interest rate swaps, Article 11 will not apply if there are no underlying debts presumed.
Are penalty charges on late payment of interest treated as ‘interest’?
As per second part of Paragraph 3 of Article 11, penalty on late payment of interest will not be ‘interest’ for Article 11, as penalty does not form part of the income of capital but a particular form of compensation for the loss suffered by the creditor through the debtor’s delay in meeting his obligations. For considerations of legal security and practical convenience, it is advisable to place all penalty charges in whatever form they are paid on the same footing for the purpose of taxation.
Are Annuities covered under Article 11?
Annuities granted in consideration of past employment are referred to Article 18 and are subject to the rules governing pensions. Although the installments of purchased annuities include elements of interest on the purchased capital as well as the return of capital, such installments thus constituting “fruits civils” which accrue from day to day, it would be difficult for many countries to make a distinction between the element representing income from capital and the element defining a return of capital in order merely to tax the income element under the same category as income from movable capital. Hence annuities are not covered under Article 11.
How to identify the State of Source of interest?
Paragraph 5 of Article 11 states, the State of Source of interest is the State, where the payer of the interest is a resident. It provides for an exception, in case of interest-bearing loans, which have an apparent economic link with a permanent establishment owned in the other Contracting State by the payer of the interest. When loans are taken for the permanent establishment, and the said permanent establishment bears the interest, the paragraph 5 determines that the source of the interest is in the Contracting State in which the permanent establishment exists, irrespective of where the owner of the permanent establishment resides.
It is important to note that the identification of the economic link plays a pivotal role. If the economic link is absent between the loan on which interest arises and the permanent establishment, then the contracting State where the permanent establishment exists can not tax the interest.
How will the interest be taxed if the payer and the recipient are in one State and the permanent establishment for which loan is taken is in the third State?
Paragraph 5 of Article 11 is silent about the case where the recipient of the interest and the payer are residents of a contracting state, but the payers’ permanent establishment, for which loan was taken and who pays the interest, is in third State. Only the first sentence of Paragraph 5 would be applicable, and the State of Source will be the State where the payer is resident. Here interest will be taxed both in the contracting State of which payer is the resident and in the contracting State of which the beneficiary is the resident. But double taxation would not be avoided between the contracting states and the third State if the latter taxes the interest on the loan at the source when the permanent establishment in its territory bears it.
The Convention does not cover such cases, hence Contracting State of payer’s residence need not relinquish its tax at the source in favor of the third State in which is situated the permanent establishment for which the loan was effected, and interest is borne.
Explain taxation of interest among related parties.
Paragraph 6 of Article 11 deals with the taxation of interest when related parties are involved in the transaction. It restricts the operation of the provision concerning the tax of interest in cases where, because of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the interest paid exceeds the Arm’s length price.
Paragraph 6 of Article 11 states that in the interest would be taxed at the arms-length price and the excess part of interest will be taxed according to the laws of the two contracting states with due regards to other provisions of the Convention.
The concept of ‘special relationship’ covers the relationship by blood or marriage and, in general, any community of interests as distinct from the legal relationship giving rise to the payment of the interest.