4.3.3.1 Introduction

The risk of double taxation with respect to interest and royalty payments is lower than the risk for double taxation of dividends, as the first two are generally deductible from the company’s taxable profit, whereas the latter is not deductible.1 If withholding taxes on deductible payments are abolished, it means the source state receives no tax revenue at all. In fact, because of the deductibility, it only costs tax money. This can provide tax planning opportunities, i.e., tax avoidance.2 On the contrary, it can also be seen as logical to tax the beneficial owner of the interest in its state of residence as it is in that case guaranteed that such income is taxed in the same jurisdiction where the related expenditure is deductible. These expenditures would be the cost of raising capital in the case of interest income and research and development expenditures in the case of royalties.3 Still, the difference with the treatment of dividends remains arbitrary: income from equity investments is taxed in the investment state (as dividends are generally non-deductible), while income from loan investments is taxed in the investor’s state (as interest is generally deductible).4 In this regard it should be noted that the domestic legislation of many countries provides for rules to limit the deductibility of interest.5 There are also countries that limit the deductibility of royalty payments.6 If the interest or royalties are non-deductible under interest limitation rules or royalty limitation rules, there is essentially no difference between their tax treatment in comparison to the tax treatment of dividends.