3.3.3.6 Art. 10 OECD MTC: Dividends

Introduction

If an entity which is a treaty resident of one state pays a dividend to a resident of another state, the state of the dividend recipient may tax the dividend.1 This rule is included in art. 10 OECD MTC. The state of residence of the distributing entity has a limited taxing right.2 This provision provides for a reduced rate of withholding tax on dividend payments (5%) if the recipient holds at least 25%3 of the shares in the entity that pays the dividends. In order to benefit from this reduced rate, the recipient of the dividends must hold at least 25% of the shares in the distributing company for a period of 365 days.4 For other dividends, a withholding tax rate of 15% applies and no holding period applies.5 Application of art. 10 OECD MTC is subject to the condition that the recipient of the dividend is the beneficial owner. The beneficial ownership requirement serves as an anti-avoidance tool within the OECD MTC. The dividend article does not include a subject-to-tax requirement.6

Art. 7 OECD MTC instead of art. 10 OECD MTC applies to dividends received by a resident, which carries on a business in the country of the paying company, if the shares in the company are part of the assets of the permanent establishment.7 In addition, the dividend provision contains a prohibition of extraterritorial taxation. This rule prohibits the source state from taxing distributed and undistributed profits of entities that are not residents of that state.8

Juridical double taxation

Art. 10 OECD MTC recognises that a parent company and subsidiary company are not completely independent parties. The provision limits the maximum withholding tax to be withheld and – in this context – has an implicit group approach. The reduced rate only applies if one entity holds at least 25% of the shares in the other entity.9 According to the OECD, it is reasonable to tax a foreign parent company at a relatively low rate in order to avoid recurring taxation and to facilitate international investment.10 The background to this part of the provision therefore appears to be that the OECD MTC wishes to prevent excessive taxation within a group relationship.11

Dividends are paid out of a company’s retained profits. In principle, profit tax has already been paid on these retained profits. Withholding tax is usually deducted when the retained profits are distributed. The profits can potentially be taxed again at the level of the recipient. Thus, in the worst case, initial income tax at the level of the subsidiary with withholding tax at the level of the parent company concurs with income tax at the level of the parent company. Dividend distributions therefore involve both economic double taxation and juridical double taxation.12

Under certain conditions, art. 10 OECD MTC limits the maximum withholding tax to be deducted. Art. 23 A and 23 B OECD MTC subsequently stipulate how the state of residence must provide for the elimination of double taxation by taking into account the taxation by the source state. This is intended to solve the juridical double taxation with regard to dividend payments, which is logical since the OECD MTC is aimed at preventing juridical double taxation. However, usually the juridical double taxation is not entirely eliminated, since the withholding tax is levied as a percentage of the gross amount in the source state,13 whereas the net amount is taken into consideration in the residence state for determining the credit for taxes paid abroad.14 Moreover, if the participation exemption is applied to the dividends, no set-off may be possible at all. Additionally, when a taxpayer suffers a loss or when the tax is withheld contrary to the tax treaty, it may not be possible to benefit from a tax credit.

Economic double taxation

Art. 10 OECD MTC does not provide for the avoidance of economic double taxation arising on dividend payments.15 If a company holds an interest in another entity, the profits are taxed for the first time when they are realized by the subsidiary and for a second time when they are distributed to the parent company. This leads to economic double taxation in group structures, which negatively impacts international investments. Considering its objectives, it is no surprise that the OECD MTC does not provide for the avoidance of this form of double taxation. Yet especially in group relations the question is whether the outcome meets the overarching objective of the OECD MTC: to promote cross-border economic activities. Hence, the question can be raised whether tax treaties in these cases should aim to prevent economic double taxation. The Commentary on the OECD MTC addresses this issue in detail and states that the precise definition of the concept of economic double taxation is not clear.16 What’s more, since the views of the various countries on the treatment of dividends under tax treaties differ widely, it is difficult to reach a solution. For this reason, it was not possible for the authors of the Commentary on the Model Tax Convention to reach consensus on this issue.17 States are therefore free to choose a solution to the problem if desired.18

Beneficial ownership

The term beneficial owner as included in art. 10 OECD MTC was introduced to eliminate ambiguities regarding the interpretation of the phrase ‘paid... to a resident’. The beneficial owner concept aims to prevent tax avoidance. The provision applies to certain forms of treaty shopping, e.g., situations where a recipient is interposed who is obliged to pass on the dividend received.19 The OECD emphasises that the concept of beneficial owner should not be interpreted in a narrow technical sense. For the interpretation of the concept, the context of the tax treaty as well as the objectives of the tax treaty should be taken into account.20 If the recipient’s right to use and enjoy the dividend is restricted because of contractual or legal obligations that require the dividend to be passed on, the recipient is not a beneficial owner.21An agent, a nominee22 or a conduit company used to claim treaty benefits is normally not considered to be the beneficial owner.23

According to the Commentary, it meets the objective of the model not to consider an agent or nominee as a beneficial owner. After all, in such a case, there is no potential for double taxation if the recipient of the income is not regarded as the person entitled to the income for tax purposes in the state of residence.24 If the person is nevertheless seen as entitled to the income, the application of the beneficial ownership requirement may lead to economic double taxation.25 If a dividend26 is paid to an intermediary instead of to the beneficial owner, both states can see themselves as the recipient of the dividend. If the beneficial owner is established in the same state as the dividend payer, both states will have unlimited taxing rights (see figure 3.2).27 If the beneficial owner is resident in another country, an unlimited taxing right also exists for both the state of the beneficial owner and the state of the intermediary – potentially resulting in economic double taxation (see figure 3.3).28 This is an example of a situation where the lack of a full group approach could result in economic double taxation. The reason for the economic double taxation is the dual allocation at the national level.

There is no consensus on whether the requirement of beneficial ownership entails a legal or an economic test (i.e., should a procedural approach be adopted or should the actual economic situation be taken into account).29 Proponents of a legal test argue that a taxpayer’s intent and subjective criteria are not relevant to the application of the beneficial ownership requirement.30 An advantage of a legal approach is the legal certainty it offers. However, a strictly legal approach provides opportunities for treaty shopping.31

In the more economic approach, the concept of beneficial owner takes into account all the facts and circumstances of a situation. This interpretation means that the term beneficial owner is not understood in a narrow technical sense, but has a meaning that makes it possible to avoid double taxation and prevent tax evasion and avoidance.32 When all facts and circumstances are taken into account, an entity’s group structure is relevant for analysing whether a beneficial owner exists. It would seem that this works both ways: on the one hand, it can combat abusive situations; on the other hand, it can lead to treaty benefits being granted in more situations.

With regard to the consideration of a group situation for the purpose of combatting abuse, the question is how far this should go. Is a holding company, which exists in particular to claim a treaty benefit for a group company, by definition not the beneficial owner because of the relationship with that company?33This would not seem to be the case. It should be examined what the economic interest is at the level of the holding company34 and how this relates to the size of the investment. In other words, the facts and circumstances of the case must be assessed.

If the group situation of an entity is taken into account when applying the beneficial ownership requirement, this can ensure that treaty benefits can be claimed in situations where no undesirable use is made of the tax treaty, while strictly speaking the beneficial ownership requirement has not been met. An example of this can be found in the OECD Commentary. When applying art. 10 OECD MTC, the granting of treaty benefits is still possible if a company is interposed, while the beneficial owner is a resident of the same Contracting State (see figure 3.4).35 In such a case, the source state should still grant a reduction or exemption of withholding tax. The fact that the group company must be taken into account underlines, in my view, that a purely procedural approach does not fit within the operation of the beneficial ownership requirement advocated by the OECD.

Income recharacterization

The treatment of dividends under the OECD MTC differs from the treatment of interest and royalties. In general, a ‘cubbyhole approach’ is applied for income tax treaties, with a different treatment for different types of income.36 For example, a withholding tax rate of 10% applies to interest,37 whereas no withholding tax may be levied on royalties.38 This fact may lead to tax avoidance via income recharacterization. Such issues will occur particularly in group situations.39 In this respect, the provision for dividends – in conjunction with the provisions for interest and royalties – does not seem to be in line with the objectives of tax treaties.

Extension of the concept of ‘shareholder’

The Commentary on art. 10 OECD MTC notes that the treaty benefits to which holding shares in a company gives rise are, in principle, only available to the shareholder itself. If company benefits are available to entities that are not considered shareholders under company law, they may still qualify as dividends if:40

This provision hence applies a variant of a group approach. For entities that are not regarded as shareholders under company law, the dividend concept is extended for persons closely connected with a shareholder. 41 Thereby, the OECD aims to prevent juridical double taxation in more situations, which contributes to one of the objectives of the OECD MTC.