The modalities of taxation in the OECD Convention against double taxation of transnational interest dividends and royalties. International tax planning tools to avoid double taxation of income.
In the context of international tax planning for companies and individuals, the OECD Convention against double taxation represents one of the elements to be taken into consideration. This convention represents, in fact, the reference basis for the international conventions signed by Italy with various foreign countries. These conventions have the objective of reducing or eliminating international double taxation of income.
In this case, this contribution aims to analyze the criteria for linking income arising from the receipt of transnational interest, dividends, and royalties.
As mentioned, the OECD Model Convention against double taxation is now one of the leading models signed by Italy with most foreign countries on the subject of double taxation. For this reason, it is essential to understand what is regulated when we are faced with the receipt of specific categories of income, such as interest, dividends, and royalties.
In this contribution, I want to analyze how to tax transnational interest, dividends, and royalties, according to the provisions of the OECD Model Convention against double taxation.
OECD Convention: Common Provisions
The provisions in the OECD Convention dealing with the taxation of dividends, interest, and royalties are very similar. Inevitably, these provisions, together with those relating to identifying the permanent establishment and the taxation of business income, constitute the most crucial part of any international treaty to mitigate double taxation of income.
For this reason, understanding how the OECD model regulates the phenomena of double taxation of interest, dividends, and royalties is an essential element for all companies that are starting to create a multinational group.
To give an example, think about the case of a holding/sub-holding located in Europe, participated by non-European entities, to benefit from the favorable treatment provided for dividends and cross-border interest. In fact, in the professional practice, it is frequent to have to analyze corporate structures of the type indicated and have to decide the tax regime of outbound dividends of the entity tax resident in Italy to the European holding/sub-holding.
The criteria for linking transnational dividends
Article 10 of the OECD Model Convention (Article 10 – Dividends) deals with dividends paid by a company resident in State A (the source state of the dividends) to a company or individual resident in State B. In this context, the term “paid” has a comprehensive meaning.
Article 10(1) and (2) give the source State a limited right to tax dividends. In particular, the source State is the country where the company distributing the dividends is resident. However, the State of residence of the recipient shareholder will also have taxing rights.
The article applies to dividends paid between residents of two different Contracting States: it does not apply to dividends paid between residents of the same State or to dividends paid or paid by residents of a third State.
The source state may impose maximum taxation of 5% of the gross amount of dividends in the case of intra-group profit distributions (i.e., one company’s interest in the other is at least 25% of the capital of the investee company), and 15% in the case of dividends linked to investment holdings.
One of the reasons for applying lower rates in the case of qualifying holdings, i.e., in the case of the existence of a parent company, is to avoid the application of double economic taxation and encourage investment. In addition, the two Contracting States may, during negotiations, agree on even lower rates.
In the treaties concluded by some States, the percentage of withholding tax on intra-group dividends is sometimes reduced to zero. The same result has been obtained, although by a different route, concerning intra-group dividends distributed within the European Union, which qualify for applying the benefits of the Parent-Subsidiary Directive.
Dividends and foreign partnerships
The definition of dividends has been the subject of conflicting interpretations, including income from partnerships. As a result, cases in which the distribution of income from a foreign partnership to a non-resident partner is equated with dividends are not uncommon.
Those States that regard partnerships as non-transparent for tax purposes argue that, based on this definition, they may impose a withholding tax on partnership profits that are distributed to the partner resident in another State. This position is contested by those States that regard partnerships as transparent for tax purposes.
The real problems arise when a partnership is located in a state that considers the company non-transparent. At the same time, the partners are residents in a state where partnerships are considered tax transparent.
The connecting criteria for transnational interests
The term interest generally refers to the remuneration paid on a loan of money. Many countries levy an exit tax on outgoing (transnational) interest. In the domestic sphere, this taxation can almost always be offset against the income tax finally due.
Article 11 of the OECD Model Convention applies only to interest arising in a Contracting State and paid to a resident of the other State. In particular, Article 11(1) establishes the right to tax interest by the recipient’s State of residence.
However, Article 11(2) gives a limited right to tax to the source State (up to a maximum rate of 10% on the gross amount).
In the treaties concluded in some cases, the percentage of withholding tax applicable on intra-group interest is sometimes reduced to zero. Similar to dividends, there is the Directive on intra-group interest and royalties in the European context, which provides for a procedure to obtain the reduction or refund of the withholding tax applied.
The definition of interests
As in Article 10, Article 11 (3) of the OECD Convention contains a definition of the term “interest” to apply the Treaty. The term “interest” includes income from a debt of every kind, whether or not secured by a mortgage, and whether or not the remuneration contributes to the right to participate in profits. According to this definition, interest includes income from government securities and income from bonds or debentures. The term also includes premiums and other income attached to such securities.
However, penalties for late payments are not considered interest for the Treaty. Bonds with participation rights are treated as loans unless the loan participates in the debtor’s own business risk. In that case, the interest will be treated as dividends under the OECD model.
Article 11(4) of the OECD Convention confirms the prohibition of applying the force of attraction to interest payments.
Article 11 (5) contains a rather complicated provision. It explains to which State the interest is to be referred if there is a triangular situation involving a permanent establishment as the person liable to pay the claim. Finally, Article 11 (6) contains the transfer pricing provision concerning interest payments.
The connecting criteria for royalties
Article 12(1) of the OECD Model Tax Convention provides that transnational royalties are taxable only in the State of residence of the beneficial owner.
The term “beneficial owner” is used in this Article with the same meaning as in Articles 10 and 11 of the OECD Convention.
However, many countries, including Italy, have made explicit reservations about the exclusive right to tax attributed to the country of residence. These States apply a withholding tax, albeit reduced, on royalties as generally agreed in bilateral treaties.
For example, under the Convention between Italy and Romania, royalties leaving Italy are subject to a 5% Italian withholding tax.
The definition of royalties
Royalties are payments for the use or right to use:
- Copyrights on works of a literary, artistic, or scientific nature, including cinematographic works;
- Patents, trademarks, designs, secret formulas, and processes;
- Information relating to industrial, commercial, or scientific experience (“know-how“).
Payments made for the provision of services of a technical nature or management services explicitly do not fall within the definition of royalties. However, many tax authorities do not apply this concept in practice.
Payments for disposals
The Commentary to the OECD Convention provides that payments made regarding the transfer of full ownership of one of the elements determining the definition of royalties cannot be treated as a royalty payment within the meaning of Article 12.
This is because the payments are not made regarding the use or right to use that property ownership.
The same rationale would apply to payments made solely to obtain exclusive rights to distribute a product or service in a given territory, payments for the development of designs, models, or plans that do not yet exist, even where the author reserves the intellectual rights such assets.
Finally, the Commentary clarifies that payments made by a software distributor to the copyright holder for the purchase and distribution of copies of such software (without the right to reproduce the software itself) should be treated as business income rather than royalties.
The lack of coordination between states
The purpose of the division of taxing rights established by the conventions on interest, royalties, and dividends is to avoid juridical double taxation, imposing on the source State the exemption/reduction from the application of withholding taxes and attributing the exclusive taxing power to the State of residence of the recipient of the flows (or moderating the effects of the concurrent taxing authority of the two States on the same subject).
The Conventions did not provide for any form of coordination between the Contracting States. The State of residence, granted the exclusive power to tax, is not obliged to exercise that power.
In situations like this, the international conventions against double taxation contain specific anti-abuse clauses necessary to counteract international tax planning and prevent forms of abuse. On this point, see E.U. Directive no. 2003/49/E.C. (Interest and Royalties Directive) and Article 26-quarter of Presidential Decree no. 600/73.
According to the commentary to the OECD model, the beneficial owner of the income streams is considered to be the person who enjoys the simple right to use the income streams and is not obliged to retrocede them to another party based on contractual or legal obligations.