Debt-claims participating in profits in tax treaties

D

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P

P

T

T

Samantha Paula G. Dy

Universiteit van Amsterdam

Advanced Masters in International Tax Law

Supervisor: O.C.R. Marres

T

C

A

3

I

4

1

D

-

6

1.1

Ordinary definitions of debt, equity, interest, and dividends

6

1.2

OECD MC definitions of dividends

8

1.3

OECD MC definitions of interest

11

1.4

Autonomy of the definitions of dividends and interest

13

1.5

General OECD MC treatment of debt-claims participating in profits

16

1.6

Borderline cases between dividends and interest

16

2

V

OECD

MC

DIVIDENDS AND INTEREST

21

3

T

-

PARTICIPATING IN PROFITS IN TAX TREATIES

22

3.1

Deviations from the OECD’s view: Income treated as dividends

23

3.2

Deviations from the OECD’s view: Income treated as dividends, even

if in the form of interest

27

4

C

(

)

28

4.1

Factors considered by domestic courts

28

4.2

What constitutes “debt-claims of every kind”

30

4.3

What constitutes “participation in profits”

37

C

40

A

“A” Summary of variations to the OECD MC definitions of dividends and

interest

43

“B” Survey of tax treaties of the Netherlands

51

“C” Survey of tax treaties of Germany

69

“D” Summaries of case law cited in Chapter 4

Australia

100

Canada

101

Czech Republic

102

France

103

Germany

104

India

112

Poland

119

Spain

121

CJEU

122

B

125

A

“CJEU” refers to the Court of Justice of the European Union.

“OECD” means the Organisation for Economic Co-operation and Development.

“OECD Commentary” means the 2017 Commentary to the OECD MC, unless

another version thereof is referenced.

“OECD MC” means the 2017 OECD Model Tax Convention, unless another version

thereof is referenced.

I

The decision in Austria v. Germany

was issued by the CJEU on 12 September

2017. It would only be the second case in which the CJEU interpreted the scope of

Article 273

of the TFEU.

In that case, the CJEU held that it had jurisdiction over the

subject matter which was brought before it under a special agreement in the form of

the arbitration clause in Article 25(5) of the relevant tax treaty between Austria and

Germany.

In the field of corporate finance, Austria v. Germany would also turn out to be

an important ruling, particularly in relation to debt-claims participating in profits. In

that case, the CJEU had the occasion to rule on what it meant for a creditor to

participate in the profits of a debtor. In essence, the CJEU found that the taxpayer did

not participate in the German company’s profits because in case of a loss situation,

the taxpayer was not entitled to a distribution but this could be recouped in the

subsequent year.

The relevance of Austria v. Germany is highlighted when the decision

by the

German Federal Tax Court on 26 August 2010 is considered. That case involved the

same tax treaty between Austria and Germany but the German court took a view

different from that of the CJEU. In that case, the German court found that the

taxpayer participated in the German company’s profits even though in case of a loss

situation, the taxpayer was not entitled to a distribution and this could be recouped in

a following year.

In reconciling the decisions by the CJEU and the German court, the logical

first step would be to refer to the OECD MC and the OECD Commentary. However,

this thesis would show that the OECD MC and the OECD Commentary are

inadequate as interpretational aids in dealing with debt-claims participating in profits.

Resort was, thus, likewise made to decisions by domestic courts to see how they have

arrived at the conclusion that a debt-claim exists and participates in the profits of a

company.

In the early days, debt and equity used to be a dichotomy. Over the years,

financial engineering has produced hybrid instruments. In a continuum with debt on

one end and equity on the other, a hybrid instrument comes closer to debt, or equity,

depending on its features. A debt-like equity instrument would be closer to equity

than debt, while an equity-like debt instrument (i.e., debt-claim participating in

profits) would be more closely-linked to debt than equity. The above notwithstanding,

in the modern age, a distinction is still made between debt and equity. For so long as

1 _{CJEU, Austria v. Germany, C-648/15, 12 September 2017, IBFD Tax Treaty Case Law}

database.

2 _{It reads: “The Court of Justice shall have jurisdiction in any dispute between Member States}

which relates to the subject matter of the Treaties if the dispute is submitted to it under a special agreement between the parties.”

3 _{B. Michel, Austria v. Germany (Case C-648-15): The ECJ and Its New Tax Treaty}

Arbitration Hat, European Taxation, January 2018, p. 3.

such distinction remains, the classification of hybrid instruments, such as debt-claims

participating in profits, for tax treaty purposes is relevant.

It is clear that in the OECD MC, income from debt-claims participating in

profits is treated as interest, while income from instruments that participate in profits

without being debt-claims qualifies as dividends. However, the OECD MC and the

OECD Commentary are inadequate as interpretational aids in determining when a

debt-claim exists and when there is profit participation.

The purpose of this thesis is to examine whether, and to what extent,

contracting states have adopted the OECD’s tax treatment of income from debt-claims

participating in profits as such income is earned by individuals and corporations and,

moreover, how the domestic courts have arrived at the conclusion that a debt-claim

exists and participates in the profits of a company.

Chapter 1 will illustrate the OECD’s view with respect to income from

debt-claims participating in profits. The starting point will be the current definitions of

dividends and interest in Articles 10 and 11, respectively, of the OECD MC and, to

the extent that they are relevant, the historical changes thereto. This chapter proceeds

to deal with borderline cases between dividends and interest as they are discussed in

the OECD Commentary on Articles 10(3) and 11(3) and, to the extent that they are

relevant, the historical changes thereto.

Chapter 2 and Appendix “A” will show some variations to the OECD MC

definitions of dividends and interest that contracting states have adopted in their tax

treaties and, to the extent that they are relevant, jurisprudence by the domestic courts.

This chapter will briefly discuss the relevant provisions of the Parent-Subsidiary

Directive and the Interest and Royalties Directive.

Without delving into the domestic laws and the rationale behind the treaty

policies of contracting states, Chapter 3 will provide some illustrative examples on

how some contracting states treat income from debt-claims participating in profits in

tax treaties. Each of the Netherlands and Germany has concluded close to a hundred

tax treaties with their respective treaty partners. For this thesis, a survey of fifty (50)

tax treaties of each of the Netherlands and Germany was done. The author believes

that such number sufficiently represents the tax treaties concluded by said countries

and reflects a basic trend or pattern thereof. The treaty partners include all the other

members of the European Union, the United States, Canada, Australia, Japan, and

BRICs. The other states were randomly selected. Appendix “B” for the Netherlands

and Appendix “C” for Germany contain summaries of the relevant provisions of the

tax treaties surveyed. For this purpose, reliance was made on the IBFD Treaties

database.

Chapter 4 will illustrate how the domestic courts of contracting states have

arrived at the conclusion that, firstly, a debt-claim exists and, secondly, the creditor

participates in the debtor’s profits. For this thesis, a survey of the IBFD Tax Treaty

Case Law database was done. Reliance was made on the summaries uploaded on the

database for jurisprudence that was not originally issued in the English language. It is,

thus, possible that certain nuances in the original language may have been

inadvertently overlooked. Appendix “D” contains digests of the case law cited in this

chapter.

The Conclusion summarizes the findings in Chapters 1 to 4.

1. D

-

Economically, debt and equity perform the same function, i.e., to enable a

company to generate profits.

_{However, debt and equity are accorded different tax}

treatment across states. Economists have gone further to conclude that there is a debt

bias as interest payments are deductible at the corporate level, while dividends are

not. Academics have proposed to eliminate the debt-equity distinction. However,

policymakers have yet to be convinced on the manner by which such objective shall

be achieved. Tax practitioners have recognized that a major problem lies in the

erosion of the underlying concepts of debt and equity,

through the use of hybrid

instruments which have the features of both debt and equity. One example of such

hybrid instrument is a debt-claim participating in profits, which may alternatively be

called a profit-sharing debt instrument or an equity-like debt instrument.

1.1. Ordinary definitions of debt, equity, interest, and dividends

The Concise Oxford Dictionary defines “debt” as money or services

owed or due, a state of owing money. On the other hand, “equity” is defined

as stocks or shares not bearing fixed interest.

According to one author,

in general, debt and equity differ with

respect to the rights and obligations, attached to the financial position, of the

parties to the arrangement. A debt-claim involves a debtor-creditor

relationship between the parties, while an equity investment creates a

shareholder-company relationship between the investor and the investee

company. The return on a debt-claim is interest, while the return on an equity

investment is a dividend.

The IBFD Glossary states that “interest,” in general, is “the amount

charged by a lender for the use or detention of money, expressed as a

percentage per annum of the principal amount of the loan over a certain period

of time. However, whether a particular payment constitutes interest will

depend on the country whose tax rules are being applied.” In the context of

trusts, interest is also “used to refer to an ownership entitlement, such as a

person’s present or future right to receive income or property” from such

trusts.

5 _{H. Matre, Deductibility of Interest Paid on Profit-Participating Loans in Stock Companies,}

2002 International Bureau of Fiscal Documentation, August/September 2002, p. 457.

6 _{W. Schon, The Distinct Equity of the Debt-Equity Distinction, Bulletin for International}

Taxation, September 2012, pp. 490-491.

7 _{As cited by S. Sanghvi, Ruling on Characterization of Income from Convertible Debenture:}

A Hybrid Instrument, Derivatives & Financial Instruments, March/April 2009, p. 75.

On the other hand, the term “dividends” is described in the IBFD

Glossary as follows:

“In economic terms, a dividends is the return on equity capital invested

in a company. In a company law sense the term is generally used to refer to

the formal distribution of retained earnings (typically by way of shareholders’

resolution) to shareholders. However, the term distribution or profit

distribution is also commonly encountered in a corporate law context. In a tax

context, the term distribution is generally used in a wider sense to refer to any

distribution of corporate assets to shareholders for no adequate consideration,

including informal distributions such as a constructive dividend. Some

countries apply differential tax treatment to dividends and constructive

dividends. Although dividends are typically paid in cash dividend, they may

also be paid in the form of an issue of new shares as stock dividends or in the

form of assets of the company as dividends in kind. In countries with a legal

system based on civil law the term dividends may also be applied to profit

distributions from shares in a partnership limited by shares.”

One author

considers that there are four (4) important factors in

distinguishing between debt and equity, namely: (a) maturity; (b) seniority; (c)

management; and (d) return.

Another author

presents the typical features of interest and dividends

in the following manner:

Interest

Dividends

Paid based on a fixed amount or

fixed percentage

Paid on a variable or fixed basis

depending on the resolution of the

shareholders

Legally certain as to the possibility

of payment

Legally uncertain as to the possibility

of payment (dependent on the

existence of profits or capital reserves

not consumed by the accumulated

losses)

Generated by a credit transaction

Generated by an equity transaction

Debt, equity, interest, and dividends certainly can be defined in

multiple ways. In the author’s opinion, it appears to be the consensus that debt

and interest are derived from a debt-claim and a debtor-creditor relationship

whereby the return to the creditor is certain as to the possibility of payment,

while equity and dividends are sourced from a corporate right and a

shareholder-company relationship whereby the return to the shareholder is

contingent on such factors as existence of profits.

9 _{R. Bispo, Cross-Border Intra-Group Hybrid Finance: A Comparative Analysis of the Legal}

Approach Adopted by Brazil, the United Kingdom and the United States, Bulletin for International Taxation, July 2013, p. 365.

10 _{R. Santos, Tax Treaty Qualification of Income Derived from Hybrid Financial Instruments,}

1.2. OECD MC definition of dividends

Article 10 of the OECD MC begins by saying that the income subject

of the article are “dividends paid by a company.”

“Company”

is then

defined in Article 3 of the OECD MC.

The OECD MC, in Article 10(3), goes on to define dividends as

follows:

“3. The term ‘dividends’ as used in this Article means income from

shares, ‘jouissance’ shares or ‘jouissance’ rights, mining shares, founders’

shares or other rights, not being debt-claims, participating in profits, as well as

income from other corporate rights which is subjected to the same taxation

treatment as income from shares by the laws of the State of which the

company making the distribution is a resident.”

The general view of authors, such as Giuliani,

_Helminen,

Hattingh,

and Vogel,

is that the above definition may be broken down into

three (3) parts, namely:

First

“income from shares, ‘jouissance’ shares or ‘jouissance’ rights,

mining shares, founders’ shares”

Second “[income from] other rights, not being debt-claims, participating in

profits”

Third “income from other corporate rights which is subjected to the same

taxation treatment as income from shares by the laws of the State of

which the company making the distribution is a resident”

It is likewise the general view that all three (3) parts of the definition

refer to “income from corporate rights.”

Giuliani,

citing Vogel, says that

11 _{“Article 10}

Dividends

1. Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.

2. However, dividends paid by a company which is a resident of a Contracting State may also be taxed in that State according to the laws of that State, but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed: xxx” [Emphasis supplied]

12 _{“b. the term “company” means any body corporate or any entity that is treated as body}

corporate for tax purposes;”

13 _{F. Giuliani, Article 10(3) of the OECD Model and Borderline Cases of Corporate}

Distributions, Bulletin – Tax Treaty Monitor, January 2002, p. 11.

14 _{M. Helminen, Classification of Cross-Border Payments on Hybrid Instruments, 2004}

International Bureau of Fiscal Documentation, February 2004, p. 58.

15 _{J. Hattingh, South Africa: The Volkswagen Case and the Secondary Tax on Companies:}

Part 2 – The Effect on the Taxation of Dividends with Emphasis on Deemed (Constructive) Dividends, Bulletin for International Taxation, November 2009, p. 517.

16 _{K. Vogel, Tax Treaty News, Bulletin – Tax Treaty Monitor, June 2005, p. 215.}

17 _{See also: M. Gomez, The BRICs: Tax Treaty Policy Regarding Dividends, Bulletin for}

International Taxation, August 2012, pp. 403, 406, 409, 411.

the term “corporate rights” cuts across the entire structure of Article 10 and

constitutes its common thread.

Helminen

holds the view that the first, second and third parts of the

definition all refer to income from corporate rights. The phrase “as well as

income from other corporate rights” in the third part indicates that the first and

second parts are likewise income from corporate rights.

Hattingh

agrees that the three (3) parts to the definition of dividends

all refer to income from corporate rights. The first part contains an exemplary

list of corporate rights that may give rise to dividends. The second part refers

to the core attribute of dividends for tax treaty purposes. Finally, the third part

is the rule that covers certain informal dividends.

While “dividends” is defined, none of the terms within the definition is

further defined in the OECD MC. Other than the reference to the domestic law

of the source state, it appears that the terms within the definition of dividends

were lifted from existing tax treaties at the time the definition was first drafted

(i.e, up to 1963).

It may be said, therefore, that the terms in the first part of

the definition were included for illustrative purposes.

The first

and second

parts of the definition of dividends have

remained the same through the years.

Between 1963 and 1977, the third part of the definition read: “income

from other corporate rights assimilated to income from shares by the taxation

law of the State from which the income is derived.” In 1977, such phrase was

replaced by “income from other corporate rights which is subjected to the

same taxation treatment as income from shares by the laws of the State of

which the company making the distribution is a resident.” [Emphasis supplied]

The definition of dividends has since remained unchanged.

While the general view subdivides the definition of dividends into

three (3) parts, a literal reading of the definition might lead to the conclusion

that the first and second parts should be looked at as one. Because there is no

comma that separates the second part from the first, it is possible to read

“income from shares, ‘jouissance’ shares or ‘jouissance’ rights, mining shares,

founders’ shares or other rights, not being debt-claims, participating in profits”

as comprising one part and, thus, “not being debt-claims, participating in

profits” describes everything that it follows.

19 _{Helminen, supra note 14.} 20 _{Hattingh, supra note 15.} 21 _{Hattingh, supra note 15.}

22 _{“income from shares, ‘jouissance’ shares or ‘jouissance’ rights, mining shares, founders’}

shares”

23 _{“[income from] other rights, not being debt-claims, participating in profits”} 24 _{J. Sasseville, Chapter 5: The Definition of “Dividends” in the OECD Model Tax}

Convention in Taxation of Intercompany Dividends under Tax Treaties and EU Law (G. Maisto ed., IBFD 2012), Online Books IBFD (accessed 2 August 2016).

Six

subscribes to the view that the definition of dividends has two (2)

parts only. According to him, the first part must be interpreted independently

from the domestic law of the source state, whereas the second part, as it relates

to the “tax treatment as income from shares,” makes reference to the domestic

law of the source state. Nevertheless, he is of the view that the entirety of

Article 10(3) of the OECD MC pertains to income from corporate rights.

Avery Jones, et. al.

posit a third view, to wit:

“The French version supports a further alternative that ‘participating in

profits’ refers only to other rights (it would not be possible to separate parts

beneficiaires), but the reference to debt-claims qualifies everything going

before.”

Nonetheless, Avery Jones, et. al. do not consider the difference

between the alternative readings as significant because none of the items in the

first part of the definition (i.e., shares, ‘jouissance’ shares or ‘jouissance’

rights, mining shares, and founders’ shares) is a debt-claim even though it

participates in profits.

The author agrees with the general view that the essence of Article 10

is that it is income from corporate rights. Further, the first part of the OECD

MC definition seems to be superfluous. It appears that the terms therein were

included merely for illustrative purposes. Such terms are also not defined

thereby attracting the possible application of Article 3(2) of the OECD MC.

Thus, it may be useful to simplify the definition of Article 10 as follows:

“3. The term ‘dividends’ as used in this Article means income from

corporate rights, including income which is subjected to the same taxation

treatment as income from corporate rights by the laws of the State of which

the company making the distribution is a resident.”

As a final note, some authors point out that while dividends is defined

in the dividend article, in principle, the term “dividends,” when used in

another article, may have a different meaning for other purposes of the

relevant tax treaty, e.g., Article 25 or elimination of double taxation. If such is

the intention of the contracting states, it should be made clear and express.

25 _{M. Six, Hybrid Finance and Double Taxation Treaties, Bulletin for International Taxation,}

January 2009, p. 23.

26 _{J.F. Avery Jones, et. al., The Definitions of Dividends and Interest in the OECD Model:}

Something Lost in Translation?, 1 World Tax J. (2009), World Tax Journal IBFD (accessed 9 December 2016).

27 _{J. Avery Jones, et. al., Whether the Definition of Dividend Limited to the Dividend Article}

Applies to the Double Taxation Relief Article Granting Underlying Credit, 1999 International Bureau of Fiscal Documentation, March 1999, p. 108; See also: Court of Appeal of England and Wales (Civil Division) of the United Kingdom, Memec plc v. Commissioners of Inland Revenue, 9 June 1998.

Otherwise, applying Article 3(2), the context of Article 25 may be deemed to

require the same definition as in the dividend article.

1.3. OECD MC definition of interest

Article 11(3) of the OECD MC contains the following definition for

interest:

“3. The term “interest” as used in this Article means income from

debt-claims of every kind, whether or not secured by 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.”

There are three (3) parts to the above definition:

First

“income from debt-claims of every kind, whether or not secured by

mortgage and whether or not carrying a right to participate in the

debtor’s profits”

Second “income from government securities and income from bonds or

debentures, [whether or not secured by mortgage and whether or

not carrying a right to participate in the debtor’s profits,] including

premiums and prizes attaching to such securities, bonds or

debentures”

Third “[p]enalty charges for late payment” which shall not be regarded as

interest

“Interest” is defined. However, none of the terms within the definition

is further defined in the OECD MC.

During the period from 1963 to 1977, interest was defined as follows:

“The term ‘interest’ as used in this Article means income from

Government securities, bonds or debentures, whether or not secured by

mortgage and whether or not carrying a right to participate in profits, and

debt-claims of every kind, as well as all other income assimilated to income

from money lent by the taxation law of the State from which the income is

derived.”

In 1977, the definition of interest was replaced by the following:

“The term “interest” as used in this Article means income from

debt-claims of every kind, whether or not secured by 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

28 _{M. Helminen, Dividends, Interest and Royalties under the Nordic Multilateral Double}

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.”

Since 1977, the definition of interest has remained unaltered.

A textual comparison of the 1963 and 1977/2017 versions reveals

significant changes in the wording of the definition of interest, thus:

1977/2017 (Current)

1963

First

“income from debt-claims of

every kind, whether or not

secured by mortgage and

whether or not carrying a right

to participate in the debtor’s

profits”

“[income from] debt-claims of

every kind”

Second “income from government

securities and income from

bonds or debentures, [whether

or not secured by mortgage and

whether or not carrying a right

to participate in the debtor’s

profits,] including premiums

and prizes attaching to such

securities,

bonds

or

debentures”

“income

from

Government

securities, bonds or debentures,

whether or not secured by

mortgage and whether or not

carrying a right to participate in

profits”

Third “[p]enalty charges for late

payment” which shall not be

regarded as interest

“all other income assimilated to

income from money lent by the

taxation law of the State from

which the income is derived”

It is undisputed that government securities, bonds, and debentures are

debt-claims. The OECD Commentary explains that the second part was added

because of the importance of government securities, bonds, and debentures

and “certain peculiarities that they may present.”

The third part of the current OECD MC definition is not universally

accepted. Some contracting states view penalty charges for late payment as

subsumed under the definition of interest.

_{Further, some tax treaties}

(concluded after 1977 and based on the text of the 1977/2017 version) omit

the third part of the 1977/2017 version, i.e., silent on whether penalty charges

for late payment shall be treated as interest or not.

The current OECD MC definition of interest is generally regarded as

very extensive and leaves nothing to the contracting states to interpret or

29 _C(11)(18).

30 _{See for example: Netherlands-Ukraine tax treaty (1995).}

qualify. Nonetheless, Pijl

believes that “income from debt-claims of every

kind” contains the core concept of, and sufficiently defines, interest. The

remainder of Article 11 merely serves to illustrate or to clarify. The reason for

the current, extensive definition is simply historic. At the time the definition

was first drafted, terms used in existing tax treaties were included.

The author agrees with Pijl and posits that it may be useful to simplify

the definition of Article 11 (without affecting its extensiveness) as follows:

“3. The term “interest” as used in this Article means income from

debt-claims of every kind.”

The illustrative examples of debt-claims may be enumerated in the

OECD Commentary.

1.4. Autonomy of the definitions of dividends and interest

Dividends and interest are defined in Articles 10(3) and 11(3),

respectively, of the OECD MC. However, the terms within such definitions

are themselves not defined. According to Article 3(2) of the OECD MC, any

term that is used but is not defined in a tax treaty shall, unless the context

otherwise requires, have the meaning according to the domestic law of the

source state. It reads:

“2. As regards the application of the Convention at any time by a

Contracting State, any term not defined therein shall, unless the context

otherwise requires, have the meaning that it has at that time under the law of

that State for the purposes of the taxes to which the Convention applies, any

meaning under the applicable tax laws of that State prevailing over a meaning

given to the term under other laws of that State.” [Emphasis supplied]

Article 31(2) of the Vienna Convention on the Law of Treaties sets out

what constitutes context, to wit:

“2. The context for the purpose of the interpretation of a treaty shall

comprise, in addition to the text, including its preamble and annexes:

a. any agreement relating to the treaty which was made between all the

parties in connection with the conclusion of the treaty;

b. any instrument which was made by one or more parties in connection with

the conclusion of the treaty and accepted by the other parties as an

instrument related to the treaty.”

32 _{H. Pijl, Interest from Hybrid Debts in Tax Treaties, Bulletin for International Taxation,}

September 2011, p. 487.

33 _{H. Pijl, Chapter 6: The Concept of Interest in Tax Treaties in Tax Treatment of Interest for}

Corporations (O.C.R. Marres & D. (Dennis) Weber eds., IBFD 2013), Online Books IBFD (accessed 14 February 2017).

34 _{For the origin of Article 3(2) of the OECD MC, see: J. Avery Jones, et. al., The Origins of}

Concepts and Expressions Used in the OECD Model and their Adoption by States, Bulletin – Tax Treaty Monitor, June 2006, pp. 229-230.

Finally, the OECD Commentary

explains that Article 3(2) of the

OECD MC applies only if the context does not require an alternative

interpretation. The context is determined in particular by the intention of the

contracting states in signing the tax treaty between them and the meaning

given to the undefined term in the domestic law of the other contracting state

(i.e., the state other than the state that seeks to apply the tax treaty).

In sum, in case of an undefined term in a tax treaty, prior to reference

to the domestic law of the source state, the context requirement must first be

satisfied. Otherwise stated, reference to the context must have failed before

recourse to the source state’s domestic law may be made.

A textual comparison of the 1963 and 1977/2017 versions of the

definition of dividends is found below:

1977/2017 (Current)

1963

First

“income from shares,

‘jouissance’ shares or

‘jouissance’ rights, mining

shares, founders’ shares”

“income from shares,

‘jouissance’ shares or

‘jouissance’ rights, mining

shares, founders’ shares”

Second

“[income from] other rights,

not being debt-claims,

participating in profits”

“[income from] other rights, not

being debt-claims, participating

in profits”

Third

“income from other corporate

rights which is subjected to the

same taxation treatment as

income from shares by the

laws of the State of which the

company making the

distribution is a resident”

[Emphasis supplied]

“income from other corporate

rights assimilated to income

from shares by the taxation law

of the State from which the

income is derived” [Emphasis

supplied]

It is widely accepted that the first and second parts of the definition

must be interpreted autonomously.

However, it must be noted that the

autonomous interpretation of the first and second parts of the definition is not

absolute. Hattingh

and Sasseville

note that the domestic law of the source

state may nonetheless play a role in the interpretation of the first and second

parts on the basis of Article 3(2) of the OECD MC because terms such as

“income,” “shares,” and “rights” are used in Article 10(3) without being

defined.

35 _C(3)(12).

36 _{Helminen, supra note 14; Six, supra note 25.} 37 _{Hattingh, supra note 15, at p. 518.}

38 _{Sasseville, supra note 24.} 39 _{Sasseville, supra note 24.}

In a 2012 German case,

the taxpayer company which was a tax

resident of Germany owned shares in a Swiss company, which in turn

indirectly held shares in a Brazilian company. In a given year, the Brazilian

company agreed to pay out “interest on equity” which would replace the

ordinary dividend stipulated in said company’s articles of incorporation. The

issue was whether the payments made by the Brazilian company to the

German company qualified as dividends or interest under the Germany-Brazil

tax treaty. At the time, under German domestic law, payments received

indirectly by a German company from a sub-subsidiary through an interposed

holding subsidiary were treated as directly received payments of the German

company.

The Federal Tax Court held that for tax treaty purposes, the

classification of the “interest on equity” must be based on the principle of

autonomous interpretation of tax treaties as set out in Article 3(2) of the

relevant tax treaty. As such, Brazilian and German domestic laws were

irrelevant. The Court looked at the general features of dividends and interest,

and determined that the payments qualified as income from shares and, thus,

dividends. The Court added that the first part of the definition of dividends

was autonomous, unlike the third part thereof which referred to the domestic

law of the source state.

Helminen

believes that the third part of the definition (in both 1963

and 1977/2017 versions) refers to classification by the source state.

Nevertheless, the term “corporate rights” must be interpreted autonomously.

Otherwise, it would not have been necessary to mention “corporate rights” in

the third part.

Six

adds that reference to the domestic law of the source state relates

only to the tax treatment as income from shares. Thus, classification by the

source state is relevant only if, after an autonomous interpretation of

“corporate rights,” it has been determined that the income is derived from a

corporate right.

Thus, the definition of dividends may be said to be partly autonomous

because pursuant to Article 3(2) of the OECD MC, the domestic law of the

source state may nevertheless play a role in the interpretation of any undefined

term, unless the context otherwise requires (first, second and third parts), and

the third part requires an autonomous interpretation of “corporate rights” as

well as reference to the domestic law of the source state.

On the other hand, the definition of interest in the 1977/2017 version is

considered to be wholly autonomous based on two (2) reasons. One, the

current definition is exhaustive so as to cover everything that domestic laws

normally regard as interest. Two, in the 1963 version, the third part of the

40 _{Federal Tax Court of Germany, Case I R 6, 8/11, 6 June 2012, IBFD Tax Treaty Case Law}

database.

41 _{Helminen, supra note 14.} 42 _{Six, supra note 25.}

definition referred to classification by the source state. However, as

mentioned, such reference to the domestic law of the source state was

eliminated in 1977.

As in the definition of dividends, the author points out that the

autonomous interpretation of the definition of interest is not absolute. This is

true where the definition uses terms that are not defined, such as

“debt-claims.” Thus, pursuant to Article 3(2) of the OECD MC, the domestic law of

the source state may nevertheless play a role in the interpretation of any

undefined term, unless the context otherwise requires.

1.5. General OECD MC treatment of debt-claims participating in profits

Article 10(3) of the OECD MC, in its definition of dividends, in part

states: “[income from] other rights, not being debt-claims, participating in

profits.” [Emphasis supplied]

On the other hand, Article 11(3), as it defines interest, partly reads:

“income from debt-claims of every kind, whether or not secured by mortgage

and whether or not carrying a right to participate in the debtor’s profits.”

[Emphasis supplied]

Based on a literal reading of the above, it appears that in classifying

income arising from a certain instrument for tax treaty purposes, the crucial

element, in the OECD’s view, is the existence, or absence, of a debt-claim.

Pijl

_{confirms that the definition of interest could have read simply:}

“income from debt-claims of every kind.” The other components of the

definition merely serve to illustrate or clarify.

Thus, to the author, it seems clear that based on a literal reading of the

OECD MC, debt-claims participating in profits produce interest, while

instruments that participate in profits without being debt-claims produce

dividends.

1.6. Borderline cases between dividends and interest

1.6.1. OECD Commentary on Article 10(3)

The text of Article 10(3) of the OECD MC is explained in the

OECD Commentary, in particular, C(10)(23) to (30).

C(10)(23). The OECD recognized that it was impossible to arrive

at an exhaustive definition of dividends (in the same fashion that it

achieved to give an exhaustive definition of interest) due to the disparities

in the domestic laws of contracting states in the field of company law and

taxation law. It was likewise not possible for the definition to be entirely

43 _{Pijl, supra note 33.} 44 _{Pijl, supra note 33.}

independent of domestic laws. The OECD left it to the contracting states

“through bilateral negotiations, to make allowance for peculiarities of their

laws and to agree to bring under the definition of ‘dividends’ other

payments by companies falling under the Article.”

C(10)(24). The OECD reiterated that the contracting states may

refine the definition of dividends to reflect their respective legal situation.

However, it stated that “debt claims participating in profits do not come

into this category [with reference to C(11)(19), which will be discussed

below]; likewise interest on convertible debentures is not a dividend.”

C(10)(25). According to the OECD, Article 10 deals not only with

dividends but also “interest on loans insofar as the lender effectively

shares the risks run by the company, i.e., when repayment depends largely

on the success or otherwise of the enterprise’s business” Each case must

be examined individually in light of all circumstances, such as the fact

that:

“ -- 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;

-- the creditor will share in any profits of the company;

-- repayment of the loan is subordinated to claims of other creditors or to

the payment of dividends;

-- the level or payment of interest would depend on the profits of the

company;

-- the loan contract contains no fixed provisions for repayment by a

definite date.”

The OECD added that: “Articles 10 and 11 do not therefore

prevent the treatment of this type of interest as dividends under the

national rules on thin capitalization applied in the borrower’s country.”

C(10)(25) was lifted from the 1992 Thin Capitalization Report.

Kosters

considers C(10)(25) as an application of the substance over form

approach in taxation.

Six

confirms that each tax treaty must be interpreted

autonomously. The qualification of income derived from an instrument as

either dividends or interest must be based on the tax treaty itself. Thus, if

the tax treaty does not make reference to the domestic law of any

contracting state, such treaty must be interpreted independently of

domestic laws.

45 _{Avery Jones, supra note 26.}

46 _{B. Kosters, Substance over Form under Tax Treaties, Asia-Pacific Tax Bulletin,}

January/February 2013, p. 7.

To Pijl,

C(10)(25) makes it clear that the tax treaty classification

of dividends and interest is distinct and independent from domestic law

classification. The latter is not automatically carried to the level of tax

treaties. Further, the result from testing the features of an instrument

against the criteria in C(10)(25) may not be consistent with the domestic

law of the source state. The above is without prejudice to the application

of Article 3(2) of the OECD MC.

C(10)(28). The OECD acknowledged that the following may be

regarded as dividends:

(a) distributions of profits decided by annual general meetings of

shareholders; and

(b) other benefits in money or money’s worth, such as bonus shares,

profits on a liquidation or redemption shares and disguised

distributions of profits.

However, distributions which have the effect of reducing the

shareholder’s membership rights shall not be regarded as dividends.

According to the OECD, it is immaterial that the benefits to

shareholders are paid out of current profits made by the company or are

derived from reserves. The reliefs under the article apply so long as the

source state taxes such benefits as dividends.

1.6.2. OECD Commentary on Article 11(3)

Article 11(3) of the OECD MC is explained by the OECD

Commentary in C(11)(18) to (23).

C(11)(18). The term “interest,” according to the OECD, generally

refers to debt-claims of every kind, whether or not secured by mortgage

and whether or not carrying a right to participate in profits. Government

securities, bonds, and debentures are specifically mentioned because of

their importance and “certain peculiarities that they may present.”

Nevertheless, debt-claims which carry a right to participate in the debtor’s

profits are regarded as loans that produce interest.

C(11)(19). Interest on participating bonds and interest on

convertible bonds (until their actual conversion to shares) are regarded as

interest. Nonetheless, C(10)(25) confirms that interest on such bonds

should be considered as dividends if the loan effectively shares the risks

run by the debtor. Further:

“In situations of presumed thin capitalization, it is sometimes

difficult to distinguish between dividends and interest and in order to avoid

any possibility of overlap between the categories of income dealt with in

Article 10 and Article 11 respectively, it should be noted that the term

‘interest’ as used in Article 11 does not include items of income which are

dealt with under Article 10.”

Kosters

considers C(11)(19) in relation to C(10)(25) as an

application by the OECD of the substance over form approach in taxation.

C(11)(20). The phrase “including premiums and prizes attaching

to such [government] securities, bonds or debentures” is explained by this

commentary.

C(11)(21). The OECD confirmed that unlike the definition of

dividends, the definition of interest is entirely independent of the domestic

laws of contracting states. Such definition is exhaustive. However,

contracting states may widen the definition so as to include any income

which is taxed as interest under the domestic law of the source state.

C(11)(22). This commentary expounds on the last sentence of

Article 10(3) of the OECD MC, which states: “Penalty charges for late

payment shall not be regarded as interest for the purpose of this Article.”

A possible reason for such treatment is that the domestic law of a

contracting state treats such charges as a special form of compensation for

the loss suffered by the creditor through the debtor’s delay in meeting

his/its obligations. Nevertheless, contracting states may omit the sentence

and treat penalty charges for late payment as interest. Finally, this

commentary affirms that contracting states may exclude from the

application of Article 11 income which they intend to be treated as

dividends.

1.6.3. Borderline cases

Reading Articles 10 and 11 of the OECD MC and their respective

commentaries together, it is clear to the author that in the OECD’s view,

income from debt-claims participating in profits is treated as interest,

while income from instruments that participate in profits without being

debt-claims qualifies as dividends. Other than qualifications that may

possibly be made by contracting states based on their domestic laws or

other reasons, the only deviation to the above is interest on loans insofar as

the creditor effectively shares the risks run by the debtor where domestic

thin capitalization rules apply.

The OECD provides a non-exhaustive list of circumstances that

may be considered in addressing the question of whether the creditor

effectively shares the risks run by the debtor. However, it acknowledges

that each case must be examined individually in light of all circumstances.

It certainly does not say whether the presence of one, two, a majority, or

all of the circumstances mentioned in C(10)(25) will serve to qualify the

income as dividends. It is, therefore, interesting to find out whether and to

what extent contracting states have adopted the OECD’s view and,

moreover, how the domestic courts have concluded that a debt-claim exists

and participates in the profits of a company.

Avery Jones, et. al.

find that it is impossible to draw a line with

certainty between debt and equity based on effective risk sharing even

considering the listed factors because: “There is a continuum of the kinds

of instruments that companies issue with varying attributes of risk and

return but it is impossible to pick some point on that continuum where a

relevant line should be drawn for tax policy. In any event, these factors can

be relevant only to the determination whether the return is interest, or not

whether it is dividend.”

C(11)(19) and (22) confirm the OECD’s view that Article 10 takes

precedence over Article 11 in the sense that to the extent that an income

falls under the definition of dividends in Article 10, Article 11 then steps

back. It appears that the 1992 Thin Capitalization Rule concluded that it

should be made clear that Article 11 did not include anything dealt with in

Article 10. However, neither Article 10 nor Article 11 of the OECD MC

was changed to expressly include this statement.

Pijl

adheres to the view that income from debt-claims with

preponderant equity characteristics, which characteristics are referred to in

C(10)(25), falls under Article 10, and not Article 11. However, he cautions

against the use of the OECD Commentary as an interpretational aid

because it is not equivalent to a tax treaty or law. Ultimately, “the treaty

text is the master.”

The value of the OECD Commentary has definitely been

controversial through the years. The other view attributes great weight and

value to the OECD Commentary as an interpretational aid to the OECD

MC. For instance, in one Danish case,

the National Tax Tribunal of

Denmark relied on the OECD MC, in particular, Article 11 thereof and the

commentary thereon, including the OECD Commentaries drafted after the

date of signing of the relevant tax treaty (after a determination that the

subsequent OECD Commentaries were mere clarifications).

Some contracting states deemed it important to include an express

statement in the interest article of some of their tax treaties that income

dealt with in the dividend article shall not be regarded as interest for

purposes of the relevant tax treaty. The Netherlands included such

statement in ten (10) out of the fifty (50) tax treaties reviewed. On the

other hand, out of the fifty (50) tax treaties concluded by Germany that

were surveyed, twenty-one (21) tax treaties contained such statement.

50 _{Avery Jones, supra note 26.} 51 _{Avery Jones, supra note 26.} 52 _{Pijl, supra note 32, at p. 482.}

53 _{Landsskatteretten (National Tax Tribunal) of Denmark, Case No. 11-00210,}

2. V

OECD

MC

To recall:

Dividends

Interest

1977/2017

(Current)

1963

1977/2017

1963

First part

“income from

shares,

‘jouissance’

shares

or

‘jouissance’

rights, mining

shares,

founders’

shares”

“income from

shares,

‘jouissance’

shares

or

‘jouissance’

rights, mining

shares,

founders’

shares”

“income from

debt-claims of

every

kind,

whether or not

secured

by

mortgage and

whether or not

carrying a right

to participate in

the

debtor’s

profits”

“[income from]

debt-claims of

every kind”

Second

part

“[income from]

other rights, not

being

debt-claims,

participating in

profits”

“[income from]

other rights, not

being

debt-claims,

participating in

profits”

“income from

government

securities and

income

from

bonds

or

debentures,

[whether or not

secured

by

mortgage and

whether or not

carrying a right

to participate in

the

debtor’s

profits,]

including

premiums and

prizes attaching

to

such

securities,

bonds

or

debentures”

“income from

Government

securities,

bonds

or

debentures,

whether or not

secured

by

mortgage

and

whether or not

carrying a right

to participate in

profits”

Third part “income from

other corporate

rights which is

subjected to the

same taxation

treatment

as

income

from

shares by the

laws of the State

“income from

other corporate

rights

assimilated to

income

from

shares by the

taxation law of

the State from

which

the

“[p]enalty

charges for late

payment”

which shall not

be regarded as

interest

“all

other

income

assimilated

to

income

from

money lent by

the taxation law

of the State

from which the

income

is

of which the

company

making

the

distribution is a

resident”

[Emphasis

supplied]

income

is

derived”

[Emphasis

supplied]

derived”

It is impossible for the OECD to give definitions of dividends and interest that

will be acceptable to all contracting states; thus, the more general the definitions, the

wider the scope.

This thesis, in Appendix “A”, shows several variations to the current OECD

MC definitions as adopted by some contracting states, but does not in any way claim

to be exhaustive. The examples given merely serve illustrative purposes. Further,

reference was made to the versions and English translations of the tax treaties on the

IBFD Treaties database. The above is in addition to the observations and reservations

on the OECD MC and the OECD Commentary made by certain states.

3. T

-

The OECD’s position in respect of income from debt-claims participating in

profits is clear. However, the OECD MC and the OECD Commentary are inadequate

as interpretational aids in determining when a debt-claim exists and participates in the

profits of a company.

Furthermore, there is a multitude of differences in the company law and

taxation law among states. While the OECD generally treats income from debt-claims

participating in profits as interest, some tax treaties classify such income as dividends.

Further, some tax treaties treat such income as dividends, even if they are “in the form

of interest.” It has been said that the tax treaty classification of dividends and interest

occur independently from domestic law classification. In addition, while each

contracting state will attempt to bring as much of its domestic law into the tax treaty,

a tax treaty is a result of negotiations that involve compromise and bargaining.

Political and economic factors, among others, come into play. Thus, as will be shown

below, it is possible for a contracting state to sometimes deviate from its tax treaty

policy with respect to a certain type of income.

The existence of model conventions, such as the 2013 German Model (as

defined in Appendix “A”), does not guarantee anything because the negotiation of

tax treaties is influenced by treaty policies and the legal traditions of the contracting

states.

The domestic laws of the mentioned states as well as the rationale behind their

respective treaty policies are outside the scope of this thesis.

3.1. Deviations from the OECD’s view: Income treated as dividends

Examples of tax treaties which treat income from debt-claims

participating in profits as dividends, instead of interest, are the India-United

States tax treaty (1989),

the Spain-United States tax treaty (1990) the and

Czech Republic-United States tax treaty (1993),

and the Netherlands-United

States tax treaty (1992).

The approach adopted by the Netherlands and Germany will be

discussed in detail below.

3.1.1. Netherlands

As regards debt-claims participating in profits, the Netherlands has

generally succeeded in having income therefrom classified as dividends,

instead of interest, in the following ways:

55 _{It defines dividends in this manner: “3. The term ‘dividends’ as used in this Article means}

income from shares or other rights, not being debt-claims, participating in profits, income from other corporate rights which are subjected to the same taxation treatment as income from shares by the taxation laws of the State of which the company making the distribution is a resident; and income from arrangements, including debt obligations, carrying the right to participate in profits, to the extent so characterized under the laws of the Contracting State in which the income arises.”

Further, it appears that upon: (i) an application of the domestic law of the source state; and (ii) a determination that the instrument carries the right to participate in profits, the income derived from such instrument shall be dividends. There is, therefore, a need to refer to the domestic law of the source state, i.e., not autonomous.

56 _{They contain identical definitions of dividends, to wit: “4. The term ‘dividends’ as used in}

this Article means income from shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident. The term ‘dividends’ also includes income from arrangements, including debt obligations, carrying the right to participate in profits, to the extent so characterized under the law of the Contracting State in which the income arises.” [Emphasis supplied]

Further, it appears that upon: (i) an application of the domestic law of the source state; and (ii) a determination that the instrument carries the right to participate in profits, the income derived from such instrument shall be dividends. There is, therefore, a need to refer to the domestic law of the source state, i.e., not autonomous.

57 _{In the case of the United States, it categorically classifies debt obligations carrying the right}

to participate in profits, thus: “6. The term “dividends” as used in this Convention means income from shares or other rights participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident. For the purposes of this paragraph, the term “dividends” also includes, in the case of the Netherlands, income from debt-claims that is subjected to the same taxation treatment as income from shares and, in the case of the United States, income from debt obligations carrying the right to participate in profits.” [Emphasis supplied]

(a) Dividend article specifically covers debt-claims participating in

profits;

(b) Interest article excludes from its coverage instruments carrying a right

to participate in profits;

(c) Dividend article subsumes debt-claims participating in profits under

“other rights participating in profits”;

(d) Dividend article subsumes debt-claims participating in profits under

any other item which is subjected to the same taxation treatment as

dividends by the source state;

(e) Dividend article covers, in the case of the Netherlands, any income

which is subject to dividend tax under its domestic law;

or

(f) Regardless of the classification of the income, nothing limits the right

of the Netherlands to apply its domestic withholding tax rates.

The Netherlands-Slovenia tax treaty (2004) goes further by

enumerating in Protocol IX the criteria which may be considered in

determining whether income from a debt-claim is subjected to the same

tax treatment as income from shares by the source state. It states:

“Notwithstanding paragraph 5 of Article 10,

_{it is understood that}

the term dividends also means income from debt-claims provided that the

law of a Contracting State subjects this income from debt-claims to the

same taxation treatment as income from shares according to a combination

of the following criteria:

-- the redemption date of a loan;

-- the size of the remuneration or indebtedness of the remuneration is

depending on the profit or the distributions of profits; and

-- the subordination of a loan.”

58 _{Netherlands-Luxembourg tax treaty (1968); Netherlands-Spain tax treaty (1971);}

Netherlands-Czech Republic Tax Treaty (1974); Netherlands-Slovak Republic Tax Treaty (1974); Netherlands-Suriname tax treaty (1975); Netherlands-Greece tax treaty (1981); Hungary tax treaty (1986); India tax treaty (1988); Netherlands-Philippines tax treaty (1989); Netherlands-Norway tax treaty (1990); Netherlands-Italy tax treaty (1990); Netherlands-Bulgaria tax treaty (1990); Netherlands-Sweden tax treaty (1991); Netherlands-United States tax treaty (1992); Netherlands-Latvia tax treaty (1994);

Finland tax treaty (1995); Ukraine tax treaty (1995); Netherlands-Russia tax treaty (1996); Netherlands-Denmark tax treaty (1996); Netherlands-Estonia tax treaty (1997); Netherlands-Iceland tax treaty (1997); Netherlands-Romania tax treaty (1998); Lithuania tax treaty (1999); Croatia tax treaty (2000); Netherlands-Poland tax treaty (2002); Netherlands-Indonesia tax treaty (2002); Netherlands-Slovenia tax treaty (2004).

59 _{Netherlands-Malta tax treaty (1977); Netherlands-South Africa (2005).} 60 _{Netherlands-Canada tax treaty (1986); Netherlands-Portugal tax treaty (1999).}

61 _{Netherlands-United Kingdom tax treaty (2008); Netherlands-Switzerland tax treaty (2010).} 62 _{Netherlands-Australia tax treaty (1976); Netherlands-New Zealand tax treaty (1980).} 63 _{Netherlands-Germany tax treaty (2012).}

64 _{“5. The term ‘dividends’ as used in this Article means income from shares, ‘jouissance’}

shares or ‘jouissance’ rights, mining shares, founders’ shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident.”