This week we will be taking a closer look at how interest is dealt with in terms of the US/AUS DTA.
Interest earned outside of your resident state is generally taxed by the source state on a withholding basis. Under domestic law a state can require a person to withhold tax on making a payment to another person.
An overly simplified example of how Article 11 (Interest) applies in practice is if a US tax resident earns interest income from Australia. The US has the right to tax the interest earned from sources in Australia. This right is however not exclusive. If Australia also wants to also tax the interest income, it is limited to the amount of tax it can levy in terms of Article 11.
Article 11 of the DTA (Interest) has a dual purpose:
– Firstly, to limit the tax imposed by the source state where the interest arises; and
– Secondly prevents the treaty benefits available where there is an excessive payment of interest arising from a “special relationship”.
INTERPRETING ARTICLE 11 OF THE DTA – INTEREST
Article 11 generally limits the withholding tax that the source country may impose on interest payments to beneficial owners in the other country to 10%.
Article 11(1) states that interest from sources in one of the contracting states to which a resident of the other is beneficially entitled may be taxed in that other country. Hence there is no exclusive right.
A person will be beneficially entitled to interest for purposes of Article 11 if they are the beneficial owner of the interest.
Article 11(2) provides that the source state (country where the interest arises) may also tax the interest that the resident of the other state is beneficially entitled subject to a maximum rate of 10%.
Currently the US has a non-treaty interest withholding tax rate of 30% and Australia has a general interest withholding tax rate of 10%.
Article 11(3) however provides an exemption for interest paid to government bodies and financial institutions subject to the restrictions in Article 11(4).
Article 11(3)(a) states that interest derived by a Contracting State or a political or administrative subdivision or a local authority of the Contracting State is only subject to tax in the State of residence. This exemption extends to interest received by any other body exercising governmental functions.
Article 11(3)(b) states further that interest derived by financial institutions that are unrelated to and dealing wholly independently of the payer are only taxed in the State of residence.
An example of the type of financial institutions that will qualify for the exemption in Art 11(3)(b) are investment banks, brokers, and commercial finance companies
A financial institution will be “unrelated and dealing wholly independently” of the payer of the interest if the financial institution and payer are not treated as Associated Enterprises as stipulated in Article 9.
Article 11(4) operates as a restrictive provision on the exemption provided in Article 11(3).
Article 11(4)(a) stipulates that the exemption in Article 11(3)(b) will not apply, and the interest derived will be taxed at 10% of the gross amount if it arises from back-to-back loans or an arrangement that is economically equivalent.
Article 11(4)(b) preserves the application of the domestic tax law of each State regarding anti-avoidance provisions. Nothing in Article 11 limits the ability of the US to enforce existing anti-avoidance provisions.
Similarly, Australia reserves the right to apply its general anti-avoidance rules where there is a conflict with the provisions of a tax treaty and Article 11(4)(b) extends this power to any anti-avoidance rule.
Article 11(4)(b) further does not limit the ability of Australia or the US to adopt new anti-avoidance provisions.
Article 11(5) defines “interest” to mean interest from:
(a) government securities, bonds, debentures, and any form of indebtedness, and
(b) income subject to the same taxation treatment as income from money lent according to the law of the Contracting State in which the income arises.
However, income dealt with in Article 10 (Dividends) and penalty charges for late payment are not treated as interest.
The exclusion of income dealt with by the Dividends Article, clarifies that Article 10 takes precedence over Article 11 in cases where both Articles can apply.
Article 11(6) simply states that tax is not payable under Article 11 where the interest income of the person beneficially entitled to it is subject to tax under Article 7 (Business Profits) or Article 14 (Independent Personal Services).
Article 11(7) defines the source of interest, which is a necessary pre-requisite for the Contracting State withholding tax under Article 11(2).
Generally, interest is deemed to arise and hence has its source in the Contracting State where the payer is a resident.
Unfortunately, it is not always that simple or straightforward. For example, if a person paying the interest has a permanent establishment in connection with which the interest is attributable, the interest is deemed to arise in that Contracting State if borne by that permanent establishment. This is irrespective of the fact whether or not the payer of the interest is a resident of one of the contracting states.
Article 11(8) states that, in cases involving special relationships between persons, Article 11 applies only to that portion of the total interest payments between those persons that would have been made absent such special relationships. Any excess amount of interest paid remains taxable according to the laws of the US and Australia, respectively, with due regard to the other provisions of the Convention.
Article 11(9) contains two anti-abuse exceptions to the treatment of interest in paragraphs (1), (2), (3) and (4)
Article 11(9)(a) states that interest paid by a resident of one of the Contracting States to a resident of the other Contracting State that is determined by reference to the profits of the issuer, or an associated enterprise may be taxed at a rate not exceeding 15%.
Article 11(9)(b) states that interest paid on ownership interests in securitization entities may be taxed in accordance with the domestic law, but only to the extent that the interest paid exceeds the normal rate of return on publicly traded debt instruments with a similar risk profile.
This article is specifically included to preserve the US taxation of real estate mortgage investment conduits (REMICs). A REMIC is a US entity that holds a fixed pool of real estate loans and issues debt securities with serial maturities and differing rates of return backed by those loans.
The purpose of Article 11(9)(b) is to permit the US to charge purchasers of REIMIC investments the domestic US tax on residual interests in REMICs.
Article 11(10) is only regarded to be relevant to US withholding tax. It states that where interest incurred by a company resident in one of the Contracting States is deductible in connection with a permanent establishment (Article 5), due to Article 6 (Real property) or Article 13 (Alienation of property) in the other Contracting State and that interest exceeds the interest actually paid, the amount of the excess interest deducted will be deemed to be interest arising in that other Contracting State to which a resident of the first-mentioned Contracting State is beneficially entitled.
An Australian company carries on business in the US via a permanent establishment (Branch). For US purposes this relates to branch profit tax. The branch incurs interest that is deductible in determining its US profits. However, the interest incurred by the branch is more than the amount of interest actually paid by the branch. Article 11(10) gives the US the right to tax the amount of interest not paid.
We would recommend seeking professional advice when it comes to Article 11. As always, our team of International Tax specialists at Asena Advisors, will guide you on how to approach and interpret Article 11.