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Taiwanese tax authority takes aggressive position to disallow interest deductions in debt push down arrangements involving downstream mergers
The Taiwanese tax authority is taking an aggressive position to disallow deductions for interest incurred by a Taiwanese company (SPV) on debt that is used solely for the purposes of a stock acquisition which is followed by a downstream merger of the SPV into the target Taiwanese company (Target).
Unlike the recently introduced thin capitalization rules, the entire interest deduction could be disallowed. In addition, the Taiwanese tax authority’s reopening of earlier cases creates uncertainties as regards prior positions taken by taxpayers.
Background and history
Since 2006, Taiwan has attracted many international investors particularly those seeking to access the rapidly developing China market by way of acquiring the stock of Taiwanese companies which have already built foundations in China.
In a typical merger and acquisition transaction where a Taiwanese target is a public company, a tender offer is often sought by a foreign investor as a means to obtain a controlling interest in the Target.
During the tender offer process, a local SPV is formed to acquire the shares of the Target. As part of the acquisition process, the SPV will obtain a loan from a consortium of banks or an offshore affiliate and use the loan to fund the acquisition. Once the SPV acquires a majority interest in the Target, the SPV may merge into the Target in a downstream merger, pushing down its loan to the Target that is the survivor of the merger.
As a result, the Target’s future taxable income is reduced by the interest expense deduction arising on the acquisition loan.
In the past, there was no clear guidance on the tax deductibility of interest on such acquisition loans. Consequently, taxpayers and tax authorities reached different conclusions. Nevertheless, many taxpayers successfully managed to deduct the interest expense, based on the theory that no regulations specifically precluded them from claiming such deductions. To resolve the disagreement, the Ministry of Finance introduced the thin capitalization rules in 2011.
However, the tax authority has recently begun reopening cases in which the tax authority had previously agreed with the taxpayer’s interest expense claims on the acquisition loans. In this regard, the tax authority has issued reassessment notices on the grounds that such interest was not incurred in the taxpayer’s ordinary course of business and is therefore not deductible.
This recent trend creates confusion and uncertainty. Whether the tax authority’s position will be upheld will be determined by the judicial system. Until such time however, if a taxpayer has taken a more liberal position to claim full interest expense deductions for a prior transaction, such a position in open years1 remains uncertain and subject to challenge. Further, a taxpayer will lose its ability to claim even a partial deduction under the thin capitalization rules.
Multinational companies with Taiwanese operations that have claimed full interest expense deductions on acquisition debt are recommended to discuss their prior and future positions with their tax advisors.
2007 Private Income Tax Agreement and Protocol between Switzerland and Taiwan enters into force
On 8 October 2007, the Trade Office of Swiss industries in Taiwan and the Taipei Cultural and Economic Delegation in Switzerland signed an agreement for the avoidance of double taxation with respect to taxes on income to be implemented by two jurisdictions (Agreement).
The Agreement entered into force on 13 December 2011, and became retroactively effective on 1 January 2011 except for the information exchange provision which was effective from 1 January 2012. The Agreement mainly adopts the current OECD Model Convention provisions with some modifications. Significant provisions in the Agreement include the following:
- Inclusion of a separate supervisory service permanent establishment (PE) in conjunction with a building site, construction or installation project - Article 5
- Reduced withholding taxes on dividend, interest and royalties - Articles 10, 11, 12
- Capital gains tax exemption on share disposition if not forming a real property interest - Article 13
- Limitation on benefits - Article 26
Definition on supervisory service PE
In addition to the more common definitions of a service PE under Article 5 of the OECD Model, the Agreement includes the following supervisory service PE conditions under Article 5(4):
- Supervisory activities for more than six months in connection with a building site or construction or installation project, which are undertaken in the other territory; or
- During a period or periods exceeding in the aggregate 183 days in any twelve-month period, performs services for the same project or for connected projects through one or more individuals who are performing such services in that territory
In conjunction with the building site or construction or installation project, the Treaty follows the United Nation (UN) Model Convention by shortening the time period from twelve months to six months.
- Dividends (Article 10)
The Taiwan and Swiss domestic withholding tax rates on dividends paid to a nonresident are 20% and 35%, respectively. The Agreement provides for a 10% withholding tax, provided that the beneficial owner is a company (other than a partnership) which holds directly at least 20% of the company paying the dividends. In all other cases, a 15% withholding tax is applicable.
- Interest (Article 11)
Generally, a withholding tax is reduced to 10% but a full exemption is available if interest is paid:
- In connection with the sale on credit of any industrial, commercial or scientific equipment;
- In connection with the sale on credit of any merchandise or service by one enterprise to another enterprise,
- On loans made between banks, or
- To the other territory or to a subdivision or local authority thereof, or to the central bank of that other territory.
- Royalties (Article 12)
Royalty payments are subject to a 10% withholding tax and covers payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.
Paragraph 5 of Article 13 provides for exclusive resident country taxation of a gain arising from the alienation of property that is not specifically described in the preceding four paragraphs. Accordingly, a capital gain from the disposition of a share/interest in an entity situated in one territory will not be taxed in that territory, provided that the value of the shares/interest disposed of do not represent more than 50% of a direct or indirect real property interest situated therein.
Limitation on benefits (LOB)
The LOB provision under Article 26 applies to a conduit arrangement and disallows benefits provided under Articles 10, 11 and 12 if the transaction falls under a conduit arrangement or is entered into primarily to obtain benefits under the Agreement.
While the Agreement provides reduced withholding taxes on dividends, interest, and royalties, the LOB’s anti-conduit requirements must be satisfied in order to qualify for the relevant benefits. Holding company structures therefore require careful review to test business and economic substance when interposing intermediary entities to obtain benefits under the Agreement.
1 A five year statute of limitation running from the date the return was filed.
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