handbook-tb

Hugh J. Ault and Brian J. Arnoldstock investment, and one country views the conversion privilege separatelyfrom the debt aspects of the instrument while the other does not.In other situations, double non-taxation is the result of differingapproaches to determining ownership for tax purposes.Example: Company A, resident in Country A, transfers sharesto Company B, resident in Country B, under an arrangement inwhich Company A agrees to repurchase the shares at some pointin the future for a fixed price (so called stock “repo”). UnderCountry A’s tax law, the formal sale is treated as a secured loanand the difference in the two prices is treated as interest that isdeductible by Company A. Country B follows the legal form ofthe transaction and treats Company B as the purchaser of theshares and the payments received on the shares by CompanyB as dividends. When the shares are repurchased by CompanyA, Company B may realize a gain. Both the dividends and thegain on the sale of the shares may qualify for the participationexemption under Country B’s tax system.2.3 Possible responses and developing country perspectivesAs a response to differing treatment of a payment, it would be possiblefor a developing country to deny a deduction for any payments thatare not taxed in the hands of the foreign recipient. A similar approachcould be taken in the case of differing classification of legal entities.To the extent that any response depends on information about thetreatment of the payment or entity in the other jurisdiction, there areadministrative problems for developing countries. More broadly, fromthe perspective of the developing country from which the payment ismade, it would be possible to protect its tax base to some extent byapplying a broad-based withholding tax on all outbound payments.Alternatively, there could be rules limiting the availability of deductionsgenerally, through an overall earnings stripping rule, or morespecifically by focusing on the connection between the deduction andthe generation of domestic source income. Deduction and withholdingrules could be coordinated to make sure that no payments aredeductible if they are not subject to withholding tax. However, whereresponses to hybrid transactions are not coordinated, double taxationmay result if the two countries involved take divergent approaches.10