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HMRC internal manual

International Manual

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EU Interest and Royalties Directive: What the Directive says

The Directive states that if the EU is to have the characteristics of a single market, transactions between companies in different Member States should not be subject to less favourable conditions than those applicable to the same transactions carried out between companies of the Member States. It sees the abolition of taxation of interest and royalty payments by the Member State in which they arise (”source state taxation”) as being the most appropriate means of achieving this goal. As implemented into UK law, the Directive is applied via a claim and exemption procedure for payments of interest and following a ”reasonable belief” scheme for royalties (similar to that described for treaty relief payments in ITA07/S911).

Limit to the exemption - the arm’s length amount

The Directive makes it clear that exemption from source state taxation only applies to the amount, if any, of interest or royalty payments which would have been agreed by the payer and the beneficial owner in the absence of a special relationship.

The special relationship clause

Article 4.2 of the Directive says: “Where, by reason of a special relationship between the payer and the beneficial owner of interest or royalties, or between one of them and some other person, the amount of interest or royalties exceeds the amount which would have been agreed by the payer and the beneficial owner in the absence of such a relationship, the provisions of this Directive shall apply only to the latter amount, if any.”

This form of wording is similar to that in the special relationship clause found at Para 6 of Article 11 (the Interest Article) of the OECD Model Tax Convention on Income and on Capital, and at Para 4 of Article 12 of the Royalties Article. This form of wording is reflected, with some variations, in most of the UK‘s double taxation agreements. There is further amplification of the meaning of these paragraphs of the Model Treaty in the OECD’s own commentaries on those Articles. The special relationship clause and what it means in the context of the OECD Model Treaty and for the purposes of the Directive is explained in more detail at INTM542130.

The term ‘special relationship’ is not defined, but some guidance regarding the interpretation is given in the commentaries to the OECD Model Treaty. As well as obvious cases such as where one party has a 51% controlling interest in the other, the term also covers any community of interests as distinct from the legal relationship giving rise to the payment. A small shareholding or inter-dependent trading relationship among other things might constitute a special relationship. In the case of a claimant and payer under the Directive, it is likely to mean a 51% direct or indirect controlling interest. It is quite conceivable that two companies with only the 25% relationship as required by the Directive might be part of a wider group of companies whereby both were under common control. Unlike the 25% associated companies rule of the Directive, establishing the special relationship is not limited to consideration of EU companies. Business International, Transfer Pricing Team should be referred to where the matter is not clear.

Companies that consider they fulfil the conditions have to apply for exemption before interest can be paid without deduction of UK tax. Exemption cannot simply be assumed. The Directive requires that exemption be granted for at least one year. An application for exemption, where required, cannot be granted for a period longer than three years.

Anti-abuse provision

The Directive does not preclude Member States from taking appropriate measures to combat what it terms “fraud or abuse”. Article 5 of the Directive says that Member States may, in the case of transactions for which the principal motive or one of the principal motives is tax evasion, tax avoidance or abuse, withdraw the benefits of the Directive or refuse to apply it. This provision is reflected at ITTIOA05/S765. It closely follows the anti treaty-shopping provisions contained in many of the interest and royalty articles of double taxation agreements. The measure will be applied in a fashion consistent with those provisions. See INTM575025 for more about treaty shopping.