Prepayment of interest without tax benefits under agreements on the avoidance of double taxation
In its judgment of 17 November 2015, file ref. no. II FSK 2575/13, the Supreme Administrative Court found that prepayment of interest in the event of early redemption of bonds by their foreign issuer did not meet a definition of interest within the meaning of Article 11 of the agreements on the avoidance of double taxation. Consequently, the taxpayer cannot free from corporate income tax, pursuant to Article 17.1.3 of the CIT Act, income received from prepaid interest since such prepayment, as not being the payment of interest within the meaning of Article 11 of the agreement, cannot enjoy the exemption from Polish tax.
The case involved a company which in 2006 acquired the bonds of a Singapore issuer with fixed monthly interest and redemption date set in 2026. After having paid the monthly interest to the company twice, in the third month the issuer exercised its option to prepay the interest and to redeem the bonds. The company did not include all the received interest under income subject to corporate income tax, in view of Article 17.1.3 of the CIT Act as well as the provisions of the agreement on the avoidance of double taxation between Poland and Singapore of 1993, i.e. Article 11.1 and 11.5 and Article 24.1.d), pursuant to which interest income that in accordance with Article 11 could be taxed in Singapore was exempt from Polish tax where such income was the subject of exemption or reduced taxation granted under the incentive provisions contained in Singapore laws designed to promote economic development.
The tax authorities of both instances did not agree with such position, claiming that only interest which constitutes compensation for the use of the company’s money over 3 months (i.e. until redemption) may be treated as interest within the meaning of Article 11 of the agreement. The remaining interest does not satisfy that definition and as the return from capital invested represents income from the company’s business activity. The company did not agree with interpretation of the law detrimental to it and claimed that all interest should enjoy the exemption in Poland envisaged by the agreement.
Article 11.5 of the agreement of 1993, which is no longer effective at the moment, stipulated that the term „interest” meant, inter alia, income from bonds, including premiums or prizes attaching to such bonds. This definition continues to be up-to-date, also pursuant to the agreement with Singapore that is currently in force, as well as many other agreements, and covers also income from bonds.
According to the Supreme Administrative Court, the essence of interpreting Article 11.5 for the purpose of the analysed case should be whether prepaid interest is compensation for the use of capital over time. Referring to the commentaries to the OECD Model Convention, the court concluded that the amounts of interest paid in advance for the period when the issuer did not use the capital because of having exercised the option of early redemption of bonds could not be recognised to be interest understood as compensation for the use of capital. For a definition of interest given in Article 11.5 of the agreement two characteristic features are of importance: the existence of surplus (i.e. the amount paid by the issuer must exceed the nominal value of the bonds) and the existence of a claim, giving grounds for the payment of compensation for the use of capital. The specification of interest at e.g. monthly rates also supports the claim that interest should be associated with the period of use of capital.
As a new agreement on the avoidance of double taxation was signed on 4 November 2012, which entered into force as of 6 February 2014, the judgment was issued in the legal regime that was no longer in force and effect. But it may be still relevant for taxpayers. The Protocol to the new agreement between Poland and Singapore envisages that the exemption of certain income from Polish tax, known from Article 24.1.d) of the previous agreement, will be still applicable. Pursuant to the Protocol, inter alia, interest income shall be exempt from Polish tax where such income is the subject of exemption or reduced taxation granted under the incentive provisions contained in Singapore laws designed to promote economic development. This exemption will cease to have effect starting only as of 1 January 2017. Moreover, interpretation of a definition of interest in the agreements on the avoidance of double taxation, as contained in the judgment of the Supreme Administrative Court, will also be a relevant guidance for all those taxpayers who will be required, in order to calculate e.g. withholding tax, to determine properly income qualified as interest within the meaning of Article 11 of the agreements on the avoidance of double taxation executed with other countries.
The decision is final and unappealable.