Tax debacle: Source of Interest – (December 2011, Issue 1)

December 11, 2011, by Junayed Chowdhury

In the recent years, Bangladesh has been marked as one of the “Next Eleven”[1] countries to have a high potential of becoming, along with the BRICS,[2] the world’s largest economies in the 21st century. Bangladesh has also received her first sovereign rating from Moody’s – a Ba3, which has been termed as “stable‟ by the rating agency.[3]

 

These have helped Bangladesh to become the newest destination for private equity investors.[4] International lending has also increased over the years because of high interest rates of the local banks. In 2011, we saw the first ever US Ex-Im Bank backed aircraft financing in Bangladesh.[5]

 

Naturally, when a market steadily opens up for new ventures and products, the revenue collection structure of an economy has to be looked under a different light to ensure that it accommodates the new developments in the market. This article reviews whether the existing Bangladeshi tax regime poses any problems for the foreign investors and concludes that unwitting investors may get entrapped in the uncertain world of taxation of income arising from interest.

 

Section 18(4) (c) of the Income Tax Ordinance, 1984 (“ITO”) deems interest income to accrue or arise in Bangladesh if payable by a person who is a non-resident where the interest is in respect of any debt incurred, or moneys borrowed and used for the purposes of a business or profession carried on by such person in Bangladesh or for the purposes of making or earning any income from any source in Bangladesh. To put it in a simpler form, interest income is deemed to accrue or arise in Bangladesh if such interest is payable by a non-resident and if such interest is accrued in respect of any debt incurred or money borrowed and such debt or borrowed money is used for the purpose of (a) any business or profession carried on by the non-resident in Bangladesh; or (b) making or earning any income from any source in Bangladesh.

 

Now, let us consider an example. A private equity fund formed in the United States (“PE Fund”) wishes to acquire Target (“T”) for $10 million, which is a company incorporated in Bangladesh and is owned by a group. Let us assume that the PE Fund has $3 million that it wishes to use in the acquisition and requires a further $7 million from some US lenders. Also assume that XBank, a US banking Corporation is interested to provide the $7 million loan. The PE Fund structures the transaction as a leveraged buyout (LBO) and let us assume that for tax purposes a new company (“NewCo”) is formed in the UK to acquire T. NewCo issues common shares to the PE Fund in exchange for PE Fund’s $3 million capital contribution and issues debt instruments to XBank for the XBank’s $7 million loan. Thereafter, NewCo does a stock purchase transaction whereby the old shareholders of T in Bangladesh are bought out by NewCo and T becomes a 100% subsidiary of NewCo.

 

Under the US laws, generally, the source of interest is the residence of the debtor. Now, if the UK and United States have double taxation avoidance treaty, the interest payment that NewCo (an English company) would be making to XBank (the US lender) may be tax exempted under English law.[6] Thus, XBank would get the interest from NewCo free from any tax deduction in the UK.

 

However, what about the interest payment attributable to the money invested by NewCo in T? The first limb of Section 18(4)(c) of the ITO seems to be inapplicable in our hypothetical scenario because the interest payable by NewCo to XBank has not been accrued in respect of any debt incurred or money borrowed by NewCo which is used for the purpose of any business or profession carried on by NewCo in Bangladesh. NewCo has no business in Bangladesh – T, which is a separate legal entity from NewCo, has such business in Bangladesh.

 

But problem then creeps in. T would be making dividend payment to NewCo or NewCo may wish to sell T to a seller if and when T‟s business in Bangladesh becomes profitable. In such an event, the dividend income from or sale price of T earned by NewCo would be regarded as income from any source in Bangladesh under the second limb of Section 18(4)(c) of the ITO. Then the second limb of Section 18(4)(c) bites because the interest payable by NewCo to XBank has been accrued in respect of a $7 million debt incurred by NewCo which is used for making or earning an income from a Bangladeshi source (i.e. the dividend income from or sale price of T earned by NewCo).

 

If the above analysis is correct, then the result is extraordinary. NewCo would have to withhold Bangladeshi income tax from the interest payment that it would make to XBank for the $7 million loan which was used by NewCo to finance T‟s acquisition in Bangladesh. The end result is that in an acquisition financing arrangement between the UK and US entities which would otherwise require no tax deduction on the interest payment under English law would result in tax gross up for the tax withheld only because the loan was used in acquiring shares of a Bangladeshi company.

 

This is an unfortunate result from the standpoint of attracting FDI in Bangladesh. This taxing approach would deter foreign investors from targeting Bangladesh as an investment destination when the over-all international financing transaction is a tax free one or involves minimal tax.

May be the National Board of Revenue would want to review this problem in the upcoming Finance Act.

 

Written by Junayed Chowdhury, Managing Partner  

† Disclaimer: The opinions and comments expressed in this Blawg are not to be regarded or construed as legal advice by and from Vertex Chambers or any of its members. It is highly advisable that any person should seek independent legal advice before relying on any of the contents of this Blawg.