All “modern” income tax treaties concluded by the United States contain a “Limitation on Benefits” (LOB) provision. The purpose of such a provision is to prevent “treaty shopping.” Romania is one of the few remaining countries that have comprehensive income tax treaties with the United States that do not contain LOB provisions.
Romania recently enacted a new holding company regime that entered into force January 1, 2014. This new regime, coupled with the fact that the current U.S.-Romania income tax treaty (the “Treaty”) should remain in existence for many more years, likely will lead to increased investment in the United States by non-U.S. taxpayers who are resident in non-treaty jurisdictions through Romania.
General Taxation of Foreign Persons
Foreign persons are subject to U.S. federal income tax on a limited basis. Unlike U.S. persons who are subject to U.S. taxation on their worldwide income, foreign persons are subject to U.S. taxation on two categories of income: (i) certain types of U.S.-source passive income (e.g., interest, dividends, rents, royalties, and other types of “fixed or determinable annual or periodical income,” collectively known as FDP income at a 30 percent rate; and (ii) income that is effectively connected with a U.S. trade or business (ECI).
Effect of Treaties
Although the statutory rate of withholding on U.S.-source payments of FDAP income to a foreign person is 30 percent, most, if not all, income tax treaties concluded by the United States reduce or even eliminate the U.S. withholding tax on payments of dividends, interest, and royalties. For a non-U.S. taxpayer to be eligible for treaty benefits, the taxpayer generally must be considered a “resident” of the particular treaty jurisdiction and must satisfy one of the LOB provisions in the treaty.
Under the current Treaty, the withholding tax rates on U.S. source FDAP income are reduced from 30 percent to (i) 10 percent for dividends, (ii) 10 percent for interest, and (iii) 10 or 15 percent for royalties (depending on the type of intangible property being licensed). Furthermore, with regards to interest, unlike the statutory “portfolio interest” rules, there are no limitations under the Treaty on the amount of voting stock that the lender can own in the U.S. borrower, and lender has the ability to receive contingent interest (i.e., an equity kicker) that is tied to the profits of the borrower at the same 10 percent withholding tax rates. This presents a significant planning opportunity for foreign investors investing in U.S. real estate, as it essentially allows those investors to receive a share of the profits from the sale of U.S. real estate in the form of contingent interest without triggering the Foreign Investment in U.S. Real Property Tax Act (FIRPTA), if properly structured.
The benefits of structuring U.S. investments through Romania become more apparent when considering the Treaty has no LOB provision or anti-triangular provision. The lack of an LOB provision essentially means that investors who are tax resident in non-treaty jurisdictions in South America (e.g., Brazil, Argentina, Colombia, etc.), Asia (e.g., Singapore, Malaysia, Hong Kong, etc.), the Middle East (e.g., the UAE, Saudi Arabia) or elsewhere can establish a company in Romania to take advantage of these treaty benefits.
The lack of an anti-triangular provision in the Treaty means that the corporate income taxes in Romania may be significantly reduced by allocating the U.S.-source income to a low-taxed third country branch of the Romanian entity (e.g., Luxembourg) without treaty benefits being denied. Almost all modern income tax treaties concluded by the United States contain an anti-triangular provision which prevents this type of planning.
New Romania Holding Company Regime
The recently enacted holding company regime in Romania makes these potential structures even more interesting. Under this new legislation, which became effective January 1, 2014, dividends, capital gains, and liquidation proceeds will be tax-exempt in Romania, provided these types of income are received in Romania from an entity established in a country that has a double tax treaty with Romania (such as the United States), and the Romanian holding company owns at least 10 percent of the share capital of such entity for an uninterrupted period of one year.
Essentially this means that non-U.S. investors who are resident in non-treaty jurisdictions can establish a Romanian entity to own shares in a U.S. corporation and receive U.S.-source dividends that only will be subject to a 10 percent U.S. withholding tax (as opposed to the statutory 30 percent rate), and those dividends will be completely exempt from corporate income tax in Romania, if the above requirements are satisfied. Notably, this benefit also extends to U.S.-source dividends received from U.S. REITs, which are typically subject to higher withholding tax rates under most income tax treaties that contain LOB provisions.