Unlike U.S. persons who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income: (i) certain types of passive U.S.-source income (e.g., interest, dividends, royalties and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP), which are subject to a 30-percent gross basis withholding tax; and (ii) income that is effectively connected to a U.S. trade or business (ECI), which is taxed at graduated tax rates applicable to U.S. persons. 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, royalties and certain other types of income.
To be eligible for treaty benefits, the taxpayer must be considered a “resident” of a particular treaty jurisdiction and, in the case of most modern income tax treaties, must satisfy the treaty’s limitation on benefits (LOB) provision. The purpose of the LOB provision is to prevent treaty shopping.
Each LOB article sets forth a number of objective tests, which if satisfied, will entitle the resident to treaty benefits, even if such resident was formed or availed of for a tax-avoidance purpose. One of these tests includes a derivative benefits test.
Derivative Benefits Provision
The purpose of the “derivative benefits” provision is to ensure that an entity owned by nonresident shareholders (i.e., “equivalent beneficiaries”) may qualify for treaty benefits, even if the other LOB tests are not satisfied, where it is clear that such entity was not used for “treaty-shopping” purposes. To qualify for treaty benefits under the derivative benefits test, a specified percentage (typically 95 percent) of an entity’s shares must be owned, directly or indirectly, by seven or fewer “equivalent beneficiaries” and a base erosion test must be satisfied.
An equivalent beneficiary generally means any person that:
- In connection with certain European country treaties, is a resident of a member state of the EU, any state of the European Economic Area (EEA), a party to NAFTA, or in some cases Switzerland, or Australia (a “Qualifying Country”);
- Is entitled to the benefits of a comprehensive income tax treaty concluded between such Qualifying Country and the Contracting State from which treaty benefits are claimed and satisfies certain LOB requirements (even if that treaty has no LOB article); and
- In the case of dividends, interest, royalties, and possibly certain other items (such as insurance premiums), would be entitled under the treaty between the Qualifying Country and the Contracting State in which the income arises, to a rate of tax with respect to the particular class or item of income for which benefits are claimed that is “at least as low as” the rate provided for under the treaty between the Contracting States.
The question is what benefits would a foreign person that is resident in a third country treaty jurisdiction derive from using an entity that is resident in another treaty jurisdiction under the derivative benefits article, if such person cannot qualify for a lower rate of U.S. withholding tax. The answer is the ability to gain access to more favorable local tax benefits, such as (i) a lower corporate income tax rate; (ii) a favorable regime for the taxation of intellectual property; (iii) a participation exemption on dividends and capital gains; (iv) no outbound withholding tax on interest, dividends or royalties; (v) no CFC rules; (vi) no thin capitalization rules; (vii) a better treaty network; and (viii) no transfer pricing rules.
For example, assume residents of Dubai establish a German company that has an active trade or business in Germany. Also assume that the German company establishes a subsidiary in Luxembourg that owns intellectual property which is licensed to the United States. The rate of withholding on royalties under both the U.S.-Luxembourg and U.S.-Germany income tax treaties is zero. Unlike Germany, however, Luxembourg has a favorable regime for the taxation of intellectual property resulting in an effective corporate income tax rate of approximately 5 percent.
The royalties paid from the United States to Luxembourg would qualify for the zero percent withholding rate under the U.S.-Luxembourg income tax treaty because the German company would be an equivalent beneficiary, despite the fact that it is owned by non-residents of Germany.
This example illustrates the tax planning opportunities available to third country investors who may reside either in non-treaty jurisdictions or jurisdictions without favorable local law benefits, such as a special regime for the taxation of intellectual property, so long as a lower rate of withholding is not being obtained under the structure.