The U.S. Model Income Tax Treaty (the U.S. Model Treaty) generally represents the United States’ opening position in treaty negotiations. As a result, when changes to the treaty are proposed, international tax practitioners should be aware of the potential impact those changes can have on their existing inbound U.S. structures. On May 20, 2015, the Treasury Department released five proposed amendments (Proposals) to the U.S. Model Treaty, which if adopted in their current form will undoubtedly have a major impact on many existing structures. The proposals are intended to ameliorate the problem of so-called “stateless income” as well as influence the OECD’s work on the “Base Erosion and Profit Shifting” (BEPS) initiative.
One of the proposals, which already is included in the Limitation on Benefits (LOB) article of many of the recently enacted income tax treaties, would amend paragraph 7 of Article 1 to state when (i) a resident derives income from the other state; and (ii) the residence state’s domestic law attributes that income to a permanent establishment (PE) located outside the company’s country of residence, then the treaty benefits that would ordinarily apply are inapplicable if (i) the PE’s profits are subject to a combined aggregate effective tax rate of less than 60% of the generally-applicable corporate tax rate in the residence state, or (ii) the state in which the PE is situated does not have a comprehensive income tax treaty with the state from which the treaty benefits are being claimed (unless the residence state includes the PE’s income in its tax base).
An example of the use of such a structure for inbound financing purposes may involve a Hungarian company that establishes a Swiss finance branch. (Other commonly used structures include the use of a Spanish or Polish company with a Swiss finance branch, and a Romanian company with a Luxembourg branch). The Hungarian entity would loan funds through the Swiss branch to a U.S. entity and in return receive interest on such loan. The interest presumably would be deductible in the United States and exempt from U.S. withholding tax under the U.S.-Hungary income tax treaty. The Hungary-Switzerland income tax treaty provides that any income allocated to Swiss PE is exempt from tax in Hungary. As a result, little, if any, tax actually is paid in Hungary. In addition, the Swiss finance branch rules provide for extremely low tax rates.
Under the Proposal discussed above, the interest payment would be subject to U.S. withholding tax because the Swiss finance branch’s profits would be subject to a combined aggregate effective tax rate of less than 60 percent of the generally-applicable corporate tax rate generally due in Hungary. As a result, this structure will no longer be useful to “strip” income out of the United States without such income being subject to U.S. withholding tax (It should be noted that the new U.S.-Hungary income tax treaty does include such a provision but such treaty is not yet in effect and may not be effective anytime soon).
A second Proposal includes revisions targeted at foreign corporations treated as U.S. corporations under the so-called inversion rules of Section 7874. This proposed change is intended to prevent post-expatriation earnings-stripping transactions that often accompany corporate inversions. The new draft paragraphs, which are to be inserted into Articles 10 (Dividends), 11 (Interest), 12 (Royalties), and 21 (Other Income) provide that the United States reserves the right to tax income paid by any “expatriated entity” in accordance with its domestic law for a period up to ten years following expatriation, notwithstanding treaty provisions reducing or eliminating source-based withholding on such income.
Therefore, payments of dividends, interest, royalties, or other income by an “expatriated entity” will not be eligible for treaty-based reductions of U.S. withholding tax, despite such entity being treated as a U.S. corporation for all purposes of the Internal Revenue Code. For this purpose, an expatriated entity is defined by reference to Section 7874(a)(2)(A). Under that provision, a foreign corporation will be treated as a domestic corporation for all purposes of the Internal Revenue Code if pursuant to a plan (or series of related transactions) (i) the foreign entity completes the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation, (ii) after the acquisition at least 80 percent of the stock (by vote or value) of the entity is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, and (iii) after the acquisition, the expanded affiliated group which includes the foreign entity does not have substantial business activities in the foreign country in which, or under the laws of which, the entity is created or organized, when compared to the total business activities of the expanded affiliated group.
Limitation on Benefits (LOB)
The Proposals also would modify the LOB provision of the U.S. Model Treaty by adding a derivative benefits clause. In general, the purpose of a derivative benefits provision is to allow an entity owned by nonresidents of that jurisdiction (i.e., equivalent beneficiaries) to qualify for treaty benefits, even if the other LOB tests are not satisfied, when it is clear that such entity was not used for treaty-shopping purposes.
Under this test, a company is treaty-eligible if (i) it is at least 95% owned by seven or fewer “equivalent beneficiaries” and (ii) it satisfies a “base erosion” test. The definition of “equivalent beneficiary” in the Proposal is significant because it allows any resident that has an income tax treaty with the United States to claim treaty benefits. Unlike most other derivative benefits provisions (other than those included in the income tax treaties with Canada and Jamaica), there is no requirement that the equivalent beneficiary (i) be a resident of the EU or EEA, (ii) be a party to NAFTA, or (iii) be a resident of Switzerland or Australia.
To qualify for benefits under the Proposal, two requirements must be satisfied: (i) the owner must be entitled to all the benefits of a comprehensive double-tax treaty with the United States (if benefits are being claimed against U.S. tax) or the other treaty country (if benefits are being claimed against the other country), and (ii) that same double-tax treaty must entitle the owner to a maximum withholding rate on the relevant category of income that is “at least as low” as the rate specified in the U.S. Model Treaty. For purposes of income governed by Articles 7 (Business Profits), 13 (Gains), or 21 (Other Income), the owner must be entitled to benefits under its treaty that are “at least as favorable” as the benefits granted under the U.S. Model Treaty. Finally, in the case of equivalent beneficiaries who own companies indirectly, the Proposal provides that all intermediate owners must be “qualified.” The definition of “qualified intermediate owner” is similar to, yet slightly more permissive, than the equivalent beneficiary test.
Special Tax Regimes
One of the more notable Proposals provides special rules for payments of interest, royalties or other income to related parties that are subject to “special tax regimes.” In particular, Articles 11 (Interest), 12 (Royalties), and 21 (Other Income) would be amended to provide that if interest, royalties, or other income is paid to a related party; and the recipient is “subject to a special tax regime” in its country of residence with respect to that item of income, then the source country may tax the category of income in accordance with its domestic law notwithstanding the treaty.
Unfortunately, the term “related parties” is not defined in the Proposals. In addition, the term “special tax regime” is not defined in any detail other than indicating that it “means any legislation, regulation, or administrative practice that provides a preferential effective rate of taxation” on the relevant item of income. The definition is fleshed out somewhat as the Proposals set forth a list of provisions that would not qualify as “special tax regimes,” including, inter alia, charitable exemptions, preferences relating to retirement and pension administration, and preferential rates on royalties that entail a “substantial activity” requirement.
The Technical Explanation to the Proposals indicates that a special economic zone stimulating and requiring investment in manufacturing is an example of a regime that satisfies a substantial activity requirement with regard to royalties (It is not clear whether any type of “patent box” legislation, for example, in the U.K. or the Netherlands, would be considered a special tax regime for this purpose, although it would seem that it would unless the specific legislation in question satisfies the amorphous “substantial activity” requirement).
Finally, it should be noted that the Technical Explanation to the Proposals indicates it is anticipated that any legislation, regulation, or administrative practice that results in an effective rate of taxation of at least 15 percent would not be considered to result in a low or no effective rate of taxation.
Subsequent Changes in Law
Finally, another significant Proposal provides that certain changes to the domestic law of either treaty country will cause some of the provisions of the U.S. Model Treaty to be inoperative. A new Article 28 would be added which would indicate that if the highest marginal rate of taxation for individuals or business entities falls below 15 percent in either treaty country, or if either country elects to exempt individual or corporate foreign-source income from taxation (under a territorial-type tax system), then Articles 10 (Dividends), 11 (Interest), 12 (Royalties), and 21 (Other income) will no longer be effective for individuals or companies, as the case may be. The Technical Explanation provides that, unlike the “special tax regime” provision, which is intended to apply in cases of specific exemptions or preferences, this new Article 28 is intended to apply to broader exemptions or rate reductions.
The Proposal indicates that in determining whether the general rate of company tax falls below 15 percent, a tax that applies to a company only upon a distribution by such company to its shareholders will not be taken into account for this purpose. This provision is interesting because certain countries, such as Estonia, have a corporate income tax rate of approximately 26 percent but such corporate tax is triggered only when an Estonian company pays a dividend to its shareholder; otherwise, no corporate income tax is imposed on company profits. Under the Proposal, the 26 percent corporate income tax will be ignored in determining whether the general rate of company tax falls below 15 percent. Therefore, the company will be treated as if it had a zero percent corporate tax rate, which would implicate the Proposal in a similar situation.
It is also interesting that the Proposal makes no mention of corporate tax regimes (such as Malta’s) that provide for a refund of corporate income tax when the company makes a distribution to its shareholders, thereby resulting in an effective corporate tax rate that actually falls below 15 percent. Presumably, under this type of regime, the Proposal would not be implicated.