Foreign parent companies of US companies may lose US treaty benefits
May give rise to need to review treaty qualification in certain circumstances.
INSIGHT ARTICLE |
Generally speaking, U.S. companies owned by foreign parent companies are required to withhold 30 percent on certain fixed, determinable, annual, or periodical (FDAP) income payments to foreign persons, unless the foreign person provides the U.S. company with valid withholding tax documentation to support a reduced withholding rate provided by an income tax treaty or the Internal Revenue Code. Typical examples of FDAP income include dividends, interest and royalties. To prevent taxpayers from improperly claiming treaty benefits, most U.S. income tax treaties contain anti-abuse rules in the “Limitation on Benefits” (LOB) article. The purpose of the LOB article is to determine whether a resident of a treaty country has a sufficient connection with that country to justify a claim to treaty benefits.
The various LOB provisions make for complex treaty analysis, especially for privately held foreign companies. These provisions contain several mechanical tests, often containing multiple subtests, to determine if a non-U.S. income recipient may claim treaty benefits. It is not uncommon for a foreign income recipient to erroneously claim treaty benefits based on a cursory review of a treaty’s LOB provisions. Below are two examples that highlight the complexities.
The claim: The foreign parent company qualifies for treaty benefits because the U.S. subsidiary is in the same business as the foreign parent company.
Under a test contained in many LOB articles, a non-U.S. parent company may qualify for benefits if the business of its U.S. subsidiary is substantial and complementary to the foreign parent company. Thus, this test incorporates quantitative and qualitative requirements. Taxpayers must apply several subtests to test the quantitative requirement and use a specific analytical framework to evaluate the qualitative component. A foreign parent company that meets these requirements in one year may fail these tests in subsequent years. Therefore, taxpayers should review their treaty analysis in each year that significant business changes occur at the foreign parent company or the U.S. subsidiary.
The claim: The foreign parent company is large and headquartered in a jurisdiction with a U.S. income tax treaty.
Many LOB articles treat non-U.S. taxpayers as qualified residents if they meet certain ownership thresholds and satisfy a base erosion test. In particular, a foreign taxpayer may qualify for benefits if other persons that are qualified residents own beneficially a sufficient amount of equity in the taxpayer. Since treaties rarely define beneficial ownership, taxpayers must apply U.S. law. Generally, a beneficial owner is a citizen, a regularly and publicly traded corporation, a governmental entity, or certain other entities of the treaty jurisdiction. Often, large multinational companies have complex organizational structures that include multiple holding companies, partnerships and trusts. Taxpayers must generally determine beneficial ownership by tracing ownership through the corporate structure to the ultimate economic owners of the taxpayer.
Further, even if the ownership tests are fulfilled, taxpayers must satisfy a base erosion test. This test assesses whether a foreign parent company has eroded the treaty country’s tax base through payments to persons resident in a non-treaty country. For example, assume a German company has gross income of $100 and makes a $70 interest payment to a Dutch bank, which is deductible on the entity’s German tax return. In this example, Germany would have had income of $100, except the entity paid 70 percent of its income to a non-German tax resident. The German company would fail the base erosion test because more than 50 percent of its income is reduced by tax-deductible payments to a non-German tax resident.
U.S. treaty benefits may further be disqualified if the payment to the foreign parent company is subject to the Foreign Account Tax Compliance Act (FATCA). If the payment is subject to FATCA, the foreign payment company will need to analyze its Chapter 4 status and provide valid withholding tax documentation to the U.S. company prior to the payment to the foreign parent company. Improper or incomplete withholding tax documentation can result in a U.S. withholding agent denying treaty benefits on a withholdable payment.
Multinational companies constantly reorganize or have changes in ownership. Even though the direct foreign shareholder of the U.S. company does not change, the ownership above the direct foreign shareholder may change, and such changes may lead to a disqualification of U.S. treaty benefits or affect a corporate group’s withholding status. Given the complexities of claiming treaty benefits, taxpayers should conduct a thorough U.S. treaty analysis when there are changes in ownership or if there is a reorganization by the foreign parent. This analysis should form part of the due diligence around any significant acquisition or disposition that the taxpayer undertakes.