United States

New US model tax treaty could make treaty benefits more elusive

INSIGHT ARTICLE  | 

Summary

In May of 2015, the U.S. Department of Treasury (Treasury) requested comments on five proposed changes to the U.S. model income tax treaty, which is the U.S. starting point for treaty negotiations with a foreign country. This unprecedented move coincided with the project from the Organisation for Economic Co-operation and Development (OECD)  on base erosion and profit shifting (BEPS), which seeks to attack harmful tax regimes and practices. On Feb. 17, 2016, Treasury released a revised Model income tax treaty (2016 Model) that includes changes that likely stakes out the U.S. position with respect to the BEPS initiatives. The request for public comment on changes to the U.S. model income tax treaty was a first for Treasury and suggests strongly that these changes are very significant indeed.

Some of the more significant revisions contained in the 2016 Model are summarized below.

Model article addressing so-called ’exempt permanent establishments’

The 2016 Model prevents taxpayers from inappropriately obtaining treaty benefits on income that escapes tax in their country of residence because it is attributable to a permanent establishment (PE) located outside the country of residence.

In particular, under paragraph 8 of Article I of the 2016 Model, no treaty benefits are available with respect to  profits attributable to such a  PE where those profits are subject to a combined aggregate effective rate of tax of the lesser of either a) 15 percent or b) 60 percent of the general rate of company tax applicable in the first-mentioned Contracting State or the jurisdiction in which the PE is situated does not have a comprehensive income tax treaty in force with the Contracting State from which treaty benefits are being claimed. Any income to which this paragraph applies will be subject to tax under the domestic law of the Contracting State from which benefits are being claimed, notwithstanding any other provision of the treaty. As a result, U.S. sourced payments such as interest, royalties and dividends may be subject to a 30 percent statutory withholding tax.

The following examples (taken from the Technical Explanation to the 2016 Model) illustrate the application of these provisions: 

A resident of the U.K. sets up a PE in a third country that imposes a low or zero rate of tax on the income of the PE. The income attributable to the PE is exempt from tax by the U.K., either pursuant to an income tax treaty in force between the U.K. and the third state where the PE is located or pursuant to the U.K.’s domestic law. The U.K. resident lends funds into the U.S. through the PE. The PE, despite being situated in a third jurisdiction, is an integral part of the U.K. resident. Therefore, interest received by the U.K. resident with respect to loans issued by the PE, absent the provisions of paragraph 8, would be entitled to exemption from U.S. withholding tax under the treaty (assuming all other requirements in Article 11 (Interest) have been satisfied). Thus, the interest income, absent paragraph 8, would be exempt from U.S. tax, subject to little or no tax in the third state of the permanent establishment, and exempt from tax in the U.K.

However, pursuant to paragraph 8, if the profits of the PE are subject to a combined effective tax rate, in the U.K. and the country in which the PE is located, that is less than 60 percent of the general rate of tax imposed on income by the U.K. on a domestic company, treaty benefits would be denied. Treaty benefits would also be denied if the jurisdiction in which the PE is established does not have an income tax treaty with the U.S.

The examples further illustrate that this result may occur even when income is paid to a non-U.S. company where the income is attributable to U.S. based activity that is not a U.S. trade or business:

Assume, for example, that a resident of the U.K. engages in an activity in the U.S. that does not rise to the level of a trade or business and is therefore not taxed by the U.S. The U.K. treats such activity as a PE situated in the U.S. U.S. source interest is paid to the resident of the U.K., and the U.K. treats the interest as attributable to the U.S. PE. If the combined aggregate effective rate of tax on the profits treated as attributable to the PE, taking into account taxes paid both in the U.S. and the U.K. is less than 60 percent of the general rate of company tax applicable in the U.K. the provisions of subparagraph 8 would be triggered. Thus, the U.S. source interest paid to the resident of the U.K. would be subject to tax in accordance with domestic law of the U.S.

However, if a resident of a Contracting State is denied treaty benefits pursuant to these rules, the competent authority of the other Contracting State may, nevertheless, grant treaty benefits with respect to a specific item of income, if such grant of benefits is justified.

Revised limitation on benefits article

U.S. tax treaties have long contained limitation on benefits (LOB) provisions to limit treaty shopping. Conceptually, treaty shopping occurs when an investor structures investments through a company that is a resident in a country in which the U.S. has a treaty in order to obtain treaty benefits that would not be available if the investment were made directly. The OECD has recommended that countries consider inserting LOB provisions in their tax treaties, the OECD has suggested that countries adopt a subjective test to determine whether to grant treaty benefits while the 2016 Model contains a variety of objective tests.

Article 22 of the 2016 Model contains several revisions to the LOB article. The first is a taxpayer friendly test known as the equivalent beneficiary test. Under this test, a taxpayer can claim treaty benefits if at least 95 percent of the taxpayer is owned by seven or fewer persons that are equivalent beneficiaries and if the taxpayer satisfies a base erosion test. An equivalent beneficiary is defined as a resident of any state if entitled to benefits under a comprehensive double taxation treaty with the U.S. or the other treaty country which is a broader definition than currently exists in most U.S. treaties. Thus, a taxpayer claiming benefits with respect to U.S. source passive income under the 2016 Model would be subject to tax at a maximum rate equal to the withholding rate to which its third country resident owners would be entitled, as opposed to the statutory U.S. rate of 30 percent. With respect to business profits, gains, or other income, the third country resident must be entitled to benefits that are at least as favorable as under the U.S. model. In addition, the 2016 Model has an important modification that allows individual shareholders to be treated as companies for purposes of private companies seeking to qualify under the derivative benefits test to allow for the lower corporate dividend withholding rate of 5percent.

The 2016 Model also contains changes to the base erosion, competent authority and active trade or business provisions of the LOB. For example, changes to the base erosion tests will require that intermediate owners be a residents of one of the two contracting states in order for a taxpayer to obtain treaty benefits. This was not always clear in other treaties.  In addition, the base erosion test now requires taxpayers to consider payments made by another member of the taxpayer’s group even if that other member is not a party to the transaction giving rise to the payment with respect to which the taxpayer seeks benefits.

Under another provision, the Competent Authority can classify a taxpayer as a qualified resident only if the taxpayer has “a substantial nontax nexus” to its country of residence. This is in addition to the requirement that the obtaining of treaty benefits was not one of the principal purposes for the establishment of operation.

Lastly, the 2016 Model contains amendments to the “active trade or business” test of the LOB article. To qualify under the “active trade or business” test, taxpayers generally must conduct some level of business operations and have substance in the residence country in order to obtain treaty benefits. The revisions would eliminate the treaty benefits for an entity that has an active trade or business in a treaty country if the income for which the benefits are sought do not “emanate from, or are incidental to” the trade or business of a company located in that country. The goal of this provision is to limit the treaty benefits allowed under this test to situations in which the business has a strong connection to the item of income for which benefits are claimed. This provision is designed to prevent large multinational organizations with varied business activities across the globe from utilizing subsidiaries in a particular treaty country to claim treaty benefits when the income has no logical connection to activities in the treaty country.   

Special Tax Regimes

Special tax regimes (STR) have been available in some countries that generally allow a taxpayer to pay little or no tax on highly mobile income (e.g. royalties and interest). These preferential regimes are under direct attack by the OECD BEPS initiative and the 2016 Model also attempts to limit benefits for payments made to STR countries. However, the 2016 Model applies only to related-party payments of interest, royalties and guarantee fees that are covered within the scope of Article 21 (dealing with so-called other income).  

In general, an STR is any legislation, regulation, or administrative practice that provides a preferential effective rate of taxation to interest, royalties or other income as compared to the rate of tax from the sale of goods or services. The preferential treatment must be accomplished through either a preferential rate for such income, a permanent reduction in the tax base with respect to such income (as opposed to some sort of deferral), or a preferential regime for companies that do not engage in an active business in that country. The 2016 Model does not treat notional interest deduction (NID) regimes as an STR, however, it does allow a treaty partner to tax interest arising in that country if the interest is beneficially owned by a related person that benefits from a NID. The Model also requires that a country must consult with and notify the other country of its intentions to invoke the STR provisions to deny treaty benefits.

Lastly, the 2016 Model provides an exception to the rules governing STRs if the rate of tax is at least 15 percent, or 60 percent of the general statutory rate in that country, whichever is lower.

New Article 28: Subsequent changes in law

New Article 28 would allow a mechanism to disallow treaty benefits based upon a country’s subsequent change in tax law. The provision would repeal treaty benefits for income that would be covered by Articles 10 (Dividends), 11 (Interest), 12 (Royalties), and 21 (Other income) effective six months after a written notification is provided through diplomatic channels. The 2016 Model explicitly requires that this written notification can only be issued after the two parties fail to progress towards a resolution through negotiation. It is important to note, that upon notification, the application of this provision is applicable on a bilateral basis. A subsequent change in law is triggered if the general rate of company tax applicable in either contracting state falls below the lesser of either 15 percent, or 60 percent of the other country’s general statutory rate.

Payments by expatriated entities

There are several provisions that suspend treaty benefits on payments made by an expatriated entity for a period of 10 years following the expatriation. Under paragraph 9 of Article 10 (Dividends), any dividends paid by an “expatriated entity” may be taxed according to U.S. law for up to 10 years after the date on which the domestic entity was acquired, and not eligible for the reductions in dividend withholding provided in paragraph 2. Similar revisions to paragraph 2(d) of Article 11 (interest), paragraph 5(b) of Article 12 (royalties), and paragraph 3(b) of Article 21 will limit treaty benefits on interest, royalty and other payments by these expatriated entities. These provisions will make corporate inversion less attractive by limiting the benefits available for payments made post-inversion to a related party resident in a treaty country.  As a result, such payments would generally be subject to withholding tax of 30 percent. For this purpose, the 2016 Model uses the definition of an “expatriated entity” contained in section 7874(a)(2)(A) of the Internal Revenue Code as of the date the tax treaty is signed.

Conclusion

The overall goal of the new model treaty is evidence of the continued effort by the U.S. to attack structures that are deemed abusive and for which the granting of treaty relief is not intended. This approach is consistent with the BEPS initiatives, although some of the details in the model highlight differences in policy. Treasury has openly commented that the update to the model treaty is necessary to keep up with a dynamic and changing environment.

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