On May 19, 2020, the IRS released Announcement 2020-6, which provides that North American Free Trade Agreement (NAFTA) references in U.S. income tax treaties will be interpreted by the Treasury Department and the IRS to mean U.S.-Mexico-Canada Agreement (USMCA), which is expected to replace NAFTA effective July 1, 2020.
On Nov. 30, 2018, the governments of the U.S., Canada and Mexico signed the Protocol replacing NAFTA with USMCA (the USMCA was amended by a Protocol signed on Dec. 10, 2019). It is expected that on July 1, 2020 the USMCA will be entered into force and officially supersede NAFTA.
The announcement points out that most U.S. tax treaties contain Limitation on Benefits (LOB) articles which are aimed at preventing entities that are resident in a treaty jurisdiction from inappropriately accessing tax treaty benefits. Many LOB articles explicitly reference NAFTA when discussing the objective tests a resident must meet in order to claim certain treaty benefits. For example, the U.S.-Germany tax treaty includes the “derivative benefits” test which includes a definition that in order to be an “equivalent beneficiary”, a person must be a resident of a country that is a party to either the NAFTA, the European Union or the European Economic Area. The guidance provides clarity around Treasury and the IRS’s view that any treaty reference to NAFTA should be interpreted as a reference to the USMCA. Absent this guidance, taxpayers who relied on such LOB articles may have lost access to an otherwise applicable income tax treaty on July 1, 2020. This guidance seeks to prevent that result.
Treasury and the IRS will reach out to countries that have an applicable tax treaty containing references to NAFTA to confirm that they agree with this interpretation. Without confirmation from the tax authority of a treaty partner, such partner may decline to extend treaty benefits to U.S. taxpayers who claim benefits under an otherwise applicable income tax treaty. Taxpayers should therefore assess whether they are at risk of losing treaty benefits with respect to foreign source income if they rely on a provision in an LOB article that contains a reference to NAFTA.