Executive summary: Income tax treaty overview
On Dec. 7, 2022, Treasury took another step forward in their efforts to expand the U.S. tax treaty network by signing a comprehensive income tax treaty with Croatia (the Treaty). The Treaty is the first of its kind between the countries and aims at further strengthening their trade and commercial ties. This is also the first comprehensive tax treaty the U.S. has signed in over 10 years.
As stated by Treasury, the Treaty closely mirrors the U.S. Model income tax treaty with specific emphasis on the following:
- Elimination of withholding taxes on cross-border payments of dividends paid to pension funds and on payments of interest;
- Reductions in withholding taxes on cross-border payments of royalties and dividends, other than those paid to a pension fund;
- Modern anti-abuse provisions intended to prevent instances of non-taxation of income as well as treaty shopping;
- Robust dispute resolution mechanisms including mandatory binding arbitration; and
- Standard provisions for the exchange of information to help the revenue authorities of both nations carry out their duties as tax administrators.
The Treaty will enter into force after ratification by both countries.
Key highlights of the Treaty
Foreign tax credits made more available
Given the recent U.S. foreign tax credit (FTC) regulations, the signing of the Treaty could not have come at a more crucial time for taxpayers. Under these regulations, historically creditable foreign income taxes can become non-creditable. In the most basic sense, the regulations allow taxpayers to credit only foreign taxes that qualify as income taxes using U.S. federal tax principles. Foreign taxes that fail this test are generally not creditable but may be deductible instead.
However, some U.S. income tax treaties specifically provide that a foreign tax is an income tax for purposes of the U.S. foreign tax credit rules. To the extent the foreign tax is an income tax under a treaty and treaty benefits are elected, the foreign tax could qualify as a 'foreign income tax' potentially eligible for a credit. Absent such a treaty provision, U.S. taxpayers must undergo a rigorous analysis, including reviewing local tax law and source rules, to determine creditability of a foreign tax.
Once the Treaty enters into force, the U.S. will recognize certain Croatian income taxes (the profit tax, the income tax and the local profit tax) as an income tax eligible as a credit against U.S. income tax liability. However, other U.S. income tax rules governing the limitation on the use and availability of the foreign tax credit still apply although taxpayers will not have to analyze whether these taxes are an income tax.
Taxpayers looking for additional information on the 2022 final FTC regulations and 2022 proposed FTC regulations can read RSM's previous tax alerts (Treasury releases technical corrections to final FTC regulations and Treasury releases much anticipated proposed FTC regulations).
Withholding taxes reduced
Dividends: The Treaty reduces the withholding rate on dividends to 15%. The Treaty rate is 5% when certain ownership and holding periods are met. There is no withholding requirement on dividends paid to certain pension funds.
Interest: In general, the Treaty provides for an exemption from tax on interest payments. However, the Treaty limits to 15% the tax imposed on certain contingent interest and on interest arising in Croatia that is determined with reference to receipts, sales, income, profits or other cash flow of the debtor (or a connected person with respect to the debtor), to any change in the value of any property of the debtor or to any dividend, partnership distribution or similar payment made by the debtor (or a connected person with respect to the debtor). A 10% rate applies to companies that are residents of a Contracting State that functions as a headquarter company for a multinational corporate group.
Royalties: The Treaty reduces the withholding rate on royalties to 5%.
A more restrictive definition to 'pension fund'
Most tax treaties define the term 'pension fund' (or pension) in a broad manner. For example, in the U.S. Model income tax treaty, a pension fund means any person established in a Contracting State that is:
- Generally exempt from income taxation in that Contracting State; and
- Operated exclusively or almost exclusively to administer or provide pension or retirement benefits; or to earn income for the benefit of one or more persons established in the same Contracting State that are generally exempt from income taxation in that Contracting State and that are operated exclusively or almost exclusively to administer or provide pension or retirement benefits.
This broad definition has left room for interpretation and the IRS has felt the need to clarify similar provisions in order to prevent abuse. For example, recently the U.S. and Malta entered into a Competent Authority Arrangement (CAA) suggesting the term be more narrowly interpreted. The CAA states that "it has come to the attention of the competent authorities that U.S. citizens and residents are establishing personal retirement schemes in Malta under the Retirement Pensions Act of 2011 with no limitation based on earnings from employment or self-employment and are making contributions to these schemes in forms other than cash (e.g., securities). Questions have arisen in the United States about whether these personal retirement schemes are “pension funds” for purposes of applying the Treaty." The CAA prohibits this much broader view as to what qualifies as a pension and now limits what may qualify going forward. Practitioners have contemplated that the IRS might seek more clarity around the definition of the term 'pension' and the Treaty accordingly contains more detail.
Of importance, the Treaty includes a comprehensive definition of a pension fund, which is not contained in other treaties. This represents Treasury’s attempt to codify what pensions qualify for treaty benefits (i.e., those that have contribution limits, allow only cash contributions and arise from earned income). We expect that Treasury will assert this definition in other treaties where the definition of a pension fund (or pension) is undefined.
Base erosion and anti-abuse tax addressed
Several tax treaties (in particular those with Chile, Hungary, Poland and Vietnam) remain stalled in the U.S. Senate. For some of these treaties, the U.S. Senate Foreign Relations Committee has expressed reservations including the following regarding the base erosion and anti-abuse tax (BEAT):
- The U.S. model tax treaty provides that business profits be determined in the same manner for residents and non-residents, alike, while BEAT imposes taxes differently based on residency;
- The U.S. model tax treaty permits eligible U.S. taxpayers the ability to credit taxes paid to treaty countries, while BEAT denies certain FTCs;
- To the extent a treaty enters into force post-TCJA and contains inconsistencies with BEAT, taxpayers may have an argument that certain conflicting provisions of BEAT do not apply (i.e., the later adoption of law trumps).
To overcome these concerns, the Treaty contains a special provision addressing the BEAT. The provision explicitly states that nothing in the Convention will be construed as preventing the U.S. from imposing a tax under section 59A on a U.S. resident company or the profits of a Croatian resident company that are attributable to a U.S. Permanent Establishment (PE). As a result, we expect Congress will raise no significant concerns over the interaction of the BEAT with the Treaty.
The Treaty will enter into force after the U.S. and Croatia have notified each other that they have completed their requisite domestic procedures, which in the case of the U.S. refers to advice and consent to ratification by the U.S. Senate. While the Senate has not formally scheduled a hearing to date, it is certainly possible that the Senate Foreign Relations committee will examine the Treaty this year.