International Tax Bulletin (June 2015)
Changes to U.S. Model
Income Tax Convention
By Brian Wainwright,
a tax partner in the
Palo Alto office of Pillsbury Winthrop
Shaw Pittman LLP.
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On May 20, 2015, the United States Treasury Department released for public comment five draft updates to the United States Model Income Tax Convention, the starting point for Treasury when it negotiates income tax treaties. The Model Income Tax Convention was last revised in November 2006. Treasury is concerned that due to more frequent changes in the tax regimes of treaty partners, and perhaps anticipating significant future changes as a result of the Base Erosion and Profits Shifting project of the Organization for Economic Cooperation and Development ("OECD"), treaty provisions intended to reduce or eliminate double taxation are instead facilitating minimal or non-taxation and the creation of so-called "stateless" income. The five draft updates concern the following topics:
- Denial of treaty benefits in the case of income earned by certain permanent establishments.
- Denial of treaty benefits for certain payments by "expatriated entities," as defined under the anti-inversion provisions of Internal Revenue Code section 7874.
- Denial of treaty benefits for certain payments from related parties where the recipient is eligible for a "special tax regime."
- Termination of certain treaty provisions upon a change in law.
- A new derivative benefits provision in the limitation on benefits article.
A new paragraph 7 would be added to Article 1 (General Scope) of the Model Income Tax Convention to deny treaty benefits where an enterprise of a Contracting State (the "resident Contracting State") derives income from the other Contracting State (the "source Contracting State") and the resident Contracting State treats the income as derived through a permanent establishment in a country other than the resident Contracting State if (i) the income is subject to a combined rate of tax in the resident Contracting State and the third country that is less than 60 percent of the general rate of tax in the resident Contracting State, or (ii) there is no comprehensive income tax treaty between the source Contracting State and the third country (unless the resident Contracting State includes the income in the tax base of the resident).
This new provision could apply even where the "third" country is the United States, for example, where the activities within the United States of an enterprise of another Contracting State are insufficient to constitute a trade or business (and, accordingly, do not give rise to effectively connected income subject to U.S. federal income tax), but are nonetheless treated by the other Contracting State as a U.S. permanent establishment. If either of the two conditions in new paragraph 7 of the revised Model Income Tax Convention were satisfied, that new provision would deny treaty benefits (i.e., reduction in or elimination of applicable U.S. withholding taxes) to, among other classes of income, U.S.-source interest income paid to the permanent establishment.
Although new paragraph 7 applies reciprocally, the United States does not exempt the income of a third-country permanent establishment of a U.S. resident from U.S. federal income taxation, either by statute or by treaty.
Under the U.S. anti-inversion rules an "expatriated entity" is any U.S. corporation or partnership (and any related U.S. person) if (i) a non-U.S. corporation completes after March 4, 2003 the direct or indirect acquisition of substantially all the properties held directly or indirectly by the U.S. corporation or substantially all the properties constituting a trade or business of the U.S. partnership, (ii) at least 60 percent (by vote or value) of the stock of the non-U.S. corporation is held by former shareholders of the U.S. corporation by reason of having been such shareholders or by former partners of the U.S. partnership by reason of having held a capital or profits interest in the U.S. partnership and (iii) the non-U.S. corporation's "expanded affiliated group" does not have "substantial business activities" in the country in which or under the law of which the non-U.S. corporation is created or organized. I.R.C. § 7874(a)(2). If the ownership percentage of former shareholders or partners of the U.S. corporation or partnership equals or exceeds 80 percent (by vote or value), rather than 60 percent, the non-U.S. corporation is treated for federal tax purposes as a U.S. corporation, but then the target U.S. corporation or partnership and related U.S. persons are not expatriated entities. I.R.C. § 7874(a)(3).
The revised Model Income Tax Convention would deny treaty benefits to payments by an expatriated entity of dividends (new paragraph 9 of Article 10), interest (new subparagraph 2(d) of Article 11), royalties (new subparagraph 5(b) of Article 12) and other income, that is, income not otherwise dealt with under the Convention (new subparagraph 3(b) of Article 21) for the ten-year period beginning on the date the U.S. corporation or partnership becomes an expatriated entity.
Special Tax Regimes
Under the revised Model Income Tax Convention, treaty benefits would be denied to a recipient of interest (new subparagraph 2(c) of Article 11), royalties (new subparagraph 5(a) of Article 12) or other income (new subparagraph 3(a) of Article 21) if a resident of the other Contracting State (the "residence State") is related to the payor of the interest, royalties or other income and benefits from a "special tax regime" in the residence State. A special tax regime is any legislation, regulation or administrative practice (including a ruling practice) that provides a preferential effective rate of taxation through reductions in the tax rate or tax base, and includes a system that provides a notional interest deduction with respect to equity.
The definition of special tax regime in new subparagraph 1(l) in Article 3 (General Definitions) contains several important exceptions.
- Legislation, regulation or administrative practice that does not disproportionately benefit interest, royalties or other income is not a special tax regime; the legislation, regulation or administrative practice must be generally applicable to income and available across industries. This category is intended to exclude from special tax regime status systems that permit standard deductions, accelerated depreciation, corporate consolidations, loss carryovers, foreign tax credits and exemption of income from permanent establishments in other countries (unless that exemption is administered in a manner reasonably expected to benefit interest, royalties or other income disproportionately).
- A special tax regime does not include a regime designed to incentivize and that requires substantial activities that are not of a mobile nature to be performed within the particular country. Obvious qualifying systems are "patent box" of "innovation box" regimes of the type found in many European jurisdictions and being considered by the United States, but this exception also includes special economic zones intended to stimulate and requiring investment in manufacturing. The exception also applies to the U.S research and production credits under Internal Revenue Code sections 41 and 199, respectively.
- Systems that implement the principles of Article 7 (Business Profits) or Article 9 (Associated Enterprises), such as advance pricing agreement procedures, are not special tax regimes unless inconsistent with the arm's-length principle or the rules for attribution of profits to a permanent establishment described in the OECD's 2010 Report on the Attribution of Profits to Permanent Establishments.
- Special treatment for persons maintained exclusively for religious, charitable, scientific, artistic, cultural or educational purposes, such as the U.S. exemption for such persons described in Internal Revenue Code section 501(c)(3), does not give rise to a special tax regime. Similarly, a special tax regime does not include special treatment for regulated entities substantially all of the activities of which consist of administering or providing pension or retirement benefits or for collective investment vehicles that are marketed primarily to retail investors and widely held, and that hold real property, a diversified portfolio of securities or a combination thereof (such as, in the case of the United States, regulated investment companies and real estate investment trusts).
- Finally, the Contracting States may agree that legislation, regulation or administrative practice does not constitute a special tax regime because it does not result in a low or no effective rate of taxation. For this purpose, it is intended that an effective tax rate of at least 15 percent would not be considered a low or no effective rate of taxation.
The Treasury draft regarding special tax regimes also includes a sample Protocol under which the Contracting States would list any legislation, regulation or administrative practice explicitly determined to be or not to be a special tax regime. Treasury anticipates that the Contracting States would endeavor to determine if any regimes coming into existence after the date of any such Protocol are special tax regimes.
Treasury notes that no currently effective U.S. legislation, regulations or administrative practices that apply to interest, royalties or other income would satisfy the definition of a special tax regime.
Change in Law
New Article 28 provides that if after signing of the Convention, the general rate of company tax applicable in one of the Contracting States (the "change State") falls below 15 percent with respect to substantially all the income of resident companies, or one of the Contracting States provides an exemption from taxation to resident companies for substantially all foreign source income (including interest and royalties), then the other Contracting State may cause the provisions of Articles 10 (Dividends), 11 (Interest), 12 (Royalties) and 21 (Other Income) to cease to apply to companies in both Contracting States six months after the other Contracting State so notifies the change State. A comparable provision applies to individuals if the highest marginal rate of individual tax falls below 15 percent in a Contracting State or the Contracting State provides an exemption from taxation to resident individuals for substantially all foreign source income (including interest and royalties).
In an effort to prevent treaty shopping, the Model Income Tax Convention and many U.S. income tax treaties contain so-called "limitation on benefits" articles restricting resident treaty benefits to persons or entities with a closer connection to a Contracting State than "tax residence." For example, one way a company resident in a Contracting State can satisfy the limitation on benefits provisions of the Model Income Tax Convention is to have its principal class of shares (and any class of shares that has a disproportionately higher share of earnings of that company from the other State (a "disproportionate class")) regularly traded on a recognized stock exchange and either (i) its principal class of shares primarily traded on a recognized stock exchange in the residence Contracting State or (ii) its primary place of management and control located in the residence Contracting State.
Relatively recent U.S. income tax treaties often contain what is called a "derivative benefits" provision under which a company can nonetheless claim benefits under the treaty if it meets an ownership test and an earnings stripping test. Central to each test is the concept of "equivalent beneficiary," discussed in more detail below. Notably, most current U.S. income tax treaties with derivative benefits provisions usually limit the states in which an equivalent beneficiary may be resident, typically to members of the European Union or European Economic Area or to parties to the North America Free Trade Agreement. See, for example, U.S.-United Kingdom Income Tax Convention, Article 23(3), U.S.-Netherlands Income Tax Convention, Article 26(3), U.S.-Germany Income Tax Convention, Article 28(3) and U.S.-Belgium Income Tax Convention, Article 21(3) (also including Switzerland).
In addition to technical and clean up changes in Article 22 (Limitation on Benefits), the revised Model Income Tax Convention would include, in paragraph 4, a derivative benefits provision without geographic limitation. Under revised paragraph 4, a company can qualify for treaty benefits if (i) at least 95 percent of the aggregate voting power and value of the company's shares (and at least 50 percent of any disproportionate class of shares) is owned, directly or indirectly, by seven or fewer persons who are equivalent beneficiaries (provided in the case of indirect ownership, each intermediate owner is a "qualified intermediate owner") and (ii) an amount less than 50 percent of the company's gross income, and less than 50 percent of the "tested group's" income is paid or accrued, directly or indirectly, in the form of payments (not including arm's-length payments in the ordinary course of business for services or tangible property) that are deductible in the company's Contracting State of residence, either to persons that are not equivalent beneficiaries or to persons that are equivalent beneficiaries but that benefit from a special tax regime in their state of residence with respect to the deductible payment.
Under Article 22(6)(e), an equivalent beneficiary is a resident of any state that would be entitled to the benefits of a another comprehensive income tax treaty with the source Contracting State (the "Other Treaty") under provisions analogous to subparagraphs (a), (b), (c) or (e) of Article 22(2) (the "Qualifying Provisions" under which individuals, Contracting States and their political subdivisions, publicly traded companies, and pension funds (if more than 50 percent of the fund's beneficiaries, members or participants are individuals resident in either Contracting State) and charitable organizations, respectively, qualify for treaty benefits; if the Other Treaty does not contain a comprehensive limitation on benefits provision, the resident would be entitled to the benefits of the subject treaty were such resident a resident of one of the Contracting States (determined by application of the residence article of the subject treaty) and, if the resident is an individual, that individual is not subject to tax in his state of residence with respect to foreign source income or gains only on a remittance basis. In addition, with respect to dividends, interest or royalties the Other Treaty must entitle the resident to a rate of tax with respect to the particular category of income for which benefits are claimed under the subject treaty that is at least as low as the rate applicable under the subject treaty had the income been received by the resident directly, and, with respect to business profits, gains or other income, the resident must be eligible for benefits under the Other Treaty at least as favorable as the benefits being claimed under the subject treaty (the "Equivalency Tests"). An equivalent beneficiary also includes a resident of the same Contracting State as the company claiming the benefits under the subject treaty if that resident is eligible for the benefits of the subject treaty under one of the Qualifying Provisions.
A qualifying intermediate owner is an intermediate owner that is a resident of a state with a comprehensive income tax treaty with the source Contracting State which treaty contains provisions analogous to the special tax regime provisions of the subject convention and which satisfies the Equivalency Tests. For purposes of the derivative benefits provisions, tested group means the company applying the derivative benefits provisions and any intermediate owner of that company that is both a resident of the same Contracting State as that company and a member with that company of a tax consolidation or similar group that allows members of the group to share profits or losses.
In its press release announcing release of the drafts, Treasury indicated that it would add a new article to the Model Income Tax Convention providing for the resolution of disputes between tax authorities through mandatory arbitration.
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