This brief review will look at the changes introduced by the recently enacted American Job Creation Act 2004 and the treatment of distribution of capital gains made to Australian investors by Real Estate Investments Trusts ("REITs") based in the United States.
The review will be centered around the double tax treaty between Australia and the United States. A protocol to the 1983 tax treaty with the U.S was signed in 2001. Legislation to give effect to the protocol in Australia was passed in 2002 and the U.S Senate ratified the protocol in 2003.
Several amendments were made to the Treaty by the Protocol.
One of the amendments which is further discussed below resulted in changes made to U.S taxation of income derived by Australian taxpayers from REITs in the U.S.
Income derived by Australian investors in REITs in the United States will be broadly, in the form of distributions of profits of the REITs and capital gains made by the REITs.
Dividends – Article 10 of the Treaty
The Protocol retained the normal features of taxing dividends. The country in which the beneficial owner of the dividends is resident has the right to tax the dividends. However the country in which the dividends arise will also be able to tax the dividends.
In the case of taxation in the U.S., whether tax will become payable in the form of a withholding tax on the gross amount paid or only on the profit made will depend on the income being "effectively connected " with the U.S. or not.
In most instances Australian investors would be subject to withholding tax in the U.S on distribution of profits made by the REITs.
Under the original Treaty there was only one rate of maximum withholding tax, 15% of the gross amount paid or payable.
The Protocol introduced 3 rates of withholding tax on dividends:
- No withholding tax is payable in the country where the paying company is resident if the dividends are paid or payable to a company in the other country and the payee company:
- has 80% or more of the voting power of the payer company; and
- is a qualified person according to subparagraph (c) of paragraph 2 of the "Limitation of Benefits" Article of the Treaty ; and
- is entitled to benefits with respect to dividends under paragraph 5 of that Article
- Maximum of 5% of the gross dividends if the dividends are paid or payable to a company in the other country and that company has at least 10% of the voting power of the payer company; and
- Maximum of 15% of the gross dividends paid or payable. This rate applies whether or not the payer is a company.
An individual is considered as a "qualified person" under the " Limitation of Benefits" Article. Even if a person is not considered as a qualified person according to paragraph 2 of the Article, that person may still become a qualified person under paragraph 5 of the Article.
Under paragraph 5, an Australian resident may be granted benefits of the Treaty if the competent authority of the United State determines, that the establishment, acquisition or maintenance of such person and the conduct of its operations did not have as one of its principal purposes the obtaining of benefits under the Treaty.
Therefore in most instances, the maximum withholding tax payable in the United States would be 15% of the gross amount of distribution made.
Real Estate Investment Trusts ("REIT")
REITs may be corporations, trusts or partnerships, which are taxed like domestic U.S. Corporations 1. The U.S. Inland Revenue Code imposes specific conditions on entities desiring to be REITs and claim tax deductions in respect of distributions made to their interest holders.
Subparagraph (a) of the new article 10 introduced by the Protocol provides that withholding tax rates of 0% and 5% will not be available in respect of dividends paid by RICs2 and REITs. Therefore the only withholding tax rate applicable is 15%. However, there are further conditions in the Protocol to be satisfied for the rate of 15% to be available.
The maximum rate of 15% will apply only if :
- The dividends are paid or payable to an individual holding interest not more than 10% of the REIT; or
- The dividends are paid or payable in respect of a class of stock that is publicly traded and the person entitled to the dividends does not hold an interest more than 5% of any class of the REIT’s stock; or
- The person beneficially entitled to the dividends holds an interest of not more than 10 % in the REIT and the gross value of no single interest in real property held by the REIT exceeds 10 % of the gross value of the REIT’s total interest in real property.
Notwithstanding the conditions referred to above, distributions made by a REIT cannot be subjected to withholding tax in excess of 15% if dividends are paid to listed Australian property trusts ("LAPT"). LAPTs are "managed investment schemes" registered under the Australian Corporations Act 2001 and are listed.
However, if any one of the unit holders in the LAPT own 5% or more of the beneficial interest in the LAPT, then that unit holder will have to satisfy one of the above 3 conditions to be entitled to the 15%. withholding tax limitation.
However, the "Business Profits" article in the Protocol will override the article on "Dividends" above, if any one of the beneficiaries of the LAPT carries on business in the U.S, through a permanent establishment in the U.S..
Capital gains from REITs
According to Sec.897(h) of the Inland Revenue Code (U.S), distribution of capital gains by REITs, to non-resident individuals and corporation, will be considered as gain derived directly by such individuals and corporations, and "effectively connected" with the U.S. The distribution will be taxed as income and not as dividend. Dividend article will not apply.
American Jobs Creation Act 2004
The Act came into force in October 2004. The major reform will result in a phased withdrawal of the extraterritorial income exemption (ETI) and it is hoped will pave the way to easing of sanctions imposed by the E.U.
There were other significant changes in international taxation, with incentives to repatriate foreign earnings back to the U.S., which would have a significant impact on Subpart F income taxation.
The amendment that is relevant to REITs is that distributions of capital gains made by REITs will not be treated as "effectively connected" income of the foreign shareholders. Consequently the capital gains will be " dividends" and the maximum withholding rate of 15% on the gross amount will apply. In addition, this change will eliminate the need for the Australian resident investor in U.S. based REITs from filing personal income tax return in the United States.
There are 2 conditions to be satisfied for the distribution to be treated as dividend:
- The distribution must be received with respect to a class of stock that is regularly traded on an established securities market in the United States; and
- The Australian investor must not own more than 5% of that class of stock.
In addition to the above, the Act has eased the application of several rules affecting investment in REITs.
1Sec. 856 of U.S. Inland Revenue Code2 Regulated Investment company
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.