On June 22, the U.S. Senate finally consented to the ratification of the United States-Chile income tax treaty by a 92-2 vote. The treaty was "initialed" in February 2010, but is still pending U.S. ratification. The Senate's approval was subject to two reservations to account for the changes in U.S. tax law since the signing of the treaty in 2010. Now, the treaty is headed to the president for signature.
The income tax treaty was ratified by the Chilean Congress in September 2015. However, since it was approved by the U.S. Senate with the reservations, these reservations would have to be accepted by Chile. Accordingly, the treaty will not enter into force until Chile has completed its additional approval process and mutual notification of approvals by both countries is made.
Key Provisions
The treaty is broadly consistent with the 2016 U.S. Model Income Tax Treaty, but it includes more restrictive limitation of benefit rules and would subject certain passive income such as dividends, interest and royalties to higher tax rates.
Reduced Withholding Tax
Typically, the United States imposes a 30 percent withholding tax on certain U.S.-sourced passive income, such as interest, dividends and royalties. However, the treaty will significantly reduce this rate.
- Dividends. The treaty reduces the withholding tax on dividends to 5 percent if the beneficial owner is a company that owns at least 10 percent of the voting stock of the paying company. Otherwise, the withholding tax rate on dividends is reduced to 15 percent.1 The treaty does not allow for complete exemption from withholding tax for dividends.
- Interest. The treaty provides an interest withholding tax rate of 4 percent when the lender is a bank, an insurance company, a financial institution or other select lender. In all other cases, during the first five years during which the treaty is in force, the withholding tax rate is 15 percent; thereafter, this rate drops to 10 percent. The interest article also contains an anti-conduit provision that scrutinizes back-to-back loans.2
- Royalties. The treaty reduces the withholding tax rate on royalties to 10 percent for most types of royalties, like payments for the use of copyright, patent, trademark and other intellectual properties. For the right to use industrial, commercial or scientific equipment (not including ships, aircraft or containers), the rate is further reduced to 2 percent.3
Permanent Establishment
The concept of permanent establishment plays an important role in income tax treaties. For example, typically, a country may not tax the business profits derived from activities in this country (source country) by a resident company of another country (resident country) unless the company has a permanent establishment in the source country and the profits are attributable to the permanent establishment.4
In general, a "permanent establishment" is a "fixed place of business" through which the business of an enterprise is carried on in whole or in part.5 As such, a permanent establishment includes a branch, office, factory, mine or other place of exploitation of natural resources.
However, the treaty provides some grace as to what constitutes a permanent establishment. For example, a building site or construction project and the related supervisory activities would be considered as a permanent establishment only if they last for more than six months. Further, when a company performs services in the source country, there is not considered to be a permanent establishment unless such services continue for a period or periods exceeding 183 days in any 12-month period, and these services are performed through one or more individuals who are present and performing such services in the source country.
In addition, a permanent establishment does not include the use of facilities solely for storage or display of goods, the maintenance of a fixed place of business solely for purchasing goods or of collecting information, or for the purpose of advertising, supplying information or carrying out scientific research, if such activity is merely preparatory or auxiliary.
Lastly, the existence of a permanent establishment may also affect the source of certain income, such as interest or royalties.6
Branch Profits Tax
Generally, the United States imposes a secondary branch profits tax at the rate of 30 percent on income that is effectively connected with a foreign corporation's U.S. trade or business. Treaties may reduce such tax.
The treaty addresses the branch profits tax in the paragraphs of the dividends article.7 Specifically, it permits the United States to impose its branch profits tax on the "dividend equivalent amount" (as that term is defined under the Internal Revenue Code)8 attributable to a foreign corporation's U.S. permanent establishment.
The rate of branch profits tax is reduced to 5 percent under the treaty.9
Limitation on Benefits
The treaty contains a comprehensive limitation on benefits article. Such an article is typically included to prevent treaty shopping?the attempt to structure an operation so as to obtain the benefits of a favorable tax treaty of a country in which the taxpayer is not a true resident.
Accordingly, the benefit of the treaty is limited to certain qualifying persons. Obvious examples include individual residents and governmental instruments of the treaty country.10 Qualifying persons also includes (i) a publicly traded company,11 (ii) a company that is recognized as a headquarters12 and (iii) a company that conducts an active trade or business in either country and derives income in connection with such trade or business.13
As with many other income tax treaties, the treaty includes an ownership and base erosion test.14 Under such test, generally speaking, an entity is considered as a resident qualifying for the treaty benefits if (i) at least 50 percent of its voting power or value is owned by the enumerated qualifying persons, and (ii) less than 50 percent of the gross income is paid to persons who are not residents of either country entitled to the treaty benefits.
Reservations
As mentioned above, the treaty was approved by the Senate subject to two reservations.15 The first reservation clarifies that the treaty shall not override the base erosion and anti-abuse tax under Section 59A of the Internal Revenue Code. Further, the second reservation modifies Article 23 (Relief from Double Taxation) of the treaty to account for the repeal of the indirect foreign tax credit under former code Section 902 of the Internal Revenue Code and its replacement with the dividends received deduction under section 245A of the Internal Revenue Code.
Exchange of Information
The treaty provides authority for the two countries to exchange tax information for carrying out its provisions, including information relating to the assessment or collection of, the enforcement or prosecution in respect of, or the determination of appeals in relation to the tax covered by the treaty.16 This language is generally consistent with the U.S. and OECD models. The language is intended to provide for the exchange of information in tax matters to the widest extent possible, while being subject to certain limitations under the treaty.
Effective Dates
The withholding provisions would become effective for amounts paid or credited on or after the first day of the second month following the date on which the treaty enters into force (i.e., the instruments of ratification are exchanged). For all other taxes, the provisions would take effect for tax periods beginning on or after the first day of January following the date the treaty enters into force. The exchange of information article will be effective from the date of entry into force. However, the two countries may generally seek information without regard to the taxable period to which the matter relates, and such period may be prior to the date of entry into force of the treaty.
Footnotes
1. Chile-U.S. Income Tax Treaty, Article 10.
2. Article 11.
3. Article 12.
4. Article 7.
5. Article 5.
6. Article 11, ¶7; Article 12, ¶5.
7. Article 10, ¶¶ 7-8.
8. IRC § 884(b); Treas. Reg. § 1.884-1(b).
9. Article 10, ¶8.
10. Article 24, ¶2(a), (b).
11. Article 24, ¶2(c).
12. Article 24, ¶2(d).
13. Article 24, ¶3.
14. Article 24, ¶2(g).
15. Exec. Rept. 118-1 (2023).
16. Article 27.
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