United States: Proposed US Model Tax Treaty Changes – Further Limiting Treaty Qualification?

Last Updated: February 17 2016
Article by Kristin Konschnik

On 20 May 2015, the US Treasury Department released proposed revisions to the US Model Income Tax Treaty (the 'US Model'), which (i) introduce 'special tax regime' provisions, (ii) propose changes to the Limitation on Benefits ('LOB') provision; (iii) add new rules on 'expatriated entities'; (iv) include a right for partial treaty termination if a treaty partner makes certain 'subsequent changes' to its domestic law; and (v) target 'exempt permanent establishments'.

The proposals were released as part of the US' bid to influence the OECD's discussions regarding combatting treaty abuse as part of the 'Base Erosion and Profit Shifting' project and represent some significant changes to US treaty policy, focused on limiting base erosion, double non-taxation and treaty qualification. This article summarizes material aspects of the proposals and highlights some of the questions and potential challenges that could arise if they are incorporated into existing US treaties as currently proposed.

'Special tax regimes'

The 'special tax regime' provisions introduce a new concept to the US Model that would deny treaty benefits on interest, royalties and 'other income' if a preferential rate of tax applies to that income in the recipient jurisdiction. While the policy reasons behind the provisions (eg, eliminating double non-taxation) are understandable, the draft provisions raise some significant questions. For example, although the provisions deny treaty benefits on payments to 'related' recipients, there is no definition of 'related' for this purpose so it currently is unclear how closely connected the payor and payee must be.

Further, it is unclear whether the provisions are intended to deny treaty benefits with respect to an item of income regardless of whether that item of income in fact benefits from a special tax regime. A 'special tax regime' is defined as any legislation, regulation or administrative practice (including a ruling practice) that provides a preferential effective rate of tax on interest, royalties or other income, including through reductions in the tax rate or the tax base; notional interest deductions are always considered a special tax regime. However, there could be several reasons why an item of income theoretically could be able to benefit from a special tax regime but would not do so in practice. For example, if a special tax regime is elective, items of income paid to recipients who have not elected into the regime could still be denied treaty benefits if the treaty provisions are intended to apply solely based on the existence of the regime, rather than its application in particular circumstances. Similarly, if the special tax regime is a ruling practice and the related recipient has not applied for a ruling, should treaty benefits still be denied as a matter of policy? This would appear to be unduly harsh.

The special tax regime provisions also could pose significant due diligence burdens, particularly given that the US withholding tax regime relies on withholding agents to enforce the provisions (and those agents may be liable for any under-withholding). It may be difficult or impossible for those withholding agents to determine whether the special tax regime provisions apply without additional certification (for example, on a Form W-8BEN-E) by the recipient upon which the withholding agent could rely. This identification issue potentially is compounded, since under the current proposal, no notification or other public notice is required if a jurisdiction adopts a special tax regime after the treaty has entered into force.

LOB Provisions

Material changes to the LOB provision include: (i) the addition of a 'derivative benefits' provision; (ii) including a 'tested group' requirement in the 'base erosion' prong of all three 'base erosion' tests (including a new base erosion requirement in the 'subsidiary of a public company' test); and (iii) changing the active trade or business test with the practical effect that holding and finance companies could no longer qualify under this test.

A typical LOB article in existing US treaties contains several possible routes under which resident entities can qualify for treaty benefits, one of which is the 'derivative benefits test'. The proposals would add the derivative benefits test to the US Model for the first time, although with significant differences compared to provisions in existing treaties. Broadly, under the proposed derivative benefits test, a tested resident entity qualifies for certain treaty benefits: (i) it is at least 95%-owned, directly or indirectly, by seven or fewer 'equivalent beneficiaries', each of which is entitled to US treaty benefits at least as advantageous as those claimed by the tested entity; and (ii) less than 50% of the gross income of both the tested entity and its 'tested group' is paid or accrued in deductible payments (other than certain arm's length payments in the ordinary course of business) to persons that are either not equivalent beneficiaries or are equivalent beneficiaries that benefit from a 'special tax regime' with respect to the deductible payment.

This test incorporates a number of important nuances. First, an equivalent beneficiary must qualify for benefits as an individual, publicly-traded company, governmental entity, exempt organization or pension fund under a treaty with the source state (ie the US) that contains a comprehensive LOB provision. Further, the equivalent beneficiary must be entitled under its treaty with the US to a withholding rate on dividends, interest and/or royalties that is 'at least as low' as the rate under the tested entity's treaty and/or to benefits 'at least as favorable' as those of the tested entity under the business profits, gains and other income provisions (depending on what treaty benefits the tested entity is claiming). These tests appear to operate as an 'all or nothing' proposition; for example, if under the respective treaties an equivalent beneficiary is entitled to a 10% rate on dividends and the tested entity is entitled to a 5% rate, no reduced rate is available and full US withholding tax at 30% applies (rather than applying the higher of the two rates, 10% in this case). The policy behind this 'all or nothing' proposition is not entirely clear.

In one liberalizing change, the 'ownership prong' in the proposed test does not impose a geographical limitation on the equivalent beneficiary's residence; the tests in existing treaties require the equivalent beneficiary to be resident either in the same jurisdiction as the tested entity or in a jurisdiction within the tested entity's economic bloc (eg NAFTA, the EEA or the EU). However, the proposed test would add a new requirement that each intermediate owner of the tested entity must be a 'qualifying intermediate owner' or QIO. A QIO is a resident of a jurisdiction that has a treaty with the source state that includes 'special tax regime' provisions; under the current proposal, a QIO cannot be an entity in the source state although the policy behind this is not clear (if in fact it was intended).

The requirement that an intermediate owner's residence jurisdiction has a treaty that includes special tax regime provisions is particularly problematic since (of course) at this stage no US treaty has these provisions. Retaining that requirement, therefore, effectively would preclude any tested entity with intermediate owners from qualifying under the derivative benefits test. Even if the requirement is retained (for example, coming into force once other treaties have adopted special tax regime provisions), should treaty benefits be denied if a tested entity's intermediate owner is resident in a jurisdiction with a special tax regime if the particular item of income does not benefit from the regime? Further, the special tax regime aspect of the QIO test is not limited to payments to related payees (unlike the special tax regime provisions themselves), which may lead to significant practical difficulties in determining whether an entity qualifies for benefits under this test depending on the status of its payees.

The proposed 'base erosion' prong also reflects substantial changes compared to those in existing treaties and would apply to all three base erosion tests under the revised LOB. Under the proposal, both the tested entity and its 'tested group' must meet the base erosion test; a tested group includes the tested entity and any 'intermediate owner' that is resident in the same jurisdiction as, and part of a tax consolidation or similar group with, the tested entity. As the definition requires an intermediate owner, a parent company does not have a tested group although the policy reasons for excluding sister companies and subsidiaries from the tested group definition is not clear. Base eroding payments include deductible payments made to (i) persons that are not equivalent beneficiaries, or (ii) equivalent beneficiaries (related or not) who benefit from a special tax regime with respect to the payment. Further, 'gross income' under the base erosion tests generally excludes dividends that are exempt from tax in the tested entity's state of residence (other than when testing for qualification with respect to the dividends article).

Although eliminating the geographical restriction in the equivalent beneficiary definition is helpful, the new limitations introduced by the QIO requirement and narrower base erosion test likely will make the proposed derivative benefits test more difficult to meet. The addition of a base erosion test to the 'subsidiary of a public company' LOB test also may pose a significant obstacle to treaty qualification for these entities, and it is not clear that there is a sound policy reason for this further limitation.

Another material change to the active trade or business test would prohibit attribution among related entities, unless the resident and related entities were engaged in the same or complementary lines of business. This change effectively would preclude holding or finance companies from qualifying under this test (since the holding company, for example, would not be engaged in the same line of business as its operating subsidiary). Treasury's comments to the proposed active trade or business test indicate its view that the more appropriate LOB qualification route for holding and finance companies is the derivative benefits test but, particularly given the significant changes to that test, this does not seem likely. Treaty qualification of holding and finance companies, therefore, may be much more difficult in practice.

'Expatriated entities'

The proposed changes include new provisions on 'expatriated entities' as a backstop to existing (and likely new) domestic rules on 'inversions'. Very broadly, in an inversion, a US corporation with multinational operations combines with a foreign corporation, which becomes the new parent of the group. Post inversion, absent rules to the contrary, the non-US parent is only subject to US federal income tax on its US source income.

The proposed expatriated entities provisions would deny otherwise available reduced treaty withholding rates and impose full US withholding tax at 30% on payments of dividends, interest, royalties and 'other income' if the payor is an 'expatriated entity'. The denial of reduced US withholding rates would apply for the ten-year period following the inversion, beginning on the date the 'acquisition' of the US corporation is completed.

The proposed provisions would supplement existing anti-inversion rules under the US Internal Revenue Code by effectively applying if, post-inversion, the foreign parent was owned more than 60% but less than 80% by the pre-inversion owners of the US company. Critically, the denial of reduced US withholding rates under these proposals is not limited to payments to related parties, although Treasury has suggested this limitation is under consideration; in other words, as currently drafted, reduced treaty withholding rates would be denied if, post-inversion, the US company made covered payments to an unrelated party (for example, interest payments to third party lenders).

'Subsequent changes'

Another proposal would add a new article permitting partial treaty termination if, after the treaty is signed, either (i) the general rate of company tax applicable in one of the treaty partners falls below 15%, or (ii) a treaty partner exempts its resident entities from tax on 'substantially all' of the entities' foreign source income (with similar provisions for individuals). The proposal would require 'generally available deductions' to be taken into account in determining the applicable rate of tax. If a treaty partner determines that either condition has been met by the other jurisdiction, the first treaty partner can notify the second through diplomatic channels that it will stop applying the provisions of the dividends, interest, royalties and 'other income' articles to residents of the partner jurisdiction. Generally, the partial termination would take effect 6 months after written notification unless the treaty partners resolve the situation.

It is understandable that a treaty partner would want to re-consider treaty provisions if the partner jurisdiction significantly changed the principles upon which the original treaty was negotiated. However, the provision as drafted raises some concerns. First, it is not clear that a fixed 15% company tax rate is the appropriate measure (particularly since some jurisdictions generally already have lower applicable rates); another option could be to calculate the trigger based on a percentage reduction from the rate in effect when the treaty was signed.

Further, the requirement that 'generally available deductions' or 'other similar mechanisms' be taken into account in determining the effective rate of tax appears to be unduly complex and raises questions such as whether US tax principles or the tax law of the local jurisdiction should apply for purposes of determining what constitutes income or deductions (the latter would be much more sensible).

Any partial termination is reciprocal so residents of the 'non-offending' treaty partner also would be denied treaty benefits. While it is understandable that treaty partners would not be interested in signing a non-reciprocal 'subsequent changes' provision, reciprocity could leave US companies in a difficult position if a treaty partner in which they have operations changed its law and the US company was denied treaty benefits on income from the treaty partner. It presumably also will be necessary to have a publicly-available system identifying partially terminated treaties so withholding agents are able to properly comply.

Exempt Permanent Establishments

Finally, the proposals would add a new section to the general scope article that would address certain income received through a permanent establishment ('PE'). Broadly, if a treaty resident receives income from the other treaty partner that is attributable to a PE outside the residence jurisdiction, treaty benefits will not apply to that income if either (i) the profits from the PE are subject to a combined aggregate effective rate of tax in the jurisdiction of residence and the PE jurisdiction of less than 60% of the generally applicable company tax rate in the residence state, or (ii) the PE is in a jurisdiction that does not have a comprehensive treaty with the source state (unless the treaty resident includes the income in its tax base).

One immediately apparent concern is that the draft technical explanation indicates that the principles of Section 954(b)(4) of the US Internal Revenue Code should apply for purposes of determining the combined aggregate effective tax rate under the first test. Section 954(b)(4) excludes income that is subject to 'high foreign taxes' from 'Subpart F' income under the US 'controlled foreign corporation' rules. However, this rule generally applies US tax principles when calculating the effective tax rate, which likely are different from the principles upon which a treaty partner resident would calculate its effective tax rate under local law. A requirement to determine the 'aggregate effective tax rate' applicable to the profits of the PE under US tax principles seems to be an unnecessarily complex approach (as with the 'subsequent changes' provision).

Conclusion

These proposals represent significant changes to the US Model that ultimately may make treaty qualification more difficult and could significantly limit treaty benefits. Although many of the policy reasons for the proposals are understandable, the proposals as currently drafted raise some significant concerns regarding interpretation, as well as practical hurdles that must be overcome in order for the relevant parties (including treaty claimants, advisors and withholding agents) to accurately identify and comply with their obligations. Treasury requested comments on the proposals and many areas of concern have been identified but the extent to which any of these concerns are addressed in the final provisions and/or the accompanying technical explanations remains to be seen.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Kristin Konschnik
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions