On February 17, 2016, the U.S. Treasury Department published a
revised model income tax convention (the "New Model
Treaty") to replace the prior 2006 version. (Treasury also
expects to publish a Technical Explanation to provide additional
guidance this spring.) Model tax treaties generally serve as
Treasury's opening position when negotiating bilateral income
tax treaties with other countries. The New Model Treaty differs
from prior versions for its emphasis on not simply preventing
double taxation but also preventing and policing instances of
double nontaxation and perceived treaty abuses. The policies
underlying this new, more restrictive New Model Treaty are part of
a larger shift in the international tax landscape, including, in
particular, the OECD's Base Erosion and Profit Shifting
("BEPS") Project.
While the New Model Treaty includes technical corrections and
existing Treasury policies already reflected in more recent U.S.
tax treaties, it also contains a number of significant departures
from the status quo. Treasury previewed the most significant of
these changes last May when it released drafts of five new
provisions (the "2015 Drafts"). All of these new
provisions appear in the final New Model Treaty, although they have
generally been fleshed out to provide more detail and modified (to
varying degrees) to incorporate comments received from the public.
As a general matter, most of the changes—with only a few
exceptions—will have the effect of making it more difficult
for taxpayers to qualify for treaty benefits. Also notable,
although not unexpected, is Treasury's rejection of a number of
the recommendations contained in the final BEPS Project report. For
example, the New Model Treaty does not generally treat
commissionaire arrangements as giving rise to permanent
establishments, nor does it include a general anti-abuse rule
denying treaty benefits if one of the "principal
purposes" of a transaction is to obtain treaty benefits.
As a practical matter, the release of the New Model Treaty does not
immediately affect existing U.S. tax treaties. Its new provisions
have no effect until incorporated into new or amended treaties, and
this is likely to take several years, as each existing treaty will
need to be renegotiated. This delay may be further exacerbated by
the U.S. Senate's current disinclination to ratify tax
treaties. (Due to a political stalemate, none has been ratified
since 2010.) Although the United States has agreed to participate
in the development of a multilateral instrument intended to
streamline and expedite the modification of existing bilateral tax
treaties in order to implement the changes mandated by the BEPS
Project, it is not anticipated that the United States will actually
sign on to such an instrument.
Although not likely to be effective in the short term, these
proposals in the New Model Treaty are nevertheless significant, as
they indicate Treasury's most recent viewpoint and are likely
to be included in future U.S. tax treaties or protocols to existing
treaties. Accordingly, prudent taxpayers planning cross-border
transactions that rely on existing treaty benefits would be
well-advised to keep these proposals in mind. The most important of
these key changes include new or modified provisions addressing:
(i) special tax regimes, (ii) anti-inversion rules, (iii)
triangular permanent establishments, (iv) limitation on benefits,
(v) subsequent changes in law, and (vi) mandatory binding
arbitration.
Special Tax Regimes
One set of new provisions would deny basic treaty benefits for
certain related-party payments of highly mobile income if the
recipient benefits from a "special tax regime" on such
income in its country of residence. Consistent with the BEPS
Project, these provisions are intended to eliminate opportunities
for low or no taxation. Article 3 of the New Model Treaty generally
defines a special tax regime as any statute, regulation, or
administrative practice that results in low (or no) effective
taxation due to a reduced tax rate or tax base for interest,
guarantee fees, and/or royalties (assuming insufficient nexus
between the royalties and related research and development). To be
deemed a special tax regime requires a country to impose an
effective tax rate of less than the lesser of (i) 15 percent or
(ii) 60 percent of the general corporate tax rate applicable in the
other country. Such a preferential tax rate would also be
considered a special tax regime if it applies to substantially all
of a company's income (rather than singling out only select
types of mobile income) if the company can benefit from the rate
without actively engaging in a trade or business. The definition of
special tax regime does carve out certain exceptions, however,
including for pension funds, charitable organizations and certain
collective investment vehicles such as RICs and REITs.
Although the introduction of the special tax regime rules reflects
a significant departure from the 2006 version, the New Model
Treaty's definition of "special tax regime" is
considerably narrower than the one that appeared in the 2015
Drafts. Further, in response to comments to the 2015 Drafts,
Treasury also added a (sensible) requirement for consultation with
the treaty partner and written public notice before any statute,
regulation, or administrative practice could be treated as a
special tax regime.
The United States proposed substantially similar "special tax
regime" language for inclusion by the OECD as part of the BEPS
Project, and the final Action 6 report (preventing treaty abuse)
adopted draft proposals based on the 2015 Drafts. Presumably the
revised language of the New Model Treaty will also be taken into
consideration by the OECD in negotiation of the multilateral
instrument under Action 15. Accordingly, even if the United States
never signs onto the multilateral instrument and the U.S. Senate
never ratifies another treaty, U.S.-based multinational
corporations may still find themselves subject to treaties
containing special tax regime rules sooner rather than later.
Anti-Inversion Rules
The new anti-inversion provisions contained in the New Model Treaty
represent another step in Treasury's ongoing effort to
disincentivize inversions by U.S. companies by generally denying
treaty benefits on certain payments of dividends, interest,
royalties, and guarantee fees made by an expatriated entity within
10 years of its expatriation. In contrast to the 2015 Drafts, the
New Model Treaty limits the denial to related-party payments. The
New Model Treaty defines an "expatriated entity" by cross
reference to the anti-inversion rules in section 7874 of the
Internal Revenue Code. (In general, an expatriated entity under
section 7874 is a foreign corporation that acquired substantially
all of the assets of a U.S. corporation if, after such acquisition:
(i) at least 60 percent of the stock of the foreign corporation is
held by former shareholders of the U.S. corporation and (ii) the
foreign corporation (or its affiliates) does not have substantial
business activities in the country in which it is
incorporated.)
In order to provide certainty about the scope of these rules, the
New Model Treaty fixes the definition of "expatriated
entity" to its domestic statutory definition as of the date
the relevant U.S. tax treaty is signed (in order to insulate it
from future legislative changes). As a practical matter, it is not
clear whether Congress will allow a treaty to preemptively override
future legislation. What is clear, however, is that suffering full
U.S. withholding for 10 years will affect the cost–benefit
analysis for doing an inversion.
Triangular Permanent Establishments
The new triangular permanent establishment ("PE")
provision contained in Article 1 addresses the treatment of income
in situations in which a resident of one treaty country (residence
country) earns income from the other treaty country (source
country) through a PE situated outside of the residence country
(usually in a third state), and such income is subject to
significantly lower (or no) tax than it would have been if it had
been earned in the residence country. The New Model Treaty
generally denies treaty benefits for such income: (i) if the
aggregate effective tax rate imposed on the income by the residence
country and PE country is less than the lesser of 15 percent or 60
percent of the general corporate tax rate in the residence state;
or (ii) if the residence country does not tax the income
attributable to the PE, and the PE is situated in a third country
that does not have a comprehensive income tax treaty with the
source state.
For example, assume the United States has an income tax treaty with
country T but has no treaty with country NT. ForeignCo is a
resident of country T and has a PE in country NT. Although country
T imposes a general corporate income tax of 20 percent, it does not
impose tax on income earned through PEs located outside of country
T. Country NT does not impose an income tax. Under these
circumstances, if a U.S. company were to pay interest to
ForeignCo's PE, the interest income would not be subject to tax
in either country T or country NT. Accordingly, this new provision
would deny treaty benefits with respect to the interest
payment.
A number of more recent U.S. tax treaties already include similar
rules denying benefits for triangular PE arrangements in the
Limitation on Benefits provisions. This new rule, however, is
broader and appears in the General Scope provision, thus removing
the affected income from the scope of a treaty entirely. Note that
this provision affects all types of income (i.e., it is not limited
to only highly mobile income) and does not contain an active
business exception similar to the ones found in some of the current
U.S. tax treaties with comparable triangular PE rules.
Limitation on Benefits
The New Model Treaty contains a number of revisions to the
Limitation on Benefits ("LOB") rules in Article 22. In
general, although a few additions are "pro-taxpayer,"
these new rules, as well as the modifications to the existing
rules, are principally designed to prevent treaty shopping abuses
by making it more difficult for third-country residents to qualify
for benefits under a U.S. tax treaty. For example, although new
derivative benefits and headquarters tests were added, they are
generally more limited than the similar derivative benefits and
headquarters provisions contained in existing U.S. tax treaties due
to the addition of a restrictive base erosion component. This base
erosion test was also newly added to the existing publicly traded
subsidiary test, and the base erosion component of the existing
ownership/base erosion test was similarly made more
restrictive.
Additionally, although Treasury broadened the scope of entities
that can potentially qualify as equivalent beneficiaries (under the
derivative benefits test) and intermediate owners (under the
various ownership-based tests) by removing the geographical
restrictions—i.e., previously only entities resident in a
treaty country or an EU/NAFTA member country were
permissible—any such geographically diverse owners are now
subject to a number of additional restrictions. Critically, one of
these new restrictions requires that any such intermediate owners
be resident in a country that has in effect a comprehensive tax
treaty containing rules addressing special tax regimes and notional
interest deductions. The current count of such treaties is zero.
Accordingly, these more "relaxed" definitions have no
effect in practice (yet) and are likely intended more as inducement
for treaty partners to adopt similar provisions in their
treaties.
Finally, the New Model Treaty makes discretionary LOB relief by a
competent authority expressly contingent on a taxpayer having
"substantial nontax nexus" to its residence state. Even
though this new standard is not yet part of any existing U.S. tax
treaty, the Internal Revenue Service has already indicated its
intention to use this standard when evaluating discretionary grants
under current treaties—i.e., it will substitute this new
standard when making discretionary LOB determinations, as well as
require that the relevant income not benefit from any special tax
regimes or double nontaxation.1
Subsequent Changes in Law
Treasury added Article 28 to the New Model Treaty to address
situations in which, after a treaty is signed, one of the countries
changes its corporate tax system to no longer impose significant
tax on cross-border income—either by adopting a territorial
tax system or reducing the statutory corporate tax rate below the
lesser of (i) 15 percent or (ii) 60 percent of the general
corporate tax rate applicable in the other country. If such a
change in law were to occur, following the requisite consultation
and provision of notice, treaty benefits would cease to have effect
for payments of dividends, interest, royalties, and other income.
This rule represents a retreat from the harsher version that
appeared in Treasury's 2015 Drafts, which was not limited to
corporate tax laws, did not first require consultation, and would
have been triggered solely by a drop in a country's tax rate
below 15 percent (regardless of the other country's tax
rate).
In general, Treasury's position is that such a fundamental
change of law could call into question the original balance of
negotiated benefits and the extent to which the treaty remains
necessary to eliminate double taxation (while increasing
opportunities for low or no taxation). It is likely this new rule
reflects Treasury's concern that certain treaty partners that
currently use rulings or other special regimes to attract foreign
investment may ultimately adopt low(er) rates across the board in
response to the BEPS Project and the European Commission's
ongoing state aid investigations. Practically speaking, this
provision appears aggressively designed to try to discourage treaty
partners from doing this in the first place—or to at least
force them to take the treaty consequences into consideration
before making such changes to domestic law.
Mandatory Binding Arbitration
Treasury has been a consistent and outspoken advocate in recent
years for the use of mandatory binding arbitration for resolving
disputes between treaty partners. Indeed, Treasury made its case
(albeit somewhat unsuccessfully) to the OECD as part of the BEPS
Project, and seven existing U.S. tax treaties already contain
similar provisions. Article 25 of the New Model Treaty memorializes
Treasury's preference for this approach and provides detailed
guidance on how the mechanisms of such a "last best
offer" arbitration process would work. The inclusion of this
new provision comes as no surprise. Indeed, Treasury is also
currently participating in the development of a multilateral
instrument as part of the BEPS Project principally to advance this
preference for mandatory binding arbitration.
Other Changes
The New Model Treaty contains a number of additional changes,
including:
Denying treaty benefits for related-party interest payments if the
recipient benefits from notional deductions with respect to amounts
the residence state treats as equity;2
Introducing 12-month holding and residency requirements for the 5
percent withholding rate on dividends;
Increasing certain exemption thresholds for income earned by
students, artists, and athletes; and
Fleshing out the definition and treatment of pension funds,
including the addition of a protocol that will enable treaty
partners to expressly define what qualifies as a pension fund in
each country.
Footnotes
1. See Rev. Proc. 2015-40, 2015-35 I.R.B. 236.
2. In the 2015 Drafts, tax regimes that permitted notional interest deductions ("NIDs") with respect to equity were treated as "special tax regimes." The New Model Treaty no longer treats such regimes as special tax regimes and instead more narrowly addresses Treasury's underlying concern with NIDs—i.e., that interest income benefitting from a NID is often subject to little (or no) taxation—by permitting the source country to (also) tax the interest beneficially owned by a related person benefitting from a NID.
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