Tax treaties are a critical part of the global economy. There are more than 3,000 bilateral tax treaties in effect, most of which are based on models from the Organisation for Economic Co-operation and Development and the United Nations. They're essentially agreements between two countries that allow individuals and corporations to avoid the double taxation of income.
Tax treaties can be used in countless situations, from calculating the home- and host-country income taxes of expatriate workers to determining whether a multinational corporation has created a taxable presence in a jurisdiction.
This post looks at one particular situation — that of a corporation benefiting from a tax treaty when financing a cross-border acquisition. This may seem like a narrow subject, but it's an important one that affects many multinational organizations. Cross-border acquisitions continue to be an enormously popular way of achieving corporate growth. 2019 was the fourth-highest year on record for M&A volume, with $3.8 trillion in deal value announced globally, despite the economic uncertainties caused by Brexit and the U.S.-China trade war.
Obviously, financing cross-border M&A deals in an efficient, compliant manner is in the best interest of the acquirer. The application of tax-treaty benefits in this area can result in significant cost savings and should always be considered. Indeed, tax treaties can be seen as one leg in a three-legged stool supporting informed corporate tax structuring, with the other stools being applicable domestic codes (such as IRS regulations) and tax-related domestic court rulings. Tax treaties are a unique element in this example, as the "tax-treaty leg" is the only one involving multiple countries. It should be emphasized, however, that tax treaties in general have provisions limiting benefits that are often overlooked.
A scenario involving a tax treaty and financing a cross-border acquisition
To illustrate how a tax treaty may in some situations help a multinational organization reduce the costs of financing a cross-border acquisition — and to show some treaty limitations — let's look at a common scenario.
A Germany-based multinational called Acquire Co. has subsidiaries in a dozen countries, including a large office in Luxembourg and a small, two-person office in the United States. Acquire Co.'s board decides to expand its U.S. presence by acquiring a 200-employee U.S.-based company that delivers similar services. As is common in multinational groups, Acquire Co. frequently uses one of its entities — in this case the Luxembourg subsidiary — to act in a financing capacity for the organization.
The acquisition in the U.S. will cost $100 million. The Luxembourg subsidiary borrows the equivalent of that amount from a Luxembourg bank that is not affiliated with Acquire Co. The Luxembourg subsidiary then makes a loan to Acquire Co.'s existing U.S. subsidiary to acquire the target company in the U.S. In order to comply with transfer-pricing rules, the Luxembourg subsidiary sets the loan at prevailing market rates. The U.S. subsidiary acquires the target company and then begins making loan payments to the Luxembourg subsidiary.
Under U.S. tax law, the U.S. subsidiary must withhold 30 percent of the interest on the loan payments it makes to the Luxembourg subsidiary and remit the withholdings to the IRS, since the interest is regarded as profit. Because the cash tax payment to the IRS is made by the U.S. company, it may appear that the U.S. company is paying the tax. But the tax is actually assessed on the recipient of the interest, and of course the amount the Luxembourg company receives for the loan has been reduced. In other words, the U.S. company is in effect serving as the IRS's collector, and the Luxembourg subsidiary is ultimately paying the tax.
Because the subsidiary issuing the loan is based in Luxembourg, it and the U.S. subsidiary may look beyond U.S. tax law to the Luxembourg-U.S. tax treaty. The language of the treaty states that, "in general, interest and royalties derived and beneficially owned by a resident of a Contracting State are taxable only in that State."
In this scenario, then, the tax treaty in effect trumps U.S. domestic tax law. The U.S. company does not have to withhold any of the interest on the loan payment, and the Luxembourg subsidiary pays no U.S. federal tax on the interest it receives from the U.S. subsidiary. Instead, the interest is considered taxable income by Luxembourg tax authorities and is taxed at the lower Luxembourg corporate tax rate of 17 percent.
Possible U.S. state taxes and limitations on benefits
Tax treaties in general only affect federal-level taxation. It is always important to keep in mind the state tax implications of any transaction, because they may differ significantly from federal treatment, particularly with respect to cross-border transactions.
Multinational groups must also understand and comply with any tax treaty's limitations on benefits (LOB) article, which addresses the problem of "treaty shopping, " or corporations and individuals seeking to benefit from bilateral tax agreements that aren't intended for them. Action 6 of the OECD's Base Erosion and Profit Shifting program specifically addresses treaty shopping. As the OECD's overview of Action 6 explains, "treaty shopping typically involves the attempt by a person to indirectly access the benefits of a tax agreement between two jurisdictions without being a resident of one of those jurisdictions."
The Luxembourg-U.S. treaty's Article 24 contains its LOB language. The article ensures that only those persons intended to benefit from the treaty do so, by not granting benefits that will ultimately be received by residents of a third country that do not have a substantial business in, or business nexus with, either the U.S. or Luxembourg. The LOB article grants the right to obtain treaty benefits to qualified residents and corporations that meet other requirements, such as that the corporation is traded on the Luxembourg stock exchange or that it is actively engaged in a business in Luxembourg other than managing investments.
In our scenario, the LOB rules would seek to eliminate the possibility that the Germany-based Acquire Co. has in effect been using its Luxembourg subsidiary as a means of benefiting from a tax treaty that is not intended to be applicable to Germany-based companies. Each situation is unique, and tax authorities will take into account various factors when making LOB determinations.
For example, let's assume that, instead of the Luxembourg company borrowing the funds, the German parent borrowed the funds and lent them to the Luxembourg company so the Luxembourg company would be able to make the loan to the U.S. subsidiary. In that case, the IRS would be more likely to treat the loan as if it were between the German company and the U.S. company, in effect disregarding the Luxembourg company. Treaty benefits would likely not be available to the German company under the LOB rules in that scenario, and the arrangement would not result in the desired tax reduction.
Tax treaties, then, can provide significant benefits to corporations in numerous situations — including the financing scenario described here — but treaty rules are complicated and compliance is more important than ever. Tax authorities around the world are intent on eliminating treaty shopping, as the OECD's BEPS program attests. Multinational groups that fail to fully understand and comply with limitations on benefits and other tax-treaty restrictions are at risk of severe tax penalties and widespread reputational damage.
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.