On May 20, 2015, the U.S. Treasury Department (“Treasury”) released five sets of proposed revisions to the U.S. Model Income Tax Convention (“Model Treaty”) for public comment. The Model Treaty was last updated in 2006.
The purpose of the proposed revisions is to ensure that the United States maintains the balance of benefits negotiated under its treaty network as the tax laws of its treaty partners change in ways that create opportunities for base erosion and profit shifting (“BEPS”) and to prevent the U.S. treaty network from encouraging inversions.
The Model Treaty is not binding law, but serves as Treasury’s baseline for negotiating tax treaties. This means that the proposed revisions will only take effect when a treaty partner agrees to them in future negotiations.
The five sets of proposed revisions are discussed below.
Exempt Permanent Establishments
Under this proposal, treaty benefits would be denied where a resident of a contracting state earns income from the other contracting state through a permanent establishment (“PE”) situated outside the residence state and such income is subject to a significantly lower tax rate than the other income of such resident. Specifically, treaty benefits would not apply to certain types of income if they are attributable to a PE situated outside the residence state and either (a) the PE’s profits are subject to a combined aggregate effective tax rate in the residence state and the state in which the PE is situated that is less than 60% of the applicable tax rate in the residence state or (b) the PE is situated in a third state that does not have a comprehensive tax treaty with the contracting state from which the treaty benefits are being claimed, unless the residence state includes the income attributable to the PE in its tax base.
Although certain U.S. tax treaties already include triangular PE anti-abuse provisions, the proposed provision is less favorable, in part, because it would apply not only to PEs located in third countries but also to a branch located in the source country that is treated as a PE by the residence country.
Special Tax Regimes
Under this proposal, the source state would retain its right to tax payments of interest, royalties, and certain other income if the treaty resident claiming benefits is related to the payor of such income and benefits from a “special tax regime” in the residence state that results in low or no taxation.
A “special tax regime” means any legislation, regulation or administrative practice that provides a preferential effective tax rate to interest, royalties or certain other income, including through reductions in tax rate or tax base. For example, obtaining a ruling that foreign source interest is subject to a lower tax rate in the residence state than the rate that generally applies to foreign source interest received by other residents would constitute a special tax regime. In the case of interest, the term would include any legislation, regulation or administrative practice that provides notional deductions with respect to equity.
The new definition of special tax regime would be subject to a number of exceptions. A special tax regime would not include any legislation, regulation, or administrative practice (a) that does not disproportionately benefit interest, royalties or other income (for example, a regime that permits standard tax deductions, accelerated depreciation, loss carryovers, or foreign tax credits would not be a special tax regime), (b) that, with respect to royalties, satisfies a substantial activity requirement designed to incentivize activities that are not of a mobile nature to be conducted in the residence state, (c) that implements the principles of the “Business Profits” or “Associated Enterprises” articles of the Model Treaty (for example, the administrative practice under which an advance pricing agreement is obtained would not be a special tax regime), (d) that applies to certain nonprofits or to pension or retirement providers, (e) that facilitates investment in collective investment vehicles marketed to retail investors that are widely held and hold real property or securities (for example, in the United States this exception would apply to regulated investment companies and real estate investment trusts), or (f) that the contracting states have agreed will not constitute a special tax regime.
Payments from Expatriated Entities
Under this proposal, the United States would impose full withholding taxes on payments of dividends, interests, royalties and certain other income made by an expatriated entity for 10 years following such entity’s date of expatriation.
For a long time, the United States has tried to reduce the tax benefits of inversions through legislation, regulations, and administrative rulings. While these changes have slowed the number of inversions, expatriating still provides tax benefits. This proposed revision to the Model Treaty would prevent the United States’ treaty network from encouraging inversions by reducing yet another tax benefit provided by these types of transactions.
Limitation on Benefits (“LOB”)
Treasury would add a “derivative benefits” test, which would entitle a company that is a resident of a contracting state to treaty benefits if (i) at least 95% of the company is owned, directly or indirectly, by seven or fewer persons that are equivalent beneficiaries (i.e., generally persons that would be entitled to all the benefits of a tax treaty with the contracting state from which the benefits of the tax treaty are claimed) and (ii) a base erosion test is met.
The derivate benefits test used in current U.S. tax treaties usually requires the company’s owners to be residents of EU or NAFTA countries; thus, the proposed derivative benefits test is more favorable in the sense that it does not impose specific geographic restrictions. Nevertheless, other aspects of the proposed derivative benefits test, such as the requirement that intermediate owners must also be equivalent beneficiaries, are less favorable.
Another proposed change would make it more difficult to qualify for treaty benefits under attribution rules for other LOB tests. For example, under existing U.S. tax treaties, holding companies and other entities that do not conduct an active trade or business may qualify for treaty benefits under the “active trade or business” test if they are deemed to conduct the activities of a related person. Under the revised “active trade or business” test, a resident seeking to qualify for benefits under “active trade or business” test will be deemed to conduct activities conducted by a related person only to the extent both the resident and the related person are engaged in the same or complementary lines of business.
Subsequent Changes in Law
This proposed change would give contracting states the option to discontinue certain treaty benefits if either state enacts certain changes to domestic law that implicate treaty terms. Specifically, if the general tax rate that applies to substantially all of a resident’s income falls below 15 percent in either contracting state or either state provides an exemption from taxation to residents for substantially all foreign source income, the provisions that reduce taxes on dividends, interest, royalties and certain other income may cease to have effect. The aim of this proposed change is to avoid unwanted instances of low or no taxation resulting from domestic law changes.
The draft changes, if implemented, would represent significant changes to the Model Treaty. These changes are being proposed at a time where the international community is focused on avoiding double non-taxation through the G20/OECD BEPS project. With these proposals, the United States is addressing the challenging situation of stateless income while also trying to influence and guide the international debate concerning BEPS.