Foreign persons are subject to U.S. federal income tax on a limited basis. Unlike U.S. persons who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income: 1) certain types of passive U.S.-source income (e.g., interest, dividends, royalties, and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP), which are subject to a 30 percent gross basis withholding tax; and 2) income that is effectively connected to a U.S. trade or business (ECI), which is taxed at graduated tax rates applicable to U.S. persons.1
Although the statutory rate of withholding on U.S.-source payments of FDAP income to a foreign person is 30 percent, most, if not all, income tax treaties concluded by the United States reduce or even eliminate the U.S. withholding tax on payments of dividends, interest, royalties, and certain other types of income.
To be eligible for treaty benefits, the taxpayer must be considered a resident of a particular treaty jurisdiction and, in the case of most modern income tax treaties, must satisfy the treaty’s limitation on benefits (LOB) provision. The purpose of the LOB provision is to prevent treaty shopping, defined by the Treasury as the “use, by residents of third states, of legal entities established in a [c]ontracting [s]tate with a principal purpose to obtain the benefits of a tax treaty between the United States and the other [c]ontracting [s]tate.”2
Each LOB article sets forth a number of objective tests, which, if satisfied, will entitle the resident to treaty benefits, even if the resident was formed or availed of for a tax-avoidance purpose. The most common of these tests include 1) a public company test; 2) an ownership and base erosion test; 3) an active trade or business test; and 4) in some cases, a derivative benefits test.3
Derivative Benefits Provision
The purpose of the derivative benefits provision is to ensure that an entity owned by nonresident shareholders (i.e., equivalent beneficiaries) may qualify for treaty benefits, even if the other LOB tests are not satisfied, when it is clear that such entity was not used for treaty-shopping purposes. To qualify for treaty benefits under the derivative benefits test, a specified percentage (typically 95 percent) of an entity’s shares must be owned, directly or indirectly, by seven or fewer equivalent beneficiaries and a base erosion test must be satisfied.
An “equivalent beneficiary” generally means any person that:
- In connection with certain European country treaties, is a resident of a member state of the EU, any state of the European Economic Area (EEA), a party to NAFTA, or in some cases Switzerland or Australia (a qualifying country);
- Is entitled to the benefits of a comprehensive income tax treaty concluded between such qualifying country and the contracting state from which treaty benefits are claimed and satisfies certain LOB requirements (even if that treaty has no LOB article); and
- In the case of dividends, interest, royalties, and possibly certain other items (such as insurance premiums), would be entitled under the treaty between the qualifying country and the contracting state in which the income arises, to a rate of tax with respect to the particular class or item of income for which benefits are claimed that is “at least as low as” the rate provided for under the treaty between the contracting states.
The following U.S. income tax treaties currently in effect contain a derivative benefits provision within the LOB article:
- Belgium — applies to residents of the EU, EEA, NAFTA countries, and Switzerland.
- Canada — applies to any jurisdiction that has an income tax treaty with the United States.
- Denmark — applies to residents of the EU, EEA, and NAFTA countries.
- Finland — applies to residents of the EU, EEA, NAFTA countries, and Switzerland.
- France — applies to residents of the EU and NAFTA countries.
- Germany — applies to residents of the EU, EEA, and NAFTA countries.
- Iceland — applies to residents of the EU, EEA, and NAFTA countries.
- Ireland — applies to residents of the EU and NAFTA countries.
- Jamaica — applies to any jurisdiction that has an income tax treaty with the United States.
- Luxembourg — applies to residents of the EU and NAFTA countries.
- Malta — applies to residents of the EU, EEA, NAFTA countries, and Australia.
- Mexico — applies to residents of NAFTA countries.
- Netherlands — applies to residents of the EU, EEA, and NAFTA countries.
- Sweden — applies to residents of the EU, EEA, NAFTA countries, and Switzerland.
- Switzerland — applies to residents of the EU, EEA, and NAFTA countries.
- United Kingdom — applies to residents of the EU, EEA, and NAFTA countries.
The “at least as low” requirement is designed to prevent residents of a third country from using an entity than is a resident of one of the contracting states to obtain a more favorable rate of withholding tax on payments sourced in the other contracting state that would otherwise be available to them. The question, therefore, is what benefits would a foreign person that is resident in a third-country treaty jurisdiction derive from using an entity that is resident in another treaty jurisdiction under the derivative benefits article, if such person cannot qualify for a lower rate of U.S. withholding tax. The answer is the ability to gain access to more favorable local tax benefits, such as 1) a lower corporate income tax rate; 2) a favorable regime for the taxation of intellectual property; 3) a participation exemption on dividends and capital gains; 4) no outbound withholding tax on interest, dividends, or royalties; 5) no CFC rules; 6) no thin capitalization rules; 7) a better treaty network; and 8) no transfer pricing rules.
For example, assume residents of France wish to lend money to the United States to finance the acquisition of U.S. real property. Instead of investing by way of a corporation that is resident in France, where the effective corporate income tax rate is approximately 34 percent, the French taxpayers capitalize a corporation in Switzerland with equity, which in turn lends money to the United States. Switzerland has an 8.5 percent effective federal corporate income tax rate, no withholding taxes on interest and royalties, and a favorable participation exemption for dividends and capital gains. Both the U.S.-France and the U.S.-Switzerland income tax treaties provide for a 0 percent withholding on interest.
The French residents would qualify as equivalent beneficiaries under the U.S.-Switzerland income tax treaty because 1) they are residents of a member state of the EU; 2) they would appear to qualify for benefits under the U.S.-France income tax treaty as individuals who are residents of France; and 3) the withholding tax rate on interest under the U.S.-France treaty is at least as low as the withholding tax rate on interest under the U.S.-Switzerland treaty. Therefore, the French taxpayers would have the ability to gain access to more favorable local tax benefits in Switzerland by qualifying under the derivative benefits article.
Different Types of Equivalent Beneficiaries
As noted above, each treaty has a specific definition of when an equivalent beneficiary can be resident for tax purposes. For example, the U.S. income tax treaties with Belgium, Sweden, and Finland allow an equivalent beneficiary to be resident in any jurisdiction within the EU, EEA, a NAFTA country, or Switzerland. Moreover, the U.S. income tax treaties with Canada and Jamaica allow an equivalent beneficiary to be resident in any jurisdiction that has an income tax treaty with the United States. These treaties should be contrasted with the treaty with Mexico, in which equivalent beneficiaries are limited to residents of NAFTA countries.
In addition to the residency requirement, however, each treaty has a specific requirement as to what provision of the LOB article the equivalent beneficiary needs to satisfy in order for the derivative benefits test to be met. Most treaties with derivative benefits articles require the equivalent beneficiary to be a resident that is either 1) an individual; 2) a government entity; 3) a publicly traded entity; or 4) a pension fund or other tax-exempt entity. Under these treaties, the equivalent beneficiary cannot qualify under the 1) ownership/base erosion test; or 2) the active trade or business test of the qualifying country. The treaties that contain this provision include the treaties with Belgium, Denmark, Finland, France, Germany, Iceland, Malta, Mexico, the Netherlands, Sweden, and Switzerland.4
These treaties also require that if the qualifying country’s treaty with the United States has no LOB provision, the equivalent beneficiary would be entitled to treaty benefits only if it qualified under one of the four tests described above (i.e., it is 1) an individual; 2) governmental entity; 3) publicly traded entity; or 4) a pension fund or other tax-exempt entity) as set forth in the treaty between the United States and the other contracting state.
For example, assume residents of Bermuda establish a company in Norway, which in turn forms a subsidiary in Switzerland to lend money to a related U.S. subsidiary. The current U.S.-Norway income tax treaty has no LOB provision. The rate of withholding on interest under both the U.S.-Norway and the U.S.-Switzerland income tax treaties is zero.
The interest paid from the United States to Switzerland would not qualify for treaty benefits under the U.S.-Switzerland income tax treaty. The Norwegian company would not be treated as an equivalent beneficiary under the U.S-Switzerland income tax treaty because it is not 1) an individual who is resident in Norway; 2) a Norwegian governmental entity; 3) a publicly traded Norwegian company; or 4) a Norwegian pension or other tax-exempt entity. This same result would apply even if the Norwegian company had an active trade or business in Norway, or satisfied the ownership/base erosion test under the U.S.-Switzerland income tax treaty.
The income tax treaties with Luxembourg5 and Ireland, on the other hand, allow the equivalent beneficiary to satisfy the derivative benefits provision by qualifying under the active trade or business test (as well as by satisfying one of the four tests described above).6 For example, assume residents of Bermuda establish a U.K. company that has an active trade or business in the U.K. Also assume that the U.K. company establishes a subsidiary in Luxembourg that owns intellectual property that is licensed to the United States. The rate of withholding on royalties under both the U.S.-Luxembourg and U.S.-U.K. income tax treaties is zero. Luxembourg has a favorable regime for the taxation of intellectual property resulting in an effective corporate income tax rate of approximately 5 percent.
The royalties paid from the United States to Luxembourg would qualify for the 0 percent withholding rate under the U.S.-Luxembourg income tax treaty because the U.K. company would be an equivalent beneficiary, despite the fact that it is owned by nonresidents of the U.K., is not publicly traded in the U.K., is not a U.K. governmental entity, and is not a U.K. pension fund. This provides a significant opportunity for third-country investors to qualify for Luxembourg’s favorable regime on the taxation of intellectual property whenever a company that is resident in a member state in the EU or is a party to NAFTA has an active trade or business in that jurisdiction and desires to license intellectual property to the United States, so long as a lower rate of withholding on the royalties is not being obtained.
- Individuals as Equivalent Beneficiaries — While the issues described above appear relatively straightforward, a number of interesting issues arise when analyzing the derivative benefits article of certain income tax treaties. One of these issues relates to whether individuals can be treated as equivalent beneficiaries with respect to U.S.-source dividends when the rate of withholding on those dividends would be higher if they were received directly from a U.S. corporation when compared to the rate of withholding that applies when the dividends are paid directly to an entity owned by the equivalent beneficiaries.
For example, assume that a U.S. company pays a dividend to a company that is resident in Luxembourg. The Luxembourg company has two equal shareholders, a corporation resident in the U.K. and an individual resident in the U.K. Both are residents of a member state of the EU. Each person’s proportionate share of the dividend payment is 50 percent. If the U.K. corporation had received this portion of the dividend directly, it would be subject to a withholding tax of 5 percent under U.S.-U.K. income tax treaty. If, on the other hand, the individual had received his or her portion of the dividend directly, it would be subject to a withholding tax of 15 percent under the U.S.-U.K. income tax treaty. These rates are the same rates that would apply if both the U.K. corporation and the U.K. individual were residents of Luxembourg.
The question is whether the Luxembourg company would be entitled to the 5 percent withholding tax rate on the dividend, even though the rate of withholding on U.S.-source dividends paid to individuals who are resident in the U.K. would be 15 percent. Logically, it would not seem possible to satisfy the “at least as low” test because the 15 percent rate is clearly not at least as low as the 5 percent rate. Interestingly, the Exchange of Notes and the Technical Explanation (from where the example above was taken) to the U.S.-Luxembourg income tax treaty suggests a different outcome.
The Exchange of Notes provides the following:
For purposes of determining under subparagraph 4(c) if a comprehensive income tax [c]onvention between one of the [c]ontracting [s]tates and a third [s]tate provides with respect to dividends a rate of tax that is equal to or less than the rate of tax provided under the [c]onvention, it is understood that the following two tax rates must be compared:
- the rate of tax to which each of the persons described in subparagraph 4(a) would be entitled if they directly held their proportionate share of the shares that gave rise to the dividends; and
- the rate of tax to which the same persons, if they would be residents of the [c]ontracting [s]tate of which the recipient is a resident, would be entitled if they directly held their proportionate share of the shares that gave rise to the dividends.
In other words, when applying the derivative benefits provision of the U.S.-Luxembourg treaty to dividends, so long as the individual withholding tax rates are the same under both the U.S.-Luxembourg income tax treaty and the U.S. income tax treaty with the qualifying country, treaty benefits will be granted, even if a lower withholding tax ultimately applies. The U.S.-Ireland income tax treaty applies this provision in the same manner.
The question is whether this rate comparison test could be extended to other income tax treaties, especially those in which the withholding tax rate on dividends is reduced to zero. For example, assume an individual resident in Canada forms a wholly owned subsidiary in the U.K., which in turn owns 100 percent of the stock of a U.S. subsidiary. Under the U.S.-U.K. income tax treaty, the U.K. company qualifies for the 0 percent withholding tax rate on dividends if it satisfies the derivative benefits provision.
If the rate comparison test set forth in the Exchange of Notes and Technical Explanation to the U.S.-Luxembourg treaty applied, the U.K. company would be eligible for the 0 percent rate on dividends because the withholding rate on dividends paid to individuals is 15 percent under both the U.S.-U.K. income tax treaty and the U.S.-Canada income tax treaty. Given that the U.S.-Canada income tax treaty does not have a zero withholding tax rate on dividends, this type of planning would permit the Canadian resident to reduce the U.S. withholding tax on dividends by choosing to form a U.K. holding company instead of, for example, a Canadian holding company. Because no other technical explanations or exchange of notes other than those relating to the U.S.-Luxembourg and U.S.-Ireland treaties contain such favorable language, it is not clear whether a similar analysis can be applied to other treaties.
- Failing the “at Least as Low” Test — Another issue that arises when applying the derivative benefits test to dividends is what happens when the equivalent beneficiary fails the “at least as low” test. The question is whether the dividend would be subject to a 30 percent U.S. withholding tax or whether the dividend still can be eligible for a reduced rate of withholding under the treaty.
The following is an example from the technical explanation to the U.S.-U.K. income tax treaty:
USCo is a wholly owned subsidiary of UKCo, a company resident in the United Kingdom. UKCo is wholly owned by FCo, a corporation resident in France. Assuming UKCo satisfies the requirements of paragraph 3(a) of art. 10 (Dividends), UKCo would be eligible for a zero rate of withholding tax. The dividend withholding rate in the treaty between the United States and France is 5 percent. Thus, if FCo received the dividend directly from USCo, FCo would have been subject to a 5 percent rate of withholding tax on the dividend. Because FCo would not be entitled to a rate of withholding tax that is at least as low as the rate that would apply under the [c]onvention to such income (i.e., zero), FCo is not an equivalent beneficiary within the meaning of paragraph 7(d)(i) of art. 23 with respect to zero rate of withholding tax on dividends.
The example concludes that the French company “is not an equivalent beneficiary...with respect to zero rate of withholding tax on dividends,” which seems to imply FCo may be treated as an equivalent beneficiary as to some other rate of withholding on dividends. The question is whether this is the right result. It would appear that the “at least as low as” requirement either is satisfied and treaty benefits are available, or the test is not satisfied and treaty benefits are not available.
The Technical Explanation to the U.S.-U.K. income tax treaty contains the following additional example that has a more favorable conclusion.
A U.K. resident company, Y, owns all of the shares in a U.S. resident company, Z. Y is wholly owned by X, a German resident company that would not qualify for all of the benefits of the U.S.-Germany income tax treaty but may qualify for benefits with respect to certain items of income under the “active trade or business” test of the U.S.-Germany treaty. X, in turn, is wholly owned by W, a French resident company that is substantially and regularly traded on the Paris Stock Exchange. Z pays a dividend to Y. Y qualifies for benefits under paragraph 3 of [art.] 23, assuming that the requirements of subparagraph 3(b) of [art.] 23 are met. Y is directly owned by X, which is not an equivalent beneficiary within the meaning of subparagraph 7(d)(i) of [art.] 23 (X does not qualify for all of the benefits of the U.S.-Germany tax treaty). However, Y is also indirectly owned by W and W may be an equivalent beneficiary. Y would not be entitled to the zero rate of withholding tax on dividends available under the [c]onvention because W is not an equivalent beneficiary with respect to the zero rate of withholding tax since W is not eligible for such rate under the U.S.-France income tax treaty. W qualifies as an equivalent beneficiary with respect to the 5 percent maximum rate of withholding tax because (a) it is a French resident company whose shares are substantially and regularly traded on a recognized stock exchange.
The example concludes that W, the French company, qualifies as an equivalent beneficiary with respect to the 5 percent rate of withholding tax, even though it is not entitled to the zero withholding rate to which Y, the U.K. company, would have been entitled if it qualified for treaty benefits. A similar example appears in the Memorandum of Understanding relating to the 2004 protocol to the U.S.-Netherlands Income Tax Treaty. Because these examples are limited to the U.S.-U.K. and U.S.-Netherlands income tax treaties, it is not clear whether this result would apply in the case of other treaties.
LOB provisions, in general, are designed to prevent treaty shopping by third-country residents. As illustrated above, however, not only can the derivative benefits article be utilized to obtain a more favorable local tax regime, but certain treaties actually may allow third-country residents to achieve a lower rate of withholding by investing through a corporation resident in another jurisdiction than would otherwise be available if those residents invested directly in the United States.
This article was first published on FloridaBar.org.