Once again, the U.S. House of Representatives has introduced a controversial treaty limitation provision recycled from past bills, some of which have been passed by the House but not enacted into law by the full U.S. Congress.1 While the new treaty limitation proposal contained in § 451 of the America’s Affordable Health Choices Act (Health Bill) follows a narrowly targeted version introduced by the Rangel bill (§ 3204 of HR 3970) and not the more broadly applicable version introduced as the Doggett bill (§ 1, H.R. 3160), the principal complaint concerning both provisions remains, i.e., it is bad tax policy to abrogate U.S. treaty obligations. The U.S. Treasury Department has opposed prior versions of the treaty limitation provision on the basis that it could trigger retaliatory actions by U.S. treaty partners. While this version of the treaty limitation provision is described as targeting tax haven-controlled corporate groups, it too will deny treaty benefits to a resident otherwise eligible to such benefits under the circumstances discussed below.
Section 451 of the Health Bill would add a new § 894(d) that disallows treaty benefits for reduced U.S. withholding tax imposed on a deductible related-party payment (e.g., interest, royalties, fees for services) unless U.S. withholding tax on such payment would also be reduced under an applicable treaty, if the payment were made directly between the U.S. payer and its foreign parent corporation. The term “deductible related-party payment” means a payment made, directly or indirectly, between members of the same foreign-controlled group of entities with a common foreign parent corporation. The foreign-controlled group is measured under § 1563(a)(1) and lowers the rate of ownership from 80% to 50%. The provision also would apply to a partnership or other entity that is treated as a member of the foreign-controlled group if the entity is owned 50% or more by members of that group. The provision provides authority for regulations or other necessary or appropriate guidance, including provisions that would treat two or more persons as one corporation, if such treatment would result in such persons collectively being treated as the common parent of the group, or the treatment of any member of a foreign-controlled group, if doing so is appropriate taking into account the economic relationships among the group. The effective date would be prospective (i.e., applicable to payments made after the date of enactment).
The following example illustrates how the provision would apply. A U.S. corporation is a member of a foreign-controlled group of entities with a U.K. common parent corporation. The U.S. member makes an interest payment to a Luxembourg corporation that is a member of the same group. Because the U.K. common parent is resident in a country with which the United States has reduced withholding tax rates on interest payments (and such U.K. parent corporation is eligible for treaty benefits under the U.S.-U.K. Treaty limitation-on-benefits article), the Luxembourg member will be eligible for the zero rate permitted under the U.S.-Luxembourg Treaty. Though it is not abundantly clear, we would expect that Article 1(8) of the U.S.-U.K. Treaty, in this case, would not invalidate the U.K. common parent’s claim to treaty benefits with respect to the interest payment. Generally, Article 1(8) treats an item of income as eligible for U.S.-U.K. Treaty benefits if such item is viewed as income of the U.K. recipient under U.K. law. Presumably, Article 1(8) would be satisfied since such interest payment would have been viewed as income of the U.K. common parent for U.K. tax purposes if as provided in § 894(d), the U.K. common parent actually received the payment made by the U.S. corporation.
By way of comparison, if the foreign common parent corporation were resident in Bermuda, the Luxembourg recipient member would not be eligible for the reduced treaty withholding tax rate and, instead, would be subject to the U.S. statutory 30% withholding tax rate. Although the United States has an income tax treaty with Bermuda, that treaty does not contain any provisions that reduce withholding rates.
As noted above, proposed § 894(d) requires not only that a foreign parent corporation be a resident in a treaty country, but also that it meets the limitation-on-benefits (LOB) requirements. A foreign parent’s failure of the LOB tests will result in treaty benefits being denied to the actual recipient member of the payment. For example, if the foreign parent is publicly traded but nonetheless does not meet the enhanced requirements for publicly traded corporations, or if the foreign parent is privately owned and fails to meet any of the LOB tests, the recipient member will be denied the reduced treaty withholding tax rates otherwise available to it. If the foreign parent meets the active trade or business provision, because each item of income is tested separately under this LOB test, it is possible that one payment would qualify for reduced withholding while another one would not. Thus, proposed § 894(d) still has the ability to override a treaty even when the foreign parent is resident in a treaty country.
One would expect that the immensely complex current version of the LOB article, as found in Article 22 of the U.S. Model Treaty and in recently revised treaties, would negate a need for an additional limitation on treaty benefits. Nevertheless, there is an apparent belief that the LOB provisions are inadequate to prevent perceived abuses with respect to payments made by a U.S. person to a member of a “haven-controlled” group (i.e., a group whose controlling entity was formed in a jurisdiction that has no treaty with the United States). Thankfully, the original Doggett version was not adopted as it had a broader scope. The original Doggett proposal limited the availability of reduced treaty withholding tax rates on U.S. source payments to recipient group members to those withholding tax rates that would apply if the foreign parent corporation received the U.S. source payment directly. By comparison, proposed § 894(d) would impose no limit on treaty benefits provided that the common parent corporation was entitled to its own treaty benefits.
Despite the significant difference in the scopes of proposed § 894(d) and the original Doggett bill, the revenue estimate for both bills is $7.5 billion. While the scoring is relatively small, proposed § 894(d) may finally be enacted into law as part of any health care legislation, given the urgent need for revenue raisers and the narrow scope of the provision as targeting “havens” abuses.