Once again, the U.S. House of Representatives has introduced the much maligned 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. (See § 12001 of HR 2419, the Food, Conservation, and Energy Act of 2008 (Farm Bill) (July 27, 2007), and § 203 of HR 6275, the Alternative Minimum Tax Relief Act of 2008 (June 25, 2008).) While the new treaty limitation proposal contained in § 451 of the America’s Affordable Health Choices Act (Health Bill) follows the amended version introduced by the Rangel bill (§ 3204 of HR 3970) and not the more restrictive version introduced in the Doggett bill (§ 1, HR 3160), the principal complaint concerning the provision remains applicable, 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 nonetheless can deny treaty benefits to an otherwise eligible taxpayer as discussed below.
Section 451 of the Health Bill proposal would add a new § 894(d) that would not allow the U.S. withholding tax imposed on a deductible related-party payment (e.g., interest, royalties, fees for services) to be reduced under an income tax treaty applicable to the income recipient unless U.S. withholding tax on such payment would also be at a reduced rate if the payment were made directly between the U.S. payer and the 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) but 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 group parent or the treatment of any member of a foreign-controlled group as the common group parent if doing so is appropriate taking into account the economic relationships among the group. The effective date would be prospective, 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 also has reduced withholding tax rates on interest payments (and such U.K. parent corporation presumably 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 by the U.S.-Luxembourg treaty.
By way of comparison, if the foreign common parent corporation were resident in Bermuda, the U.K. member would not be eligible for the reduced withholding tax and, instead, would be subject to the U.S. statutory 30% withholding rate. Although the United States has an income tax treaty with Bermuda, that treaty does not contain any provisions that reduce withholding rates. Obviously, if the foreign parent corporation were resident in a country that does not have an income tax treaty with the United States, the U.K. member also would not be eligible for reduced withholding tax rates.
The health legislation proposal as noted above nonetheless requires a foreign parent corporation to not only be resident in a treaty country but also to meet the limitations on benefits (LOB) requirements. Failure of the limitation on benefits tests will result in treaty benefits being denied. 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 member will be denied the reduced withholding rates otherwise available under the applicable treaty. If the foreign parent meets the active trade or business provision, because each item of income is tested separately under this test, it is possible that one payment (e.g., interest) would qualify for reduced withholding while another payment (e.g., royalty) would not. Thus, the amended provision still has the ability to override a treaty even when the foreign parent is resident in a treaty country.
If enacted, further clarification will be needed to explain how the provision would coordinate with related provisions such as § 7701(l) (conduit financing arrangements), § 884(f) (treaty benefits for branch interest), and § 894(c) (payments through hybrid entities).
One would expect that the immensely complex current version of the limitation of benefits 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, as discussed above, proposed § 894(d) generally limits treaty benefits for deductible related-party 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). The Doggett bill had a broader scope and it limited reduced withholding rates for group members to those withholding rates applicable to the foreign parent corporation. Although for groups headed by a foreign parent corporation that is not eligible for the benefits of a U.S. income tax treaty, the result is the same under either version of the bill, the amended version would require only that the parent corporation be entitled to benefits and not limit the withholding tax rate to that of the parent corporation.
It is interesting to note that the modification of the original Doggett language has not changed the revenue estimate, which remains at $7.5 billion, the same amount estimated for the Doggett provision when it was included in the House version of the Farm Bill. This is somewhat surprising because of the more narrow scope of the amended version of the treaty limitation provision. As noted above, the Doggett bill would not only deny treaty benefits in some cases, but it would also increase the withholding tax rate in other cases. As a result, one would anticipate that the Doggett bill would have had a higher revenue estimate.