By
Marshall J. Langer, London, UK
The typical bilateral income tax treaty provides benefits in the form of reduced tax rates and exemptions on income such as dividends, interest and royalties paid to companies or individuals who are residents of the other treaty country. Apart from special steps limiting treaty benefits, there is nothing to prevent someone who really lives in a third country from forming a closely-held company in one treaty country and using it to invest in the other treaty country, a practice sometimes called treaty shopping. Some countries have used judicial theories to block treaty shopping in cases allegedly involving the abuse of law. Others have inserted clauses into their tax treaties blocking the use of companies that could be used for treaty shopping, such as Luxembourg’s 1929 holding companies. A few countries have enacted laws that deny treaty benefits to otherwise- qualified companies that are not sufficiently taxed in the other treaty country. All recent US tax treaties contain a limitation on benefits article designed to prevent treaty shopping.
During the 1960s and 1970s, many thousands of foreign individuals had formed offshore companies in places such as the Netherlands Antilles and the British Virgin Islands and had used their companies to invest in the United States. In a typical case, Juan Sanchez of Panazuela formed a Netherlands Antilles company called Aardvark Investments NV. The company received dividends from US corporations at a reduced 15% rate and it paid the Netherlands Antilles a tax of less than 3%. Even better, it received otherwise taxable US interest and royalties free of US tax and it paid the Antilles a tax of from 2.4% to 3%. Amendments made to the treaty failed to reduce the use of the Netherlands Antilles-US treaty for treaty shopping and the United States eventually terminated the treaty and began inserting anti-treaty shopping clauses in all new and amended tax treaties.
Some older US tax treaties still in force contain provisions blocking the use of holding or investment companies to obtain reduced rates of tax on dividends, interest, royalties or capital gains. For example, Article 27 of the current US tax treaty with Iceland provides that an Icelandic corporation deriving US dividends, interest, royalties or capital gains is not entitled to treaty reductions and exemptions with respect to those types of income if by reason of special measures the tax imposed by Iceland on the corporation is substantially less than Iceland’s normal corporate income tax rate, unless more than 75% of the corporation is owned directly or indirectly by individual residents of Iceland or US citizens. Similar provisions are still found in the current US tax treaties with Egypt, Korea, Morocco, Norway, and Trinidad and Tobago. The United States is actively negotiating new tax treaties with Iceland and Norway that should replace the current treaties with those countries within the next few years. The proposed new US tax treaties with Iceland and Norway will undoubtedly contain comprehensive limitation on benefits articles.
Surprisingly, the United States still has some very old (one might say ancient) tax treaties in force that do not contain any provisions limiting treaty benefits. These tax treaties, and the years in which they were signed, are with: Greece (1950), Pakistan (1957), Armenia (1973), Azerbaijan (1973), Belarus (1973), Georgia (1973), Kyrgyzstan (1973), Moldova (1973), Tajikistan (1973), Turkmenistan (1973), Uzbekistan (1973), Romania (1973), Poland (1974), the Philippines (1976) and Hungary (1979). You will note that nine of these are with former members of the USSR.
When the US Senate Foreign Relations Committee approved ratification of the current tax treaty with the Philippines in 1981, it noted the absence of any clause limiting treaty benefits and it requested the Treasury Department to negotiate an anti-abuse provision that followed the principles of the provision in the US model income tax treaty1. Today, more than 25 years later, it appears that the Treasury has never carried out that request.
Does anyone have the guts to use a Turkmenistan holding company to receive US royalties free of any US withholding tax? Article III(1)(a) of the old USSR tax treaty (now the Turkmenistan-US treaty) provides that US royalties are subject to tax only in Turkmenistan. Does anyone in the US Congress, Treasury or Internal Revenue Service even know whether Turkmenistan would tax such income or the tax rate it would impose?
Since the early 1980s, every new US tax treaty has contained an article generally limiting treaty benefits to resident individuals and entities owned by bona fide residents of the two treaty countries. The reason for such a provision is that US legislation imposes a 30% withholding tax on most dividends, royalties, interest and other passive income paid to non-resident alien individuals and foreign corporations investing in the United States. It should not be possible for someone from a third country to reduce or eliminate that US tax by interposing a company formed in a country that has a favourable tax treaty with the United States.
The current US model income tax treaty contains a limitation on benefits article, whereas the current OECD model treaty does not do so. However, the commentary to Article 1 of the OECD model treaty contains a detailed discussion of improper use of a treaty. It contemplates the use of any of several types of anti-abuse measures such as jurisprudential rules, legislation or treaty provisions.
The world now has several thousand tax treaties. Many countries seem to take a more relaxed view of the treaty shopping problem than does the United States. Some have targeted known cases of likely abuse. Most countries don’t consider the problem as worth worrying about. A few countries have dealt with the problem by domestic legislation. Here are some examples:
Luxembourg has a large number of tax treaties in force. Many of these treaties provide that they do not apply to any holding company entitled to any special tax benefit under the Luxembourg Law of 31st July, 1929 or under any similar law subsequently enacted. Thus, Luxembourg’s so-called 1929 holding companies do not generally benefit from Luxembourg tax treaties. These 1929 holding companies are in any case being phased out by Luxembourg since they have been targeted by the European Union.
As noted in last month’s column, recent tax treaties signed by Malaysia with Chile, Luxembourg, Seychelles, South Africa and Spain contain clauses that would deny treaty benefits to persons carrying on offshore business activities under the Labuan Offshore Business Activity Tax Act. Some older Malaysian tax treaties also prevent the use of Labuan companies to obtain treaty benefits. These include Malaysia’s treaties with Australia, Japan, the Netherlands and the United Kingdom.
Korea’s Finance Ministry recently announced that interest, dividends and capital gains derived from Korean investments by Labuan investors are subject to a 2% withholding tax2. The move was intended to ensure that the Korea-Malaysia tax treaty cannot be used by Labuan residents to shelter foreign capital from Korean taxes. Korea had previously announced that it would designate a list of tax havens through which foreign investors will no longer be able to automatically claim treaty benefits3. Investors from such countries will generally be subject to 27.5% Korean withholding tax. Korean tax officials will also review all transactions conducted through these tax havens during the previous five years in an effort to curtail treaty abuse.
Some recent tax treaties contain a “main purpose” provision. For example, Article 23 of the 2005 treaty between Belgium and San Marino provides that a resident of either country is not entitled to treaty relief if it was one of the main purposes of anyone concerned with the creation or assignment of that income item to take advantage of the treaty. The extremely broad scope of that provision is scary.
Similar conditions were imposed in the dividends, interest, royalties and other income articles of the long-pending 1999 Italy-US income tax treaty. The US Treasury’s technical explanation of the treaty noted that such provisions would address abusive transactions that would not be caught by the treaty’s limitation on benefits article.
Some Italian tax treaties give tax authorities even broader discretionary authority to deny treaty benefits in what they consider to be abusive cases. The main purpose test used in the proposed Italy-US treaty was intended to be a compromise between the US and Italian treaty negotiators. Nevertheless, the US Joint Committee on Taxation, in testimony before the Senate Foreign Relations Committee, told the Committee that the treaty’s main purpose test would create considerable uncertainty as to the application of the treaty because the test is subjective and vague. The Committee inserted a reservation that effectively struck the main purpose test from the treaty. Years have passed and the treaty has still not been ratified.
Germany’s 2007 tax act contains a provision designed to prevent both treaty shopping and directive shopping under the EU parent-subsidiary directive4. The new law was enacted because the German authorities considered some recent court decisions to have been overly friendly to taxpayers. Under the new law, a foreign company is not entitled to full or partial treaty relief (or directive relief) from withholding taxes to the extent that the company has shareholders who would not be entitled to the same relief if they received the relevant income directly, if any of three tests applies. Treaty benefits are denied unless the company meets all three of these tests:
• Business purpose test: There must be important business reasons or other non-tax reasons for interposing the foreign company. The official commentary to the law stated that legal liability protection, asset protection and estate planning are not acceptable reasons for interposing a foreign company.
• Gross receipts test: The foreign company must derive at least 10% of its gross income from its own commercial activities, excluding any income it derives from administering its own assets or from activities that have been outsourced to other parties. Reports indicate that this is likely to be a very difficult test for many foreign companies to meet.
• Substance test: The foreign company must maintain its own business infrastructure, such as an office and employees.
The new provision does not apply if the foreign company is a public company and its shares are regularly traded on a stock exchange. Some foreign entities that qualify as foreign investment funds under Germany’s Investment Tax Act may also be exempt even if their shares are not publicly traded. Closely held foreign holding companies are now required to disclose sufficient information to enable German tax authorities to assess the status of their shareholders.
ENDNOTES
1 See Senate Executive Report 97-39 (1981); 1984-2 IRS Cumulative Bulletin 398 (1984).
2 See Tax Analysts Doc 2006-12645, 30 June 2006.
3 See Tax Analysts Doc 2006-4327, 13 March 2006.
4 See Germany Tightens Rules for Foreign Holding Companies, by Christian Ehlermann and Andreas Kowallik, of Deloitte & Touche GmbH, Munich, in Tax Notes International, 8 January 2007, pages 11-17.
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