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American Bar Association Business Law Section. Tax Treaties and Anti-Treaty Shopping Initiatives . Edward Tanenbaum, Alston & Bird LLP – Panel Chair. Peter Blessing, Shearman & Sterling LLP John Harrington, International Tax Counsel, U.S. Department of the Treasury.
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American Bar Association Business Law Section Tax Treaties and Anti-Treaty Shopping Initiatives Edward Tanenbaum, Alston & Bird LLP – Panel Chair Peter Blessing, Shearman & Sterling LLP John Harrington, International Tax Counsel, U.S. Department of the Treasury Dr. Klaus Sieker, Flick Gocke Schaumburg Diana Wessells, Alston & Bird LLP Frankfurt May 30, 2008
Topics Covered • Overview of U.S. taxation of foreign persons • Overview of German domestic taxation of foreign investors in Germany • Commentary to Article I of the OECD Treaty on anti-treaty shopping initiatives • U.S., German, and EU statutory anti-treaty shopping initiatives • Overview of U.S. Limitation on Benefits treaty provisions and policy considerations • Overview of German Limitation on Benefits treaty provisions • Related Treaty Provisions • Proposed U.S. anti-treaty shopping provisions • Effect of treaties on structuring international holding companies
Basic Treaty Shopping Example B A • A and B are individuals resident in a country that does not have an income tax treaty with the United States • 30% U.S. withholding tax would apply to payments made directly to A and B by U.S. Corp. • Absent an exception, anti-treaty shopping rules prevent A and B from obtaining zero or a reduced rate of U.S. withholding tax under U.S. – Germany tax treaty. German AG US Corp.
Overview of U.S. International Tax Rules • U.S. persons and foreign persons are taxed differently • U.S. person includes: • U.S. individual (citizen or tax resident) • U.S. corporation (created or organized in the United States) • U.S. partnership (created or organized in the United States) • Any estate (other than a foreign estate – non-U.S. source income and not U.S. trade or business income) • Any trust (if U.S. court supervision and U.S. fiduciary) • A foreign person is a foreign individual who is not a U.S. person (i.e., a non-resident alien individual) or an entity that is formed under foreign law
Overview of U.S. International Tax Rules • Two basic regimes apply to foreign persons: • Effectively connected income regime: • Income effectively connected with the conduct of a trade or business within the United States by a foreign person is subject to U.S. tax on a net income basis (This regime taxes U.S. source income and certain foreign source income as well) • Gains from disposition of U.S. real property interests under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) • Gross basis withholding regime: • Certain types of U.S. source passive income and certain capital gains not effectively connected with a U.S. trade or business are taxed at a flat rate of 30 percent, unless a specific Code exception or treaty benefit applies • Passive income includes dividends, interest, rents, royalties, etc. • Capital gains taxed if non-resident alien present in U.S. for 183 days or more during the year • No benefit of deductions or credits
Overview of U.S. International Tax Rules • Sourcing rules determine if income is U.S. source or foreign source • U.S. source income includes: Dividends paid by U.S. corporations; interest if obligor is a U.S. resident; income from services performed in the United States • Interest from a Swiss bank account is foreign source income
Overview of U.S. International Tax Rules Exemptions from gross withholding tax: • Interest on U.S. bank deposits • Short-term original issue discount • Obligation payable 183 days or less from the date of original issue • Portfolio Interest • Obligation must be in either registered form or bearer form; detailed requirements apply to each • Interest cannot be paid to person owning 10% or more (vote) of obligor • Certain types of contingent interest ineligible • Interest cannot be received by a bank • Treaty exemptions or reductions • U.S. income tax treaties typically reduce or eliminate withholding tax on interest, dividends, and royalties
Overview of U.S. International Tax Rules Collection of Tax • Taxpayers engaged in conduct of U.S. trade or business (or who have U.S. source taxable capital gains ) must file income tax returns • Taxpayers not engaged in a U.S. trade or business do not file if all tax is collected by the withholding agent • If no exemption applies, the withholding agent (typically, the payor) must withhold the 30% tax and file an information return • If an exemption or reduction applies, withholding agent must have certification from payee: • Form W-8 BEN: “beneficial owner” of income and/or entitlement to treaty benefits • Recipient must file “Treaty-Based Return Position Disclosure” with IRS on Form 8833 (some exceptions)
Overview of U.S. International Tax Rules Withholding under FIRPTA • FIRPTA treats gains and losses from U.S. real property interests as effectively connected income, but withholding applies. Includes sale of stock of U.S. Real Property Holding Corporation • Transferee of U.S. real property generally must withhold 10% tax • Disclosure requirements apply Withholding for partnerships • Partnerships required to withhold tax on effectively connected taxable income of foreign partners at highest marginal rate • Foreign partner can claim credit for its share of withholding tax
Overview of U.S. International Tax Rules German Individuals GmbH Sale Div 100% 25% Interest US Co. USRPHC Unrelated US Bank • Dividend subject to 5% withholding tax – U.S. company withholds tax and remits to IRS • Portfolio interest from bank is exempt from tax if not effectively connected with U.S. trade or business • Sale of USRPHC subject to tax at U.S. marginal rates • Transferee (buyer) withholds tax of 10% of purchase price • GmbH files tax return reporting receipt of all items of income and takes credit for 10% advance tax withheld by transferee on sale of USRPHC
Overview of German Domestic Taxation of Foreign Investors in Germany • Foreigners (i.e., non-residents) are subject to German tax on German source income only. • German source income comprises, inter alia (in broad terms): 1. Dividends received from German corporations 2. Royalties from intangibles used in Germany 3. Interest on profit participating loans/silent partnerships 4. Interest if the principal is secured by mortgage of domestic real estate 5. Income from a trade or business for which a German permanent establishment is maintained 6. Income from professional services and employment performed in Germany 7. Income including capital gains from real estate situated in Germany 8. Capital gains earned on shares in German corporations (exceptions apply)
Overview of German Domestic Taxation of Foreign Investors in Germany • Dividends, royalties and interest from profit participating loans/silent partnerships are taxed on a gross basis (i.e., no deductions allowed), the other items of income are taxed on a net basis. • Tax on dividends, royalties and interest from profit participating loans/silent partnerships is collected by way of withholding • Dividends at a rate of 21.1% • Royalties at a rate of 21.1% when earned by individuals and at a rate of 15.825% when earned by corporations • Interest from profit participating loans/silent partnerships at a rate of 26.375%
Overview of German Domestic Taxation of Foreign Investors in Germany • Tax on other items of income is collected by way of assessment (i.e. , non-resident must file a German tax return) • Individuals pay income tax at marginal rates ranging from 26.375% to 47.5% • Corporation tax rate is set at 15.825% • Income earned through a German permanent establishment is further subject to trade tax (Gewerbesteuer) • Trade tax on individuals is creditable against their income tax • Combined corporate tax/trade tax burden for corporations is about 30%
Treaty-based reduction/elimination of German tax on foreign investors • Tax treaties provide eligible foreign investors with benefits, i.e., reduction or elimination of German tax • Reduction of WHT on dividends to a rate of 0%, 5%, 15% • Elimination of WHT on interest and royalties (sometimes reduction to a rate of 10%) • Elimination of German tax on capital gains earned on shares (sometimes exceptions for shares in real estate companies)
EU directive-based elimination of German tax on foreign investors • EU Parent/Subsidiary Directive (dividends), EU Interest and Royalties Directive • Zero WHT on dividends paid to EU resident corporations • Minimum participation of 15% • Minimum holding period of 12 months • Elimination of German tax on interest and royalties paid to an affiliated EU resident corporation or to an affiliated Swiss corporation
Example for treaty/directive shopping by U.S. investors (1) “Simple” Structure German Co is a real estate corporation Dividends paid by GCo to U.S. Co subject to 5% WHT under U.S.-Germany tax treaty No protection of U.S. Co against German tax on capital gain under U.S.-Germany tax treaty US Co 75 % German Co
Example for treaty/directive shopping by U.S. investors (2) “Advanced” Structure US Co Zero WHT on dividends paid by GCo to Lux Co under EU P/S Directive Zero Lux WHT on profit repatriation to U.S. Co (e. g. CPECS) • Lux Co is protected against German tax on capital gains under the Lux-Germany tax treaty • Result subject to anti-treaty/directive shopping provisions 100 % Lux Co 75 % German Co
Commentary to Article 1 of OECD Model Treaty • Two fundamental questions re tax treaty abuse: • (1) whether the benefits of tax treaties (conventions) must be granted to abusive transactions; and • (2) whether specific provisions of the domestic law of a Contracting State that are intended to prevent tax abuse conflict with tax treaties. • Re (1), a proper construction of tax conventions can allow disregard of treaty-abusive transactions. • Conventions must be interpreted in good faith (see Article 31 of the Vienna Convention on the Law of Treaties).
Commentary to Article 1 of OECD Model Treaty • Re (2), in many States, taxes are ultimately imposed through the provisions of domestic law, as restricted (or occasionally broadened) by the provisions of tax conventions. • Thus, treaty abuse = an abuse of these domestic provisions. • Domestic anti-avoidance rules are not affected by treaties; thus, no conflict. • Relevant rules include “substance-over-form”, “economic substance” and general anti-abuse rules. • Recharacterization of income or in a redetermination of the taxpayer per these rules may be given effect for treaty purposes.
Commentary to Article 1 of OECD Model Treaty • Guiding principle: “the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favorable tax position and obtaining that more favorable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions.”
Commentary to Article 1 of OECD Model Treaty • Some common forms of tax avoidance are expressly dealt with, e.g. by • the concept of “beneficial owner” (in the Dividends, Interest and Royalties Articles), • special provisions dealing with, e.g., so-called artiste-companies, and • provisions regarding related party dealings. • Convention may include provisions that focus directly on the relevant avoidance strategy • where specific avoidance techniques have been identified, or • domestic law lacks the necessary anti-avoidance rules.
Commentary to Article 1 of OECD Model Treaty • The “treaty shopping” issue may be addressed in a comprehensive by a detailed limitation-of-benefits provisions. • More limited formulations that may deal with treaty shopping: • Ownership provisions, which deny benefits to a company that is a resident of a Contracting State if it is owned or controlled directly or indirectly by persons who are not residents of a Contracting State. • General subject-to-tax provisions provide that treaty benefits in the State of source are granted only if the income in question is subject to tax in the State of residence.
Commentary to Article 1 of OECD Model Treaty • Base erosion provisions, which deny benefits if more than e.g. 50% of gross income is paid out via certain types of deductible payments to ineligible persons. • Provisions that deny benefits to income received or paid by a company enjoying tax privileges or to income that is preferentially taxed. • Provisions which deny benefits if it was “the main purpose or one of the main purposes” of any person concerned with the creation or assignment of shares, debt-claims, licenses or other rights to take advantage of reduced treaty withholding rates.
U.S. initiatives: Section 894 and Treasury Regulations • These rules apply if an entity is treated as fiscally transparent in either the United States or the foreign jurisdiction (hybrid or reverse hybrid) • Rules determine eligibility for treaty benefits for payments made or received by such an entity • Treaty eligibility only if item of income is “derived by” a foreign entity • Rules apply only to U.S. source passive income
Meaning of “Derived By” • Income is “derived by” an entity if entity is not fiscally transparent • Income is “derived by” an interest holder in entity if interest holder is not fiscally transparent and entity is fiscally transparent under laws of interest holder’s jurisdiction • Entity is fiscally transparent if interest holder required to take item of income into account on a current basis and character and source of income are determined as if realized directly from the source • Determination made under principles of foreign law • Entity specifically identified in a treaty • Dual claims can be made by entity itself and on behalf of interest holders (withholding agent option)
The Canadian Fact Pattern • Canadian parent with U.S. subsidiary sets up single member U.S. LLC to lend $ to U.S. subsidiary • Subsidiary pays interest (deductible) to U.S. LLC, which would be subject to current favorable 10% treaty withholding rate • Canada treats the payment as exempt dividend income from U.S. LLC, which is regarded as corporation Canada US LLC LOAN US Sub
Example • In Country C, Entity C is treated as not fiscally transparent • In Country A, Entity C is treated as fiscally transparent • In Country B, Entity C is treated as not fiscally transparent • Entity C receives royalty income and portfolio interest from unrelated U.S. corporations • U.S.-Country A Treaty has 0% withholding on royalties • U.S.-Country C Treaty has 5% withholding on royalties • One-half of the royalty income is subject to 0% withholding; balance subject to 5% withholding • Entity C receives interest which qualifies as portfolio interest exempt from tax A 50 B 50 Entity C
Example A Entity B • In Country B, Entity B is treated as fiscally transparent • In Country A, Entity B is treated as not fiscally transparent • Entity B receives royalty income from an unrelated U.S. corporation • U.S.-Country A Treaty has 0% withholding on royalties • U.S.-Country B Treaty has 5% withholding on royalties • No treaty relief is available to either entity B or individual A because of section 894. US Corp.
Domestic Reverse Hybrids Treated as corporation for US tax purposes and fiscally transparent for foreign purposes • Income from the United States paid to domestic reverse hybrid not entitled to treaty benefits Domestic reverse hybrid
Domestic Reverse Hybrids • Income paid by domestic reverse hybrid – treated as “derived” by its interest holders (provided they are not fiscally transparent) by treating and testing the income as if paid by a non-fiscally transparent entity • If interest holder “derives” at time of payment, then receive treaty relief • This is the case even if the item of income were characterized differently or treated as having been received earlier under foreign law
Domestic Reverse Hybrid Shutdown Debt/Equity Interest FC Shut-down of abusive transaction Domestic reverse hybrid US LLC Dividend US Sub Capitalization with part debt, part equity U.S. corporation pays dividend and domestic reverse hybrid pays interest Foreign country treats entity as fiscally transparent and interest holder as receiving dividends United States treats entity as receiving dividends but deducting interest Reduced withholding rate under treaty Deduction at U.S. level
Domestic Reverse Hybrid Shutdown Cannot manipulate difference in entity classification rules to inappropriately reduce tax • So, if: • Payment from domestic entity to related (80%) domestic reverse hybrid is treated as dividend under either United States or foreign jurisdiction (and interest holder treated as deriving his proportionate share of the dividend) and • Domestic reverse hybrid makes payment to related (80%) interest holder which is deductible in United States and entitled to reduced withholding rate under a treaty, then • Payment by domestic reverse hybrid to be treated as a dividend for all purposes (up to the interest holder’s proportionate share of the dividend payment from the U.S. corporation to the related domestic reverse hybrid). No interest deduction. FC Interest Debt/Equity Domestic reverse hybrid Dividend US Corporation
Bank Loan • Bank Loan untouched by domestic reverse hybrid regulations • Even if loan guaranteed by related foreign interest holder. • Beware conduit financing anti-avoidance rule for unrelated parties FC Bank Equity 100% Domestic Reverse Hybrid Loan Interest 100% Dividend US Corporation
Conduit Financing Regulations • IRS may disregard certain intermediate entities (i.e., conduit entities) in “financing arrangements,” with the result that the conduit entity cannot claim benefits of a tax treaty between its country and the United States • Purpose is to disallow treaty benefits where conduit entities are interposed to gain treaty benefits • A financing arrangement is series of transactions by which the financing entity advances money or other property (or rights to use property) to another person, i.e., the financed entity, if advance and receipt are effected through one or more intermediate entities (generally, conduit entities)
Grounds for Disallowing Treaty Benefits in Conduit Financing • Treaty benefits are disallowed if: • Participation of the intermediate entity reduces gross basis withholding tax in comparison to tax imposed absent intermediate entities; • Participation of the intermediate entity is pursuant to tax avoidance plan; and • Either: • The intermediate entity is related to the lender or the borrower; or • The intermediate entity would not have engaged in the financing arrangement on substantially the same terms but for the fact that lender engaged in the transaction with the intermediate entity
Grounds for Disallowing Treaty Benefits in Conduit Financing Factors considered for tax avoidance purpose: • Significant reduction in tax as compared to financing absent intermediate entities; • Whether intermediate entity was able to advance the funds on its own; • Length of time between separate advances; • If parties involved in the advance of funds to or from an intermediate entity are related, whether advance occurs in ordinary course of business Favorable (but rebuttable) presumption: • Participation of intermediate entity in financing arrangement not pursuant to tax avoidance plan if: (1) intermediate entity is related to either or both of lender or borrower and (2) intermediate entity performs significant financing activities in the financing arrangement
U.S. Borrower Foreign Parent Loan Example: Conduit Financing Regulations Interest German Sub Foreign Parent is a bank organized in a country that does not have a tax treaty with the United States. Foreign Parent establishes and capitalizes a German subsidiary with the sole purpose of having the German subsidiary make a loan to U.S. Borrower. Zero withholding on interest under the U.S.-Germany treaty is unavailable because: Participation of the German subsidiary reduces (i.e., eliminates) the 30% withholding tax on interest that would apply if loan made by Foreign Parent (because Foreign Parent is a bank, the portfolio interest exemption would be unavailable); Participation of German subsidiary is pursuant to a tax avoidance plan (e.g., significant reduction of tax; German subsidiary would be unable to make loan absent the plan); German subsidiary is related to the lender, Foreign Parent.
German domestic anti-treaty shopping provision: § 50 d (3) ITA (1) • Current version applicable since 2007 • Foreign corporation (FCo) is denied relief from German tax provided for in a tax treaty or in an EU Directive to the extent that the shareholders of FCo were not entitled to tax relief if the shareholders (rather than FCo) would have earned the income themselves and 1. There are no sound reasons for interposing FCo or 2. FCo derives less than 10 % of its gross revenue in a given year from its own economic activities or 3. FCo does not participate by means of a proper business operation in the general economy.
German domestic anti-treaty shopping provision: § 50 d (3) ITA (2) • Scope of the provision is limited to items of income which are subject to withholding tax (dividends, royalties, interest from profit participating loans/silent partnerships) • Tax relief is not denied it there is a substantial and regular trade with the principal class of shares in FCo on a recognized stock change (or if FCo falls under the provisions of the Investment Tax Act) • Provision is strictly enforced by German tax authorities • FCo must provide the German payor of dividend/interest/royalty with a certificate issued by the Federal Central Tax Office confirming FCo’s entitlement to treaty benefits • Certificate is granted upon application and only if FCo demonstrates that there is no treaty shopping (burden of proof is on FCo)
German domestic anti-treaty shopping provision: § 50 d (3) ITA (3) • Own economic activity of FCo – the 10 % test • At least 10 % of FCo’s gross revenue must be derived from its own economic activities • Rendering services to group companies constitutes its own economic activity • Economic activities carried out in a country other than the home state of FCo do not count as own economic activity • Passive investment income does not count. However, dividends, interest and royalties earned by FCo from subsidiaries do count if these subsidiaries are managed by FCo (e.g., FCo operates as management holding company). • Derivative benefits granted
Example - Denial of tax relief Japan Co Dividends from GCo to Dutch Co quality for zero WHT subject to § 50 d (3) 15 % WHT rate for dividends from GCo to Japan Co 15 % WHT if Dutch Co is caught by § 50 d (3) (i. e. Dutch Co has not sufficient “substance”) 100 % Dutch Co 100 % German Co
Example – Derivative Benefits US Co Suppose that Dutch Co does not have sufficient substance Is Lux Co entitled to zero WHT rate on dividends from GCo? No, if Lux Co fails the § 50 d (3) test unless Lux Co’s shareholder (e. g. U.S. Co) qualifies for the zero rate which depends on the U.S.-Germany tax treaty. 100 % Lux Co 100 % Dutch Co 100 % German Co
Example – Denial of Derivative Benefits US Co Suppose that Lux Co does not have sufficient substance Bermuda Co is not entitled to treaty relief. • The fact that U.S. Co is entitled to treaty relief under the U.S.-Germany tax treaty is irrelevant for § 50 d (3). • If Lux Co fails the § 50 d (3) test, the German domestic 21.1 % WHT rate applies. 100 % Bermuda Co 100 % Lux Co 100 % German Co
EU anti-treaty shopping provisions • Art. 1 (2) EU P/S Directive and Art. 5 (1) Interest/Royalty Directive provide that the Directive shall not preclude the application of domestic or agreement-based provisions required for the prevention of fraud or abuse • Even further, Art. 5 (2) Interest/Royalty Directive provides that member states may, in the case of transactions for which the principal motive or one of the principal motives is tax evasion, tax avoidance or abuse, withdraw the benefits of this Directive or refuse to apply this Directive • As per the ECJ, a national anti-abuse measure is compatible with EC law only if the measure is proportionate and serves the specific purpose of preventing wholly artificial arrangements • Taxpayer must be given the opportunity to rebut a presumed abuse • The objective of minimizing ones tax burden does in itself not constitute abuse • § 50 d (3) ITA is thus not compatible with EC law in as far the benefits of the Directives are denied to a foreign company not being a wholly artificial arrangement
Overview of U.S. Limitation on Benefits Provisions and Policy Considerations
Overview of U.S. International Tax Rules Qualification for treaty benefits (in general) • Recipient must be the beneficial owner of the income • Must be a resident of one of the treaty states (liable to tax) • What if distributions to shareholders deductible and no tax paid by entity? • What if country exempts income of investment company from taxation? • Limitation on benefits (treaty shopping) • U.S. Code overlay (e.g., section 894(c) and Treasury regulations)