By Anthony Diosdi
Generally, a non-U.S. taxpayer that is not engaged in a U.S. trade or business is taxable in the United States only on U.S. source “fixed determinable, annual or periodical” income (“FDAP”). Unless an applicable income tax treaty applies to reduce the rate of tax, FDAP income typically will be subject to a 30 percent gross basis withholding tax.
While most income tax treaties entered into by the United States with foreign countries reduce or eliminate the 30 percent withholding tax on FDAP, not all foreign jurisdictions have comprehensive income tax treaties with the United States. This article analyzes whether a resident of a country that has not entered into a bilateral tax treaty with the United States can utilize the U.S.-Cyprus tax treaty to reduce the 30 percent withholding tax on FDAP income.
FDAP Background
Foreign persons are subject to U.S. federal income tax on a limited basis. Unlike U.S. taxpayers who are subject to U.S. federal income tax on their worldwide income, non-U.S. taxpayers generally are subject to U.S. taxation on two categories of income: 1) certain passive types of U.S.- source income known as “FDAP;” and 2) income that is effectively connected to a U.S. trade or business. FDAP income is subject to a 30 percent withholding tax that is imposed on a non-U.S. taxpayer’s gross income. Effectively connected income is subject to tax on a net basis at the graduated tax rates applicable to U.S. taxpayers.
For a non-U.S. taxpayer to be eligible for reduced withholding tax rates on FDAP income under a U.S. income tax treaty, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy a limitation on benefits (or “LOB”) provisions contained in the tax treaty. The principal target of a LOB provision is a corporation that is organized in a treaty country by a resident of a non-treaty country merely to obtain the benefits of that country’s income tax treaty. A LOB provision denies such corporations the benefits of the treaty. Therefore, even if a corporation qualifies as a resident of the treaty country, that corporation is not entitled to treaty benefits unless it also satisfies the requirements of the treaty’s LOB provision. For example, under the LOB provision found in Article 22 of the U.S. Model Treaty, a corporation that is a resident of a treaty country generally is entitled to treaty benefits only if the corporation meets one of the following additional requirements: 1) more than 50 percent of the corporation’s stock is regularly traded on a recognized stock exchange (i.e., the corporation is a publicly traded company) and the corporation’s primary place of management is in its country of incorporation, 2) the corporation is a 50 percent or more owned by 5 or fewer companies entitled to treaty benefits, or 3) the corporation meets both a stock ownership test (at least 50 percent of the corporation’s stock is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50 percent of the corporation’s gross income is used to make deductible payments to persons who are not residents of either country).
For example, FORco, a foreign company incorporated in foreign country F, owns all the shares of its U.S. subsidiary, USAco. FORco is owned 45% by Nonresident, a citizen and resident of foreign country F, and 55% by Kong, a Hong Kong individual. The United States has a treaty with foreign country F, but does not have a tax treaty with Hong Kong. USAco pays a dividend to FORco. Although FORco would ostensibly be entitled to withhold at only 5% controlled company rate under the treaty, the dividend from USAco is not entitled to the benefits of the treaty and withholding must occur at the 30 percent statutory rate. More specifically, FORco fails to satisfy the LOB article because only 50 percent of the FORco shares are owned by a resident of country F, Nonresident, who is entitled to treaty benefits.
U.S.- Cyprus Tax Treaty
The purpose of LOB provisions in tax treaties is to prevent treaty-shopping. To qualify for treaty benefits under a LOB, a specified percentage of an entity’s shares must be owned, directly or indirectly by a resident or residents of the applicable treaty country. As typically the case in international tax planning, there are always exceptions to the general rule. One such exception to this general rule is the U.S.-Cyprus tax treaty. The U.S.-Cyprus income tax treaty contains an unusual LOB provision, under which a Cypriot corporation is not eligible for the benefits of the treaty unless more than 75 percent of the number of shares of each class of the corporation’s shares is owned, directly or indirectly, by one or more individual residents of Cyprus treaty, and certain other requirements are met (LOB Provision 1). However, the U.S.-Cyprus treaty also provides that LOB Provision 1 does not apply to a Cyprus corporation and the conduct of its operations does not have as a principal purpose obtaining benefits under the treaty (LOB Provision 2).
In 2013, the Internal Revenue Service (“IRS”) issued an internal legal memorandum. The IRS internal legal memorandum concluded that a U.S. individual was entitled to treat dividends (at a favorable treaty rate) received from a Cyprus holding company even though the entity had no Cypriot ownership. Under the facts of the legal memorandum, a U.S. individual owned an interest in a Cyprus company (“HoldCo”). The remaining shares were owned by persons who were not residents of the United States or Cyprus. HoldCo, which owned an operating company in a third country, was apparently established in Cyprus for reasons unrelated to the Treaty.
HoldCo did not qualify under LOB Provision 1 because none of its shares were owned by individual residents of Cyprus. However, the legal memorandum concluded that LOB Provision 2 was satisfied because there was no principal purpose of obtaining benefits under the U.S.-Cyprus treaty and HoldCo was a “qualified foreign corporation” that was entitled to favorable U.S. tax treatment. The legal memorandum does not state why the establishment of a Cyprus holding company did not have a principal purpose of obtaining benefits under the U.S.-Cyprus tax treaty.
Given the wording of the U.S.-Cyprus LOB and the IRS’s apparent broad interpretation of the term “there was no principal purpose of obtaining benefit” under the U.S.-Cyprus treaty, it is not too difficult to envision a number of strategies that would allow non-resident corporate taxpayers with FDAP income to utilize the U.S.-Cyprus tax treaty to substantially reduce its U.S. withholding tax, regardless of the jurisdiction in which it is a resident.
Anthony Diosdi is an international tax attorney at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi advises clients in areas of international tax planning and international tax compliance throughout the United States, Asia, Europe, Australia, Canada, and South America.
Diosdi Ching & Liu, LLP also has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.