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A Closer Look at the United States- Republic of Chile Income Tax Treaty


The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States- Chile income tax treaty.

There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the United States is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- Chile Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Chile income tax treaty and the implications to individuals attempting to make use of the treaty.

Definition of Resident

The determination of an individual’s country of residence is important because the treaty only applies to residents of the United States and Chile.

The term “resident of the United States” means: 1) a business entity formed in the United States, or 2) any other person (except a corporation or any entity treated under United States law as a corporation) resident in the United States for purposes of United States tax, but in the case of an estate or trust only to the extent that the income derived by such person is subject to United States tax as the income of a resident. Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ) equals or exceeds 183 days) or iii) makes a first year election.

Chile taxes its citizen resident or domiciled in Chile on worldwide income. Domicile is physical presence with the intent to remain in the country. Residence is mere physical presence. Foreigners working in Chile are subject to taxation only on their Chilean-source income during their first three years in Chile, after which worldwide income is taxed. Residence for tax purposes is acquired upon remaining six consecutive months in Chile in one calendar year, or more than six months, whether or not, in two consecutive calendar years. 

The tax exemptions and reductions that the United States- Chile income tax treaty is available only to a resident of the treaty countries. Because each country has its own unique definition of residency, a person may qualify as a resident in the United States and Chile. For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of Chile under its definition of residency. To resolve this issue, the United States- Chile income tax treaty has included a tie-breaker provision in the treaty. Article 4 of the United States- Chile income tax treaty provides the following tie-breaker rules for individuals:

A) He or she shall be deemed to be a resident only of the country in which he or she has a permanent home available to that individual; if he or she has a permanent home available in both countries, the individual shall be deemed to be a resident only in the country with which his or her personal and economic relations are closer (center of vital interests);

B) If a country in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either country, he shall be deemed to be a resident only of that country in which he has an habitual abode;

C) If he has an habitual abode in both countries or in neither of them, he shall be deemed to be a resident only in the country of which he is a national;

D) If he is a national of both countries or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

Business Profits and Permanent Establishment

All items of income attributable to the permanent establishment will be included in a foreign corporation’s or foreign entity’s gross income for U.S. tax purposes. Article 5 of the United States- Chile income tax treaty reflects this approach to determine the extent to which income will be attributable and taxed to a permanent establishment. Article 5(2) of the United States- Chile income tax treaty defines permanent establishment as a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; and f) a mine, an oil or gas well, a quarry, or other place of extraction or exploitation of natural resources.

A permanent establishment also includes: a) an installation used for the on-land exploration of natural resources only if it lasts or activity continues for more than three months; b) a building site or construction or installation project and the supervisory activities in connection therewith, or a drilling rig or ship used for the exploration of natural resources; and c) an enterprise that performs services in the other country for a period or periods in the aggregate of 183 days in any twelve month period.

“Business profits” means income from any trade or business, including income derived by an enterprise from the performance of personal services. See United States-Chile income tax treaty Art. 7(5). Once the enterprise is conducting business through a permanent establishment, only the income attributable thereto may be taxed in the country where the profits are being generated. See United States- Chile income tax treaty Art. 7(3). Article 7(2) provides that the profits attributable to a permanent establishment include only those derived from the assets or activities of the permanent establishment.

“Business profits” requires a determination of the net income of a permanent establishment. Its gross income is reduced by allowable deductions. Article 7(3) provides that deductions allowable in determining the net income of the permanent establishment are those “incurred for purpose of the permanent establishment” and, include “a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment), whether incurred in the State in which the permanent establishment is situated or elsewhere.” The provisions of U.S. law should generally apply in determining what constitutes a “reasonable allocation” for these purposes. For example, the interest allocation set forth in the regulations are applicable to determining interest expense attributable to the business profits of a permanent establishment. See Treas. Reg. Section 1.882-5(a)(2).

A Chilean company may have more than one permanent establishment in the United States. Income and losses from such permanent establishments of the enterprise will be combined to determine the U.S. income tax liability. As a result, losses generated by one may offset income produced by another. While transactions between a branch and a home office or between two branches of a corporation are not normally recognized under U.S. tax law, the treaty treats each permanent establishment as a “distinct and independent” enterprise and permits a “reasonable allocation” of certain expenses in determining net profits attributable to a permanent establishment. See United States-Chile income tax treaty Art. 7(2) and (3).

Dividends

Under Article 10 of the United States- Chile income tax treaty, dividends paid by a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other state. However, such dividends may also be taxed in the Contracting State of which the company paying the dividend is a resident shall not exceed five percent of the gross amount of the dividends if the beneficial owner is a company that owns directly at least 10 percent of the voting stock of the company paying the dividends and 15 percent of the gross amount of the dividends in all other cases.

The term “dividends” is defined in Article 10(4) as income from shares or other rights, not being debt-claims, participating in profits, as well as income from rights that is subjected to the same taxation treatment as income from shares under the laws of the State of which the company making the distribution is a resident.”

Interest

Article 11 of the United States- Chile income tax treaty allows the source state to impose a maximum tax of 10 percent if paid to a resident of the other Contracting State that beneficially owns the interest. Article 11(a) reduces the tax on interest income to 4 percent if the interest is paid by 1) a bank; 2) an insurance company; 3) an enterprise substantially deriving its gross income from the active and regular conduct of lending or finance business involving transactions with unrelated parties; 4) an enterprise that sold machinery or equipment, where interest is paid in connection with the sale on credit of such machinery or equipment; or 5) any other enterprise that is in the three taxable years preceding the taxable year in which the interest is paid, the enterprise derives more than 50 percent of its liabilities from the issuance of bonds in the financial markets or from taking deposits at interest, and more than 50 percent of the assets of the enterprise consists of debt-claims.

Article 11(5) defines “interest” as income from debt-claims of every kind, whether or not secured by mortgage.

Royalties

The United States- Chile income tax treaty provides for lower withholding rates on royalties. The withholding rate is 2 percent of the gross amount of royalties for payments received as a consideration for the use of, or the right to use, industrial, commercial or scientific equipment, but not including ships, aircraft or containers. Income received from ships, aircraft or containers are not subject to withholding taxes. See United States v. Chile income tax treaty Art. 8, 12(2)(a). The treaty provides for a 10 percent withholding royalties for the use of a patent, trade secret, or formula. A royalty is any payment for the use of, or the right to use, the following:

1. Any copyright of literacy, artistic, scientific of other work (including computer software, cinematographic films, audio or video tapes or disks, and other means of sound reproduction;

2. Any patent, trademark, design, model, plan, secret formula or process, or other like right or property;

3. Any information concerning industrial, commercial, or scientific experience; or

4. Any gains derived from the disposition of any right or property described above, where the proceeds are contingent upon the future productivity, use, or disposition of that property. See United States v. Chile income tax treaty Art. 3(b).

Independent Personal Services

The source of personal service income is the place where the services are rendered. See IRC Section 861(a)(3). The performance of personal services in the United States usually constitutes a U.S. trade or business. See IRC Section 864(b). However, the United States-Chile income tax treaty provides an exemption from U.S. tax for nonresident aliens who work temporarily in the United States. In Article 14, the United States-Chile income tax treaty exempts nonresident aliens who are residents of the treaty partner from tax on all compensation for the performance of professional services or other activities of an “independent character” (presumably meaning as an independent contractor) in the United States if the services are not attributable to a “fixed base” that that is “regularly available.”

Pensions and Social Security

Article 18 of the United States- Chile income tax treaty provides a basic rule for cross-border taxation of pensions. Article 18 of the United States- Chile income tax treaty income tax treaty provides-

(1) Pension payments and other similar remuneration derived from sources within a Contracting State beneficially owned by a resident of the other Contracting State may be taxed by both Contracting States. Any tax so charged by the first-mentioned State may not exceed 15 percent of the gross amount of the pension payments or other similar remuneration.

Subparaph 1(b) contains an exception to the State of residence’s right to tax pension payments and other similar remuneration under subparagraph 1(a). Under subparagraph 1(b), the State of residence must exempt from tax any amount of such payment that would be exempt from tax in the Contracting State in which the pension plan is established if the recipient were a resident of that State. Thus, for example, a distribution from certain individual retirement accounts (“IRAs”), such as U.S. “Roth IRA” to a resident of Chile would be exempt from tax in Chile to the same extent the distribution would be exempt from tax in the United States if it were distributed to a U.S. resident. The same is true with respect to distributions from a traditional IRA to the extent that the distribution represents a return of non-deductible contributions. Similarly, if distributions from a traditional IRA were not subject to U.S. tax because they were “rolled over” to another IRA, then the distributions would be exempt from tax in Chile.

Paragraph 1 is intended to cover payments made by qualified private retirement plans. In the United States, the plans covered by paragraph 1 include qualified plans under Internal Revenue Code Section 401(a), individual retirement plans such as 401(k) plans.

Paragraph 3 deals with the taxation of social security benefits. This paragraph provides that social security or similar legislation will be taxable only to the Contracting State making the payment.

Other Income

Article 21 of the United States- Chile Income Tax Treaty applies to “other income.” This article applies to income not otherwise dealt with in other articles of the treaty. Examples of the types of income that fall under Article 21 are income received from covenants not to compete, punitive damage awards, gambling income, and income received from certain financial instruments.

Relief From Double Taxation

Article 23 of the United States- Chile income tax treaty provides relief from double taxation. Under Article 23 of the United States-Chile income tax treaty, the United States shall allow a resident or citizen of the United States a credit against United States tax on income tax paid or accrued to Chile. Residents of Chile are permitted the same credit for taxes paid to the United States against Chilean income tax.

Limitation on Benefits

The United States- Chile income tax treaty contains detailed rules intended to limit its benefits to persons entitled to such benefits by reason of their residence in a Contracting State. The rules are specifically intended to eliminate “treaty shopping” whereby, for example, a third-country resident could establish an entity in a Contracting State and utilize the provisions of the treaty to repatriate funds under favorable terms. To eliminate this potential abuse, the full benefits of the treaty are available to only a specified class of persons, limited treaty benefits are provided to an additional class of persons, and a facts and circumstances test provides discretion to make the treaty provisions available to others.

Under Article 24, a resident is entitled to all the benefits of the treaty only if it can be described as one of the following: an individual resident, certain government entities; including central banks; a company that is publicly traded or has a parent company that is publicly traded, as defined; certain charities and tax exempt organization; a pension fund provided that more than 50 percent of its beneficiaries are individual residents of either Contracting State; or an entity that satisfies both a resident-owner test and a base-erosion test. Under Article 24, even if a resident does not meet one of the above descriptions, the resident may be able to claim treaty benefits for some items of income to the extent the resident can establish the items are sufficiently connected to an active trade or business in the resident’s own Contracting State. Residents who do not meet any one of the above tests, including an active trade or business test, may still be able to claim treaty benefits if the Competent Authority of the Contracting State from which the benefits are claimed determines that it is appropriate to grant benefits in that case.

Disclosure of Treaty-Based Return Positions

Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.

The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:

1. The name and employer identification number of both the recipient and payor of the income at issue;

2. The type of treaty benefited item and its amount;

3. The facts and an explanation supporting the return position taken;

4. The specific treaty provisions on which the taxpayer bases its claims;

5. The Internal Revenue Code provision exempted or reduced; and

6. An explanation of any applicable limitations on benefits provisions.

Wherever a U.S. person claims a position under the United States- Chile tax treaty, the treaty position must be accurately reported on Form 8833.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or contacted here.

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.

Anthony Diosdi

Written By Anthony Diosdi

Partner

Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.

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