The United States-Cyprus Tax Treaty and Its Unusual LOB Explained

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-Cyprus 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 U.S. 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- Cyprus income tax treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States-Cyprus income tax treaty and the implications to individuals attempting to make use of the treaty.

Definition of Resident for Treaty Purposes

In order to take advantage of the United States- Cyprus income tax treaty, an individual or entity must be classified as a tax resident of either the United States, Cyprus, or both. Residency is determined by local law of the United States and Cyprus.

How Tax Residence is Determined in the United States

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 years (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.

In contrast, in determining whether a person is a resident of Cyprus for a particular year, certain facts are of considerable significance, the most important being physical presence, habituality of visits and availability of place of abode.

Key Provisions of the United States-Cyprus Income Tax Treaty

The United States-Cyprus income tax treaty provisions favorable or reduced withholding rates for residents, including 5% to 15% on dividends, 0% on certain dividends, 0% on certain interest, and reduced or zero rates for royalties.

Can U.S.-Cyprus Tax Treaty be Used by Companies from Third Party Countries?

The country of Cyprus has been nicknamed the “Moscow on the Med.” The tiny island of Cyprus has attacked Russian investment. Cypriot holding corporations wholly owned by Russians are often used to avoid both Cyprus domestic tax and foreign taxes. Cyprus has a global network of double tax treaties. Included in that network is a bilateral tax treaty with the United States. The United States- Cyprus income tax treaty is unusual in that it may permit a Cypriot holding company with no Cypriot ownership to qualify for benefits of the treaty. Sometimes shareholders from third party countries may establish a Cypriot corporation to attempt to avoid U.S. withholding taxes on so-called “FDAP” income. The next portion of this article will discuss the unusual position of the Internal Revenue Service (“IRS”) in relation to the United States- Cyprus income tax treaty that may permit shareholders from third countries to utilize the treaty.

U.S. Tax on FDAP Income

U.S. -source income that is effectively connected with a U.S. trade or business is taxable to foreign persons or foreign companies at the usual individual or corporate rates. Appropriate deductions and credits will apply in the determination of U.S. tax liabilities.

More often, U.S. source income received by foreign persons or foreign entities is not effectively connected with a U.S. trade or business and instead is subject to a flat tax of 30 percent on the gross amount of income received. Internal Revenue Code Sections 871(a) (for nonresident aliens) and 881(a) (for foreign corporations impose a 30-percent tax on interest, dividends, rents, and royalties. This withholding tax is often referred to as “FDAP income.” The collection of FDAP is effected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person or entity to withhold the tax and pay it over to the Internal Revenue Service (“IRS”). As in the case of U.S. trade or business income, tax treaties may reduce or eliminate FDAP withholding taxes.

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, let’s assume that FORco, a foreign company, is incorporated in foreign country F. Let’s also assume that FORco owns all the shares of its U.S. subsidiary, USAco. FORco is owned 45 percent by Nonresident, a citizen and resident of foreign country F, and 55 percent 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 percent 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.

Qualifying for Treaty Benefits Under Cyprus Treaty’s LOB

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. In order to qualify for the benefits under an income tax treaty that contains a LOB, a foreign individual or entity must not only be a resident of one of the countries party to the treaty, but also satisfy additional restrictions set forth in a LOB article contained in the treaty. LOB articles typically require a corporation who is a resident of a contracting state to also satisfy one of the article’s corporate tests before such a corporation can claim benefits under the treaty. 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% 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 the country of incorporation; 2) the corporation is a 50% 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% of the corporation’s stock is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50% of the corporation’s gross income is used to make deductible payments to persons who are not residents of either treaty country).

The LOB provision of the United States- Cyprus income tax treaty differs from most other tax treaties. The LOB contained in Article 26 of the Cyprus Treaty provides for two alternative tests of which must be met for a Cypriot company to be eligible for treaty benefits. Under the first test, more than 75% of the number of shares of each class of the corporation’s shares must be owned, directly or indirectly, by one or more individual residents of Cyprus and certain base erosion tests must be met at the same time. A resident of Cyprus for income tax treaty purposes is an individual or company liable to tax in Cyprus based on domicile, residence, or place or management. In order to be a resident of Cyprus, the individual or company must physically be present in Cyprus for more than 183 in a calendar year or satisfy a so-called 60-day rule.

Under the 60-day rule, an individual is physically present in Cyprus if they: 1) stay in Cyprus for at least 60 days in the tax year; 2) does not stay in any other single country for more than 183 days; 3) are not tax residents in any other country; 4) are not tax residents in any other country; 5) maintain a permanent home in Cyprus; and 6) carry on business as employed, or hold an office in Cyprus.

As long as 75% of the number of shares of each class of the Cypriot corporation are satisfied, the Cypriot entity will satisfy the first prong of the test.

Under the second test of the LOB provision, a Cypriot corporation must not use a “substantial part” of its gross income to pay liabilities, such as interest or royalties, to residents of a third state. This provision of the LOB ensures that only entities with substantial ties to Cyprus receive benefits of the United States- Cyprus income tax treaty. This second test is typically referred to as the “ownership-base erosion test.” The ownership-base erosion test generally requires that more than 50% of the vote and value of the company’s shares be owned, directly or indirectly, by residents of the same country as the company. In general, this second requirement is that less than 50% of the company’s gross income occurs or paid, directly or indirectly, to the persons who are not residents of the same country of the company.

Most LOB provisions of an income tax treaties contain an active trust or business test provision. The active trade or business test generally requires that the company be engaged in an active trade or business in its country of residence, that its activities in that country be substantial in relation to its U.S. activities, if the payor is a related party, and the income be derived in connection with or incidental to that trade or business. Unlike most tax treaties, the United States- Cyprus income tax treaty lacks a specific “active trade or business” test. Instead, Article 26(2) of the United States- Cyprus income tax treaty contains a principle purpose test. Under this test, benefits of the Treaty may be denied if the entity is a shell/conduit used to access the treaty, but are granted if the “establishment, acquisition and maintenance” of the entity and “conduct of its operations” did not have obtaining benefits as a principal purpose.

Under an additional test contained in Article 26(2) of the United States-Cyprus income tax treaty, the establishment, acquisition and maintenance of the corporation must be in Cyprus. In 2023, the IRS issued a legal memorandum which provided guidance for purposes of satisfying the second prong of the LOB. In the memorandum, the IRS determined that a Cypriot company was qualified for treaty benefits. In the facts of the 2013 legal memorandum, the Cypriot company was a holding company that never earned U.S. source income. The IRS did not challenge the company’s status as a resident. Rather, the IRS focused on the principal purpose test contained in the LOB of the United States- Cyprus income tax treaty. The IRS concluded that the company was a resident of Cyprus because it was not set up for the purpose of obtaining tax treaty benefits. In support of that conclusion, the IRS looked to the Treasury Department Technical Explanation for the LOB provision in the Cyprus Treaty and concluded that the company was established in Cyprus, and was being maintained for reasons unrelated to the Treaty. Hence, obtaining benefits under the Treaty was not a principal purpose of the formation and existence. Consequently, it was eligible for benefits under the LOB provision of the United States Cyprus income tax treaty.

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 United States-Cyprus income tax treaty.

Given the wording of the United States-Cyprus income tax treaty’s LOB and the IRS’s apparent broad interpretation of the term “there was no principal purpose of obtaining benefit” under the United States-Cyprus income tax 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 United States-Cyprus income tax treaty to substantially reduce its U.S. withholding tax, regardless of the jurisdiction in which it is a resident.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals.

Anthony has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.