By Anthony Diosdi
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- Japan 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- Japan Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Japan 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 Japan.
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 – ⅙) equals or exceeds 183 days) or iii) makes a first year election.
In contrast to the U.S. law, an individual’s Japanese citizenship is not a basis for taxation; instead, residence is dispositive. An individual is considered a resident if he or she has resided in Japan continuously for one year or more. Individuals who have lived in Japan for less than one year and who are not domiciled in Japan are considered nonresidents and are subject to tax only on certain categories of income. A corporation is considered a resident of Japan if either its headquarters or principal office is located in Japan.
An individual who is a resident of both Contracting States shall be deemed to be resident of that Contracting State in which he maintains his permanent home. If he has a permanent home in both Contracting States or in neither Contracting State, he or she shall be deemed to a resident of that Contracting State with which his or her personal and economic relations are closest (center of vital interests).
While Article 2 of the treaty looks to each country’s laws to define the term “resident,” Article 4 of the treaty limits who may benefit from the provisions of the treaty- even if they can be classified as a resident of a Contracting State. In particular, Article 4 provides a limitation on the use of fiscally transparent entities when an item of income is derived through an entity inconsistent by the source or residence state. For example, a fiscally transparent partnership established in one state that is taxed as a corporate taxpayer by the other State raises issues as to which person or persons are liable to tax on the income and which persons qualify as residents for treaty purposes.
Let’s assume for example that a Japan-sourced royalty is paid to X, an entity organized in Chile, and that X’s holders (or investors) are U.S. residents. Neither the United States nor Japan has an Income Tax Treaty with Chile. Assume X is an eligible entity under the U.S. Entity Classification Regulations and elects to be treated as a partnership for U.S. tax purposes. Further assume that under Japanese law, X is viewed as a non-fiscally transparent Chilean corporation. Thus, the company is a so-called hybrid entity, in that it is classified inconsistently by at least two countries with arguable claims to tax jurisdiction over the income it receives.
From Japan’s perspective, the royalty is being paid to X Corporation, a resident of Chile, with which Japan has no tax treaty. Thus, Japan would impose its full withholding tax on the royalty income. But because the United States views X as a fiscally transparent partnership, it would treat the U.S. resident partners as deriving the royalty income, whether or not distributed. Finally, assuming Chile views X as a domestic corporation and does not exempt foreign-source income, Chile would also tax X on its receipt of the royalty income. Thus, in the absence of specific treaty rules addressing how parties to a tax treaty are to determine who is liable to tax on the income for purposes of identifying who is potentially qualified to claim treaty benefits, the royalty income could be taxed three times.
Not surprisingly, tax planners have been exploiting conflicts in entity classification laws by deliberately structuring cross-border transactions with hybrid entities to avoid paying tax in any country on items of income. For example, assume that X is organized in a tax haven country, the Cayman Islands, and X elects under U.S. tax law to be taxed as a fiscally transparent partnership for U.S. tax purposes. Further, assume that Japan views the Cayman entity as a non-fiscally transparent corporate taxpayer. X’s interest holders are Japanese residents; the United States views them as partners liable to tax, and Japan views them as resident shareholders of a foreign corporation.
Without specific rules for determining who is liable on tax on the royalty income for treaty purposes, each Contracting State would be left to apply its own classification rules without regard to the other Contracting State’s inconsistent classification and treatment. Thus, when a U.S.-sourced royalty is paid to X, the United States will ignore Japan’s characterization and treat the royalty as income of the Japanese partners of the X partnership. This would reduce its withholding tax to zero under Article 12 of the United States- Japan Income Tax Treaty (discussed in more detail below). Japan, however, would view the royalty as income of an opaque Cayman corporation and thus would not tax the Japanese shareholders, even though the United States- the source state in this example- reduced its withholding tax on the implicit but erroneous assumption that Japan- the residence state- also views X as a partnership and would therefore tax the income in the partners’s hands. The royalty is subject to only nominal tax in the Cayman Islands- a tax haven. Thus, in the absence of special treaty rules for determining which persons are conceivably liable to tax on the income received by a hybrid entity, the royalty income could conceivably cross borders and be subject to no tax in the residence state, and little or no tax in the country of the entity’s incorporation because it is a tax haven. Although this tax result distorts the true economic value of the investment, sophisticated tax planning uses this type of structure to avoid paying global tax.
The United States- Japan Income Tax Treaty attempts to resolve the problem of fiscally transparent entities with Article 4. The relevant provisions of the United States- Japan Income Tax Treaty deals with fiscally transparent entities in a way not provided in any U.S. bilateral tax treaty currently in force. Article 4(6) of the treaty establishes the general rule that one must look to the internal tax laws of the residence state- not the State from which the income is sourced- to determine whether or not an entity is fiscally transparent and who is actually liable to tax. It is the residence state characterization that counts, and in almost all cases one is to ignore the source state’s characterization (or a third state’s characterization) of the entity if it conflicts. The primary operational rule of the treaty with respect to fiscally transparent entities is that when an item of income is derived from a Contracting State (i.e., the Source State) through an entity organized in a second Contracting State (i.e., the Residence State), and that entity is treated as fiscally transparent under the internal tax laws of the Residence State (e.g., as a partnership or tax transparent trust), the entity will be entitled to treaty benefits only to the extent its beneficiaries, members, partners, or participants are residents of that second Contracting State and otherwise qualify for treaty benefits under other provisions of the treaty. See The Japan-U.S. Income Tax Treaty: Signaling New Norms, Inspiring Reforms, or Just Tweaking Anachronisms in International Tax Policy, Pamela A. Fuller, The International Lawyer, Vol. 40, No. 4.
The Technical Explanations to the treaty defines a fiscally transparent entity as one in which the income is normally taxed at the beneficiary, member, or participant level. U.S. partnerships, limited liability companies, and revocable trusts, for example, are all considered fiscally transparent from a U.S. legal perspective because they are not subject to income tax at the entity level. Entities that are subject to tax, but with respect to which the tax may be relieved under an integrated system, are not considered fiscally transparent for purposes of the treaty. In applying this general rule of the United States- Japan Income Tax Treaty, assume that a Japanese-resident shareholder incorporates company Z in Chile, which does not have a tax treaty with either the United States or Japan. The Japanese shareholders elect to have the company treated as a partnership for U.S. tax purposes, but their Chilean company is viewed as a taxable corporate entity under Japanese law. If a U.S. debtor pays interest to the Chilean company, the interest payment would not qualify for a treaty reduced rate under the United States- Japan Income Tax Treaty because Japan (i.e., the non-Source State) sees the entity as a non-resident of Japan. The fact that the United States (i.e., the Source State) sees the entity as fiscally transparent is irrelevant for purposes of applying the United States- Japan Income Tax Treaty, as is Chile’s characterization of the entity.
The test of Article 4 of the United States- Japan Income Tax Treaty does not address the most common problem that arises with respect to fiscally transparent entities. This is illustrated below:
Assume an entity is organized in Japan as a tokurie yugen kaisha (“TYK”) – a special kind of kabushiki Kaidba (“KK”) or joint stock corporation that is treated as fiscally non-transparent under Japanese law and taxed at the entity level. Further assume that the TYK’s members are residents of the United States, that the entity receives a Japan-sourced interest payment, and that the TYK’s members elect to have the TYK entity treated as a fiscally transparent partnership for U.S. tax purposes.
In most cases, Article 4(6) provides that the State applying the treaty- Japan, in this example- is required to look to the internal tax law of the other Contracting State to see whether any of its residents are liable to tax on the income before granting treaty benefits. Here, the United States will tax the TYK partners on their distributive shares of TYK interest income. Nonetheless, the Technical Explanation to the treaty states that Article 4(6) does not apply to this situation and does not prevent the Source State from taxing its domestic corporation or other entity in accordance with its domestic law. The result in this example turns on the fact that TYKs are liable to tax at the entity level under Japanese law. According to the Technical Explanations, if any item is derived from one of the Contracting States (i.e., the Source State) through an entity organized therein, and the Source State’s internal law treats that item as income of the domestic entity, then the Source State is not prevented from taxing the entity in accordance with its own domestic law pursuant to the Savings Clause of the treaty. Because the U.S. investors elected to have the TYK taxed as a partnership, they will be subject to tax on their distributive shares of TYK’s interest income. However, they are also treated as paying a share of the taxes that are paid by TYK on the interest.
As indicated above, Article 4(6) of the treaty is applicable to fiscally transparent entities, but it is not easy to apply. Understanding Article 4(6) is not only important to avoid double taxation, it is also important to understand if and when arbitrage structures can be utilized in U.S. and Japanese cross-border transactions.
We will now discuss the operative articles of the United States- Japan Income Tax Treaty.
Business Profits and Permanent Establishment
Article 7(1) of the United States- Japan Income Tax Treaty states that profits are taxable only in the Contracting State where the enterprise is situated “unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein,” in which case the other Contracting State may tax the business profits “but only so much of them as [are] attributable to the permanent establishment.” The concept of permanent establishment is a key term to this and any bilateral tax treaty. Article 5 of the United States- Japan Income Tax treaty defines permanent establishment as a “fixed place of business” – including a place of management, a branch, an office, a factory, mine, or place of extraction of natural resources.
Independent Personal Services
A contracting State may tax the income from personal services of a nonresident individual acting as an independent contractor (and not as an employee or “dependent agent”) only if 1) the individual has a fixed base in the Contracting State that he uses regularly in performing the services, in which case the Contracting State may tax income attributable to such fixed base, or 2) the individual is present in the Contracting State for a total of more than 183 days in the taxable year, in which case the Contracting State may tax the income from personal services performed in the Contracting State during that period.
Dependent Personal Services
A Contracting State may tax employment income derived by a nonresident to the extent the employee services are performed in the Contracting State unless 1) the employee is present in the Contracting State less than 183 days during a taxable year; 2) the wages are paid by, or on behalf of, an employer that is a nonresident of the Contracting State.
Under Article 10 of the United States- Japan Income Tax Treaty, the Source State can impose a gross withholding tax of 10 percent on all types of cross-border dividends. The treaty specifically discusses portfolio dividends and provides the 10 percent withholding rate when such dividends are received by a resident of the other Contracting State when the resident qualifies as the beneficial owner of the dividend on the date when entitlement to the dividend is determined. If the beneficial owner of the dividend is a company that owns, directly or indirectly (through tiers of entities), at least 10 percent of the voting stock of the payor company, then the Source State can impose a gross withholding tax of no more than 5 percent. Notwithstanding these provisions, the treaty provides for a zero percent withholding rate for dividends paid if the beneficial owner of the dividend is a company that has owned, directly or indirectly, greater than 50 percent of the voting stock of the company paying the dividend during the 12-month period ending on the date on which the entitlement to the dividend is determined, and one of three alternative tests is satisfied. Under the additional requirement, the payee company must either: 1) meet the “publicly traded” test set forth in the limitation on Benefits (“LOB”) article; 2) meet both the “publicly traded” test discussed in the LOB article; or 3) be granted express eligibility by the competent authorities pursuant to the LOB article.
Certain tax-exempt pension funds are also eligible for the zero percent withholding rate on cross-border dividends, provided the dividends are not derived from the carrying on of a business, directly or indirectly, by the pension fund. Article 10(4) provides special rules to dividends paid by a U.S. Regulated Investment Company (“RIC”) or a U.S. Real Estate Investment Trust (“REIT”), and their Japanese counterparts.
Branch Profits Tax
The U.S. imposes a 30 percent branch profits tax on the “dividends equivalent amount” of a foreign corporation engaged in a trade or business in the U.S., where the “dividend equivalent amount” is roughly equal to the taxable income of the branch, less income of the branch, less income tax paid by the branch and less amounts retained in U.S. operations. The treaty generally permits the U.S. to impose a branch tax at a maximum rate of 5 percent of business profits that are effectively connected with a U.S. trade or business and either attributable to a permanent establishment in the U.S. or attributable to income and gains on U.S. real property.
Article 11 of the United States- Japan Income Tax Treaty allows the source state to impose a withholding tax of 10 percent if paid to a resident of the other Contracting State that beneficially owns the interest. However, Article 11(3) of the treaty eliminates source-state withholding tax on broad categories of interest. The most significant of these is the elimination of source-state withholding tax for interest earned by financial institutions. This provision in the treaty is due to the highly-leveraged nature of financial institutions, imposition of a withholding tax on interest received by such enterprises could result in taxation that actually exceeds the net income from the transaction. Article 11(3)(c) provides that interest falling within this exemption includes interest beneficially owned by a resident bank, an insurance company, a registered securities dealer, or a qualified deposit-taking entity. In addition, Article 11(3)(d) exempt interest earned by pension funds from source-state withholding tax.
Article 11(5) defines interest fairly broadly to include “income from debt-claims of every kind…whether or not carrying a right to participate in the debtor’s profits.”
As with royalties, transfer pricing principles are also reflected in Article 11 of the treaty. Article 11 provides that in cases involving a “special relationship between the payor and the beneficial owner,” where the amount of interest paid exceeds the amount that would otherwise have been agreed upon in the absence of the special relationship, then the treaty rate applies “only to the last-mentioned amount” – that is, the “arm’s length interest payment,” as it is referred to in the Technical Explanation to the United States- Japan Income Tax Treaty. The treaty does not define the term “special relationship,” but the Technical Explanation states that the determination of whether such a relationship exists turns on the definition of control as it is interpreted within the context of Internal Revenue Code Section 482.
Benefits under Article 11 of the United States- Japan Income Tax Treaty are not available with respect to back-to-back loan schemes, where the recipient of the interest payments would not have established the debt-claim but for the establishment of another debt-claim with a person that is not entitled to the same or more favorable treaty benefits.
Article 12 of the United States- Japan Income Tax Treaty completely eliminates source-state taxation of royalty income “beneficially owned by a resident of the other Contracting State.” In other words, the United States- Japan Income Tax Treaty allocates the right to tax royalties solely on the residence state, which will tax them on a net basis in the same manner as other business income. Although beneficial ownership is a critical prerequisite to claiming a treaty-position for royalty income, the text of the United States- Japan Income Tax Treaty does not define the term “beneficial owner.” Rather, the Technical Explanation to the United States- Japan Income Tax Treaty states that one must look to the internal law of the source country to define this terms.
Article 12(2) of the treaty defines “royalties” broadly to include:
“Payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films or tapes for radio or television broadcasting, any patent, trademark, design or model, plan, or secrete formula or process, or for information concerning industrial, commercial or scientific experience.”
The United States- Japan Income Tax Treaty bringings transfer pricing concepts into the royalty article of the treaty. Article 12(4) provides that in cases where there is a non-arm’s length relationship between the payor and the beneficial owner of the royalty, then the zero percent withholding rate is available “only to the extent the royalties would have been paid absent such special relationship(s).” Any excess amount of royalty income may be taxed at the source state rate at up to 5 percent.
Gains from the Alienation of Property
With a few exceptions, Article 13 of the United States- Japan Income Tax Treaty provides for exclusive resident state taxation of gains from the alienation of property. An exception to this general rule are gains from the sale of real property and gains from the sale of shares or other interests in certain real property holding companies. In these cases, gains may be taxed in the country where the property is located and by the owner’s home country.
Income from Employment and Stock Options
Article 14 of the United States- Japan Income Tax Treaty apportions taxing jurisdiction over the remuneration derived by a resident employee between Japan and the United States. Under Article 14, employee services are taxed in the jurisdiction where the employment services are performed. For example, if a Japanese citizen earns wages while working in the United States, the United States may tax the wages. Employee stock options or ESOPs are a form of compensation which are governed under Article 14. Article 14 provides that stock options are fairly apportioned between the two Contracting States, either through the operation of the treaty or through a mutual agreement procedure.
Pensions and Annuities
Article 23 of the United States- Japan Income Tax Treaty provides a basic rule for cross-border taxation of pensions and annuities. Under Article 23 of the treaty, pensions and annuities in consideration of past employment can be taxed only by the country of residence of the recipient.
Article 21 of the United States- Japan 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.
Limitation on Benefits
The United States- Japan 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 22(i)(f), 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 22(2), 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.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.