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- Italy 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- Italy Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Italy 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 Italy.
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, according to Article 2 of the Italian Tax Code, an individual is considered an Italian resident for tax purposes if, for the greater part of the fiscal year (i.e. for more than 183 days): 1) the individual is registered in the Records of the Italian Resident Population or Angrafe; 2) the individual has a ‘residence’ in Italy, or 3) the individual has a ‘domicile’ in Italy (principal centre of business, economic and social interests). If one of these conditions are satisfied, the individual qualifies as a tax resident of Italy.
Companies that have their legal or administrative headquarters or principal business activity within Italy are considered to be resident companies and are taxable in Italy on their worldwide income. A foreign company holding one or more Italian subsidiaries is deemed to be a resident of Italy for tax purposes if at least one of the following conditions take place: 1) the foreign company is, either directly or indirectly, held by Italian resident persons; 2) the board of directors of the foreign company is made up mainly of Italian resident individuals.
Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. 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 Italy under its definition of residency. To resolve this issue, the United States- Italy Income Tax Treaty has included a tie-breaker provision in the treaty. The tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. Article 4(2) of the United States- Italy Income Tax Treaty provides the following rule for individuals:
1) he shall be deemed to be a resident of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident of that State with which his personal and economic relations are closer (center of vital interests);
2) if the State in which he has his center of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident of the State in which he has an habitual abode;
3) if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident of the State of which he is a national;
4) if he is a national of both States or neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement;
5) if the taxpayer is a citizen of both countries or of neither country, the competent authorities of the two countries will settle the matter by mutual agreement.
The treaty does not provide for a tie-breaker rule for companies. Another omission from the United States- Italy Income Tax Treaty is a provision dealing with income derived through hybrid and reverse hybrid entities. The terms “hybrid” and “reverse hybrid” entities are employed from a U.S. perspective. A hybrid entity is a legal entity whose characterization for U.S. tax purposes is different from that for foreign tax purposes. The typical hybrid is a foreign entity that is considered a corporation for foreign tax purposes, but a disregarded entity or partnership for U.S. tax purposes. A reverse hybrid entity is an entity that is non-transparent in the United States and fiscally transparent in the foreign jurisdiction.
The 1996 U.S. Model Treaty revised the definition of “resident” with respect to fiscally transparent entities. Instead of classifying these entities as residents or non-residents in either country the Model provision examines individual items of income earned through the entities. When an item of income is derived through an entity, it is considered to be derived by a resident of a country to the extent the country treats the income as income of a resident for purposes of its tax law. Thus, the treatment of an entity as fiscally transparent or nontransparent in the country of asserted residence will govern the determination of who derives income, and income is not eligible for a reduction of source-state taxation unless the other country considers it income of a resident.
The treatment governing fiscally transparent entities in the United States- Italy Income Tax Treaty is based on the 1981 U.S. Model Treaty. The provision does not deal with the “derivation” of income but relies instead on the definition of “resident,” stating that residents including partnerships, estates, and trusts only to the extent that income derived by such entities is taxable in the country of claimed residence, of the partnership, estate, or trust or in those of its partners or beneficiaries.
Although the results under the treaty are somewhat unclear, the provisions of the United States- Italy Income Tax Treaty might permit the use of hybrid and reverse hybrid entities to reduce source country taxation on items of income that are not taxed by the residence country. For example, when dividends, interest, or royalties are derived through an entity that the source country views as transparent but the residence country treats as non-transparent, the beneficial owners of the income are the partners or beneficiaries of the entity. If the partners or beneficiaries are residents of the treaty partner, income derived through the entity appears to qualify for treaty benefits. It is not clear that the residence of the entity itself is relevant. Since the residence country views the entity as fiscally non-transparent, its income would not be subject to tax in the residence country if it is formed in the source country or a third country.
We will now discuss the operative articles of the United States- Italy Income Tax Treaty.
Permanent Establishment
Article 7 of the United States- Italy 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- Italy Income Tax treaty defines permanent establishment as a “fixed place of business” – including a place of management; a branch, an office, a factory, mine, a workshop; a mine, quarry, or other place of extraction of natural resource; and a building site or construction or assembly project which exists for more than twelve months.
The term “permanent establishment” does not include: 1) the use of facilities solely for the purpose of storage, display, or delivery of goods or merchandise belonging to the enterprise; 2) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or delivery; 3) the maintenance of a stock or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; 4) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or for collecting information, for the enterprise; and 5) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research, or for similar activities which have a preparatory or auxiliary character for the enterprise.
Associated Enterprises
Article 9 of the United States- Italy Income Tax Treaty incorporates into the treaty the arm’s-length principle reflected in the transfer pricing provisions of Internal Revenue Code Section 482. Article 9 provides that when related enterprises engaged in a transaction are related and the enterprises engage in a transaction on terms that are not arm’s length, the Contracting States may make appropriate adjustments to the taxable income and tax liability of such related enterprises to reflect what the income and tax of these enterprises with respect to the transaction would have been had there been an arm’s-length relationship between them.
Independent Personal Services
Under Article 14 of the United States- Italy Income Tax Treaty, 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
Under Article 15 of the treaty, 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. The 183-day period is measured using the “days of physical presence” method. Under this method, the days that are counted include any day in which a part of the day is spent in the host country. Thus, days that are counted include the days of arrival and departure; weekends and holidays on which the employee does not work but is present within the country; vacation days spent in the country before, during or after the employment period, unless the individual’s presence before or after the employment can be shown to be independent of his presence there for employment purposes; and time during periods of sickness, training periods, strikes, etc., when the individual is present but not working. If illness prevented the individual from leaving the country in sufficient time to qualify for the benefit, those days will not count. Also, any part of a day in the host country while in transit between two points outside the host country is not counted.
Dividends
Under Article 10 of the United States- Italy Income Tax Treaty, the Source State can impose a gross withholding tax of 15 percent on all types of cross-border dividends. However, in certain cases, the 15 percent rate is reduced to 5 percent. The 5 percent rate is available to beneficial owners of a corporation if they own 25 percent or more of the payer’s voting stock for at least 12 months before the dividend is declared. According to the Technical Explanations, shares are considered voting stock for purposes of the 5 percent rate if they provide the power to elect, appoint, or replace any person vested with the powers ordinarily exercised by the board of directors of a U.S. corporation. The Technical Explanation also provides that a company holding shares through fiscally transparent entities (such as partnerships or disregarded entities) is treated as owning its proportionate interest in the shares held by such intermediate entities and thus may be entitled to the dividend treaty rates.
The treaty also exempts source-state taxation for dividends paid to qualified governmental entities as long as the qualified governmental entity holds, directly or indirectly, less than 25 percent of the payor’s voting stock. A “qualified governmental entity” is classified as: 1) any person or body of persons that constitute a governing body of Italian or United States political or administrative subdivision or local government authority; 2) a person that is classified as a political or administrative subdivision of the government; 3) a pension or fund of a person that operates exclusively to administer or provide pension benefits.
Finally, the United States- Italy Income Tax Treaty provides that dividends from regulated investment companies (“RICs”) and real estate investment trusts (“REITs”) do not qualify for the 5 percent dividend rates. RIC dividends are taxed at taxed at 15 percent if: 1) the beneficial owner is an individual owning no more than 10 percent of the REIT; 2) the dividends are paid with respect to a publicly traded class of stock and the beneficial owner is a person owning no more than 5 percent of any class of REITs stock; or 3) the beneficial owner owns no more than 10 percent of the REIT and the REIT is diversified. A REIT will be considered to be “diversified” if the value of no single interest in the REIT’s real property exceeds 10 percent of the REIT’s total interests in real property.
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 10 percent branch level tax on excess interest.
Interest
Article 11 of the United States- Italy 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. The treaty expands the categories of interest income exempt from source-country taxation to include the following: 1) interest beneficially owned by a “qualified governmental entity” that owns, directly or indirectly, 2) interest paid with respect to debt guaranteed or insured by a qualified governmental entity of either Italy or the U.S. and beneficially owned by a resident of the other state; 3) interest paid or accrued with respect to a sale on credit of goods, merchandise, or services provided by one enterprise to another enterprise; or 4) interest paid or accrued in connection with the sale on credit of industrial, commercial or scientific equipment.
The term “beneficial owner” is not defined in the treaty or the treaty’s Technical Explanations, and is, therefore, defined as under the internal law of the country imposing tax (i.e., source country).
Article 11(7) of the United States- Italy Income Tax Treaty provides that in cases involving special relationships between persons, the treaty rates applies only to that portion of the total interest payments that would have been made absent such special relationship (i.e., an arm-length interest payment). Any excess amount of interest remains taxable according to the laws of the United States and Italy, respectively. This provision permits the U.S. to treat “excess interest” paid by the U.S. branch of an Italian resident as U.S. source income subject to 10 percent U.S. tax on a gross basis. Excess interest is defined as: 1) interest allocable to the profits of the Italian resident that 1) are attributable to a permanent establishment of the Italian resident in the U.S. or 2) are subject to U.S. taxation as income or gain from immovable property (real property) located in the United States; 3) the interest actually paid by that permanent establishment or trade or business.
Royalties
Article 12 of the United States- Italy Income Tax Treaty exempts from source-state withholding tax royalties paid with respect to a copyright of literary, artistic or scientific work (excluding computer software, motion pictures, films, tapes or recording devices used for radio or television broadcasting). The treaty however provides for a reduced 5 percent withholding rate on the gross amount of royalties for the use of, or the right to use, computer software or industrial, commercial or scientific equipment. Finally, Article 12 of the United States- Italy Income Tax Treaty provides an 8 percent withholding on all other royalty income.
Gains from the Alienation of Property
With a few exceptions, Article 6 of the United States- Italy 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.
Pensions, 401(k), 403(b), and IRA Plans
Article 18 of the United States- Italy Income Tax Treaty addresses the taxation of social security benefits, lump-sum payments or severance payments, and cross-border pension contributions. Article 18(6) allows a deduction for both employees and employers for cross-border contributions to pension plans. Article 18(6) also exempts from income tax both pension benefits accrued and employer contributions made during a period of employment in the country where the taxpayer does not reside. Article 18(4) includes provisions requiring that the U.S. tax treatment of contributions by U.S. citizens resident in the other country to pension funds in that country will be comparable to the treatment of contributions to U.S. funds.
The way the United States- Italy Income Tax Treaty is drafted provides Italian nonresidents that work in the United States planning opportunities to reduce U.S. income tax consequences associated with IRA, 403(b) or 401(k) contributions after they depart the United States. For example, let’s assume that Tom is an Italian national that came to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Tom contributed money to an IRA. Tom has returned to Italy and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. 20 percent withholding tax and the 10 percent early withdrawal penalty.
Since Tom is a citizen of Italy, he may utilize the U.S.-Italy Income Tax Treaty to avoid the 20 percent withholding tax and the early withdrawal penalty. This is because under Article 18, Paragraph 1, of the U.S-Italian Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explain that “paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment….shall be taxable only in the State [of residency].” This means that under the applicable provisions of the U.S.-Italy Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the United States- Italy Income Tax Treaty. However, the OECD defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 18. See OECD 2014 Commentary, Art 18. Thus, although Article 18 of the United States- Italy Income Tax Treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Tom from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Article 18 of the United States- Italy Income Tax Treaty does not mention the term IRA, the Internal Revenue Service (“IRS”) has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Tom is a resident of Italy, he can utilize the United States- Italy Income Tax Treaty to avoid U.S. federal tax on the distribution from his IRA.
Other Income
Article 22 of the United States- Italy 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 22 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- Italy 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.
The limitation on benefits provision of Article 2 covers benefits under all articles of the treaty. The provision allows the full benefits of the treaty to individuals, qualified government entities, charities, and pension plans at leasat 50 percent of whose beneficiaries, members, or participants are individuals of whose beneficiaries, members, or participants are individual residents in either country. Companies that satisfy a “publicly traded” test can qualify for benefits, as can any resident not otherwise eligible for benefits that satisfies an “ownership base erosion” test or an “active trade or business” test. The competent authority of the source country may also grant benefits to persons not otherwise entitled to them.
The publicly traded test allows treaty benefits to a company if all shares in the class or classes of shares representing more than 50 percent of the voting power and value of the company are regularly traded on a “recognized stock exchange.” A “recognized stock exchange” for this purpose means NASDAQ and any stock exchange with the SEC as a national securities exchange for purposes of the Securities Exchange Act of 1934, and any stock exchange constituted and organized under Italian law. According to the Technical Explanation, with respect to the United States and pursuant to existing provisions of the Internal Revenue Code, a class of shares will generally be treated as “regularly traded” if: 1) trades in the class of shares are made in more than de minimis quantities on at least 60 days during the taxable year; and 2) the aggregate number of shares in the class traded during the year is at least 10 percent of the average number of shares outstanding during the year. A company will also qualify if it is owned directly or indirectly by five or fewer companies meeting the publicly traded test, as long as each intermediate owner is entitled to benefits.
The “ownership base erosion” test consists of two prongs. Under the first, persons qualifying for benefits as individuals, qualified governmental entities, charities, pension plans, or publicly traded companies must own, directly or indirectly, at least 50 percent of each class of shares or other beneficial interest in the entity on at least half the days in the taxable year. In the case of indirect ownership, each indirect owner must be entitled to treaty benefits under any of the aforementioned tests or under the ownership base erosion test. Under the second prong, the percentage of the entity’s gross income for the taxable year that can be paid or accrued, directly or indirectly, to persons who are not residents of either country in the form of payments that are deductible for income tax purposes in the entity’s country of residence must be less than 50 percent of gross income, unless the payments are to permanent establishments in either country.
The “active trade or business” test is available to entities not otherwise qualifying for treaty benefits with respect to certain items of income. The entity must be engaged in the active trade or business in its country of residence in the active conduct of a trade or business in its country of residence, the income in question and with respect to which treaty benefits are claimed must be connected with or incidental to such trade or business, and the trade or business must be substantial in relation to the activity generating the income in the source country. For purposes of determining whether a trade or business in the residence country is “substantial,” the treaty provides a safe harbor test based on a comparison of assets, gross income, and payroll expense expenses in each of the countries. Under this safe harbor, a trade or business will be deemed “substantial” if the average of the following three ratios exceeds 10 percent and each individual ratio exceeds 7.5 percent:
1) the value of the assets in the state of residence to the assets used in the other state;
2) the gross income derived in the state of residence to the gross income derived in the other state; and
3) the payroll expense in the state of residence to the payroll expense in the other state.
If a resident of the United States or Italy is not otherwise entitled to benefits of the United States- Italy Income Tax Treaty, the competent authority of the state from which benefits are claimed may grant benefits to such a resident at its discretion.
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: 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.