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- France 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- France Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- France Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Income derived by a partnership or other pass-through entity is treated as derived by a resident of a treaty country to the extent that, under the domestic laws of that country, the income is treated as taxable to a person that qualifies as a resident of that treaty country. Under the United States- France Income Tax Treaty, a resident is any person who, under a country’s internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation, or other criterion of a similar nature. Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. Whether a person is a resident of the United States of France for treaty purposes is determined by reference to the internal laws of each 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 France under its definition of resident. To resolve this issue, the United States has included tie-breaker provisions in the United States- France Income Tax Treaty. The first test is where the individual has a permanent home. If that test is inconclusive because the individual has a permanent home available to him in both States, he will be considered to be a resident of the Contracting State where his personal and economic relations are closest, i.e., the location of his “center of vital interests.” If that test is also inconclusive, or if he does not have a permanent home available to him in either State, he will be treated as a resident of the Contracting State where he maintains an habitual abode. If he has an habitual abode in other States or in neither of them, he will be treated as a resident of his Contracting State of citizenship. If he is a citizen of both States or of neither, the matter will be considered by the competent authorities, who will attempt by mutual agreement to assign a single State of residence.
Below, please see Illustration 1 which provides an example how a treaty-tie breaker can be analyzed and resolved for an individual under the United States- France Income Tax Treaty. .
Charles de Gaulle is a citizen and resident of France. Charles owns Zoomtube, a company incorporated in France that is in the process of expanding to the much more lucrative U.S. market by opening a branch office in the United States. Charles is divorced and maintains an apartment in India, where she spends every other weekend visiting her children. Charles’ first wife, who kept their house in their divorce, has never left France. Charles becomes a U.S. resident alien under the substantial presence test as he operates Zoomtube’s U.S. branch. In the United States Charles owns a luxury condominium in New York where he lives with his second wife.
Because Charles is considered a resident of both the United States and India, the treaty tie-breaker procedures must be analyzed to determine which country has primary taxing jurisdiction. With an apartment in France and a condominium in the United States, Charles has a permanent home available in both countries. With Charles’ children and his home office in France as opposed to the lucrative portion of his business and his new wife in the United States, Charles does not have a center of vital interests in either country. Furthermore, because Charles regularly spends time in both countries, he arguably has a habitual abode in both. As a result, under the treaty tie-breaker, Charles may be considered a resident of France because he is a citizen of France.
A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.
The United States-France Income Tax Treaty defines a permanent establishment as a fixed place of business through which the business of an enterprise is wholly or partly carried on. This includes the following: 1) a place of management; 2) a branch; 3) an office; 4) a factory; 5) a workshop; and 6) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.
The term “permanent establishment” shall also include a building site or construction or installation project, or an installation or drilling rig or ship used for the exploration or to prepare for the extraction of natural resources, but only if such site or project lasts, or such rig or ship is used, for more than twelve months.
The treaty specifically excludes certain activities from the definition of permanent establishment. Some of these activities are: 1) the use of facilities 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 resident for the purpose of storage, display, or delivery; 3) the maintenance of a stock of goods 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 of collecting information, for the enterprise; 5) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; 6) the maintenance of a fixed place of business solely for combination of the activities mentioned above.
According to the United States- France Income Tax Treaty, the profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. Although the United States- France Income Tax Treaty firmly establishes the business profits rule. There still remains uncertainty as to how professional partnerships are taxed under the United States- France Income Tax Treaty. Under the domestic laws of the United States and France, the source of partnership income is determined differently, and certain partnerships are taxed in a different fashion. This creates double taxation problems for all partners, but especially for French residents who are United States citizens.
For purposes of United States federal tax law, each partner is considered to have earned that proportion of partnership income and to have incurred that proportion of partnership deductions that corresponds to his proportionate interest in the partnership (unless there is a valid special allocation). See IRC Section 704. The distributive share of each partner includes a share of each type of income derived from sources within each country in which the partnership earns income. To illustrate, assume that a taxpayer is 75 percent partner in a partnership with $300,000 of income from long term capital gains to which no deductions are attributable. The other $260,000 is United States-source business income to which $200,000 of deductions are attributable. The partnership also has $400,000 gross income from sources outside the United states to which $300,000 in deductions are attributable. The taxpayer has $30,000 United States-source long term capital gain (.75 x $40,000) and $45,000 of net United States-source business income (.75 x $260,000) less (.75 X $200,000). Net business income from foreign sources (as well as net foreign-source income) is $75,000 (.75 x $400,000) less (.75 x $300,000). The taxpayer would be subject to United States tax at ordinary income rates on the business income and at the special reduced rate on the capital gains income. Within the limits of the foreign tax credit rules, a taxpayer may take a credit for 75% of the foreign income tax paid on the business income from foreign sources. See Rev. Rul. 67-158, 1967-1 C.B. 188.
This general rule is subject to two exceptions. First, when the partner only receives a share if there is income from a specific source, all of that partner’s share is income from that source. Second, when the partner receives a guaranteed payment regardless of partnership earnings, the payment is considered to be for services as though paid under an employment contract, and the payment has its source in the place where the partner’s services are rendered. The French source rule for partners who perform services outside France is the same as the general United States rule: a pro rata share of income from each partnership source. However, the rule for a partner who performs services in France is that all of his partnership income is considered to be from French sources. This means that the partners in the aggregate may have more French-source income than the partnership does where any partner performs services in France. See Business Impact of the United States France Income Tax Protocol, Herbert I. Lazerow, March 1982 Vol. 19. No. 2 San Diego Law Review.
The rule also creates unrelieved double taxation for United States citizen-French resident partners performing his services in France where the partnership itself derives income from sources within the United States. France taxes the partner on all of his income because it is the source country (where the services are performed) and gives no double taxation relief; the United States taxes all of the income because of the taxpayer’s citizenship, but gives a tax credit only for the portion of the income tax due on foreign-source income determined under United States law. If the partnership derives 90 percent of its income from United States sources, the United States will give the foreign tax credit against only ten percent of the United States tax.
The treaty strikes a compromise that promises some relief from double taxation in every case, and full relief if the partner affected can persuade the partnership to elect it. First, the Protocol establishes the general principle that income of a partner from a partnership has the same source pro rata as the income in the hands of the partnership. This is the United States rule and the French rule for partners in certain professions, however, no more than 50 percent of the earned income of a United States citizen residing in France will be exempted from French tax under that general principle. Further, that income which is not exempt from French tax will be considered French-source income for United States tax purposes, if and only if the partnership so elects.
The result of these three provisions is that where there is a French-resident partner who is a United States citizen in a service partnership with more than 50% United States-source income, 50 percent of the partner’s distributive share will be taxed in France. The entire distributive share will be taxed in the United States because of the taxpayer’s citizenship, however, a credit will be given for tax on income from sources outside the United States. If the partnership so elects, all the income taxed by France will be from sources within France, giving a tax credit for 50 percent of the United States tax. The final result relieves the partner of double taxation while splitting the revenue more-or-less equally between the two countries, instead of allocating the vast majority of the income to one country as is the case with most other treaties.
There is a problem with this treaty solution. The French position has been that a French resident partner who receives his partnership share for the performance of services in France is considered to have received entirely French source income. France has taken the position in the past that the entire amount of a U.S. resident partner’s income was French source to him even though it conceded that the partnership may have had no French source income. The compromise confirms the U.S. rule in Article 6(4) whereby France agrees that source is determined at the partnership level; but the U.S. then conceded in Article 14(4) the right of France in any event to limit the excluded income to 50 percent of the total. A possible anomaly is that a French citizen partner may, under the treaty, exclude his entire share of U.S. source income from the partnership because Article 14(4) only refers to U.S. citizens or residents. See Newly Revised Income Tax Treaty with France: A Breakthrough in U.S. Tax Treaty Law, Stephanie H. Simonard, Northwestern Journal of International Law & Business Volume 2 (1980).
An area of potential concern is that many American partners residing outside the United States are paid part of their partnership earnings in the form of “guaranteed payments” for services rendered overseas. Under U.S. tax law, these are considered to be foreign sources on a similar basis as salary, and in the past have enabled partners to claim both foreign earned income deductions, foreign exclusions, and foreign tax credits. The published U.S. and French interpretations on the treatment to be accorded a guaranteed payment are markedly different. The French interpretation considers these payments as salary to the partner from the partnership, taxable in France under Article of the treaty. The French do not permit exclusions on such payments. Hence, in a case where a partner received a guaranteed payment plus other partnership earnings from U.S. sources, the implication is that these earnings may be taxed in France on 100 percent of the guaranteed payment plus 50 percent of the additional partnership earnings.
A literal reading of the treaty would, however, lead to the conclusion that the 50 percent limitation applies to total income from the partnership, including the guaranteed payment. Article 14(4) states that the amount of income exempt from French tax under Article 6(4) will be limited to 50 percent of “total earned income from the partnership.” This wording is intended to ensure that France is allowed to tax at least one-half of a partner’s income; there seems to be no reason why this should be changed if a partner receives a guaranteed payment. For example, if a partner receives a guaranteed payment of $75,000, and a distributive share of U.S. source income of $125,000, his income taxable in France should be $100,00, applying the 50 percent to the total partnership income of $200,000. Apparently, the French taxing authorities may not agree with this analisis.
Independent Personal Services
Article 14 of the United States- France Income Tax Treaty provides the rule that an individual or firm of individuals (other than a company) who is a resident of a Contracting State and who derives income from the performance of professional services or other independent activities of a similar character will be exempt from tax in respect of that income by the other Contracting State unless certain conditions are satisfied. The income may be taxed in the other Contracting State if the person has a fixed base regularly available to him in the other Contracting State for the purpose of performing his activities and the income is attributable to that fixed base.
Dependent Personal Services
Article 15 of the United States- France Income Tax Treaty discusses dependent personal services. Subject to Article 15 of the treaty, directors fees, income earned by entertainers and athletes, payments received by students and apprentices, payments received by professors, teachers, and research scholars, and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State.
Article 15(2) of the United States- France Income Tax Treaty provides that remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if: 1) the recipient is present in the other State for a period or periods not exceeding in the aggregate 183 days in any 12-month period; 2) the remuneration is paid by, or on behalf of, an employer who is not a resident of the other State; and 3) the remuneration is not borne by a permanent establishment or a fixed base which the employer has in the other State.
Income from Real Property
Article 5 of the United States-France treaty permits the U.S. to tax income from U.S. real estate, including capital gains. The Internal Revenue Code permits the U.S. to tax gains on French real estate gains held by U.S. citizens or residents. Article 23 of the United States- France treaty allows France the right to tax capital gains
Dividends, Interest, and Royalties
Like the United States, most foreign countries impose flat rate withholding taxes on dividends, interest, and royalty income derived by offshore investors from sources within the country’s borders. Tax treaties usually reduce these withholding taxes. Tax treaties usually reduce the withholding tax rate on dividends to 15 percent or less.
Article 10, 11, and 12 of the United States- France Income Tax Treaty limits the source country’s right to tax dividends, interest, and royalty income. The United States may tax the income at source up to the rate it would be permitted to impose were the income going to a resident of France who is not a United States citizen to 15 percent for dividends. However, Article 10(3)(a) provides for the elimination of withholding tax on dividends beneficially owned by a company that has owned, directly, or indirectly through one or more residents of either Contracting State, 80 percent or more of the voting power of the company paying the dividend for the 12-month period ending on the date entitled to the dividend is determined. The determination of whether the beneficial owner of the dividends owns at least 80 percent of the voting power of the company is made by taking into account stock owned both directly and indirectly through one or more residents of either Contracting State.
Eligibility for the elimination of withholding tax is provided if a company meets the “publicly traded,” “ownership-base erosion,” and “active trade or business” tests discussed below. According to the technical explanations to the United States-France Income Tax Treaty, these restrictions are necessary because of the increased pressure on the limitation on benefits tests resulting from the fact that the United States has relatively few treaties that provide for such elimination of withholding tax on inter-company dividends. These restrictions are also intended to prevent companies from re-organizing in order to become eligible for the elimination of withholding tax in circumstances where the limitation on benefits provision does not provide sufficient protection against treaty shopping.
For example, assume that ThirdCo is a company resident in a third country that does not have a tax treaty with the United States providing for the elimination of withholding tax on inter-company dividends. ThirdCo owns directly 100 percent of the issued and outstanding voting stock of USCo, a U.S. company, and of FCo, a French company. FCo is a substantial company that manufactures widgets; USCo distributes those widgets in the United States. If ThirdCo contributes to FCo all the stock of USCo, dividends paid by USCo to FCo would qualify for treaty benefits under the active trade or business test described in Article 30 of the United States- France Income Tax Treaty. However, allowing ThirdCo to qualify for the elimination of withholding tax, which is not available to it under the third state’s treaty with the United States, would encourage treaty shopping.
Article 10(5) of the United States- France Income Tax Treaty imposes limitations on the rate reductions in the case of dividends paid by a Regulated Investment Company (“RIC”), Real Estate Investment Trust (“REIT”), Collective Investment Scheme (“SICAV”), Limited Real Estate Investment Companies (“SIIC”), and Societe de Placement a Preponderance Immobiliere a Capital Variable (“SPPICAV”). Article 10(5) provides that a 15 percent maximum rate of withholding tax applies to dividends paid by PICs, SIIC, SPPICAV, RIC, and RIETs provided certain conditions are satisfied.
Article 10(8) of the United States- France Income Tax Treaty authorizes a “branch profits tax.” However Article 10(9) of the treaty limits the branch profits tax to 5 percent.
Article 11 of the United States- France Income Tax Treaty provides that interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the other State. Article 11(3) of the United States- France Income Tax Treaty defines “interest” as income from indebtedness of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from government securities and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures, as well as other income that is treated as income from money lent by the taxation law of the Contracting State in which the income arises. Penalty charges for late payment are not regarded as interest.
Article 12 of the United States- France Income Tax Treaty provides that royalty arising in a Contracting State and paid to a resident of the other contracting State may be taxed in that other State. Such royalty may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner is a resident of the other Contracting State, the tax charged shall not exceed 5 percent of the amount of the royalties. The term “royalties” means:
(a) 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 or any neighboring right (including reproduction rights, or any software);
(b) payments of any kind received as a consideration for the use of; or the right to use, any patent, trademark, design or model, plan, secret formula pr process, or other like right or property, or for information concerning industrial, commercial, or scientific experience; and
(c) Gains derived from the alienation of any such right or property.
Private Pensions and Annuities
Private pensions have always been taxable at the taxpayer’s residence, always reserving the right of the United States to tax its citizens. A United States citizen residing in France who had worked all his life in the United States would be subject to double taxation on his pension income. France would be subject to double taxation on his pension income. France would tax such income because of residence and the United States would tax it because of source and citizenship. The entire pension would be considered for United States tax purposes as income from sources within the United States because it accrued as a result of United States work and went into a United States fund. The foreign tax credit limitation would likely preclude any foregn tax credit for tax paid to France on the pension. No method is set forth for determining what part of the pension is attributable to a particular country in the event of a working life split between a number of countries, but the fairest and most easily administered system would be on the basis of time, rather than on the basis of contributions.
Alimony and Annuities
Two items of income which the treaty does not mention are alimony and annuities received by a United States citizen or resident residing in France. Under the United States- France Income Tax Treaty, alimony and annuities are taxable only in the state of residence, but the United States retains the right to tax its citizens on them. Thus, both the United States and France have the right to tax these items to dual tax residents residing in France.
Articles 20, 22(4)(a) of the United States- France Income Tax Treaty provides that security payments to a resident of the other state are taxable only by the paying state. Thus, a United States citizen who retires on United States social security in Paris is not taxed in France on that payment. Much more common, however, is the person who retires in the country of past employment. An American who worked then subsequently retired in France would be subject to a tax by France on French social security payments. That American would also be subject to a United States tax on those French social security payments because the taxpayer is not a United States resident to qualify for treaty benefits. The treaty expressly extends the benefits of the social security article to United States citizens without any limitation as to residence: they may be taxed only by the country making the payment.
Limitation on Benefits
Article 30 (Limitation on Benefits of the Convention) of the United States- France Income Tax Treaty contains anti-treaty provisions that are intended to prevent residents of third countries from benefiting from what is intended to be a reciprocal agreement between two countries. In general, the provision does not rely on a determination of purpose or intention but instead sets forth a series of objective tests. A resident of a Contracting State that satisfies one of the tests will receive benefits regardless of its motivations in choosing its particular business structure.
Article 30 of the United States- France Income Tax Treaty follows the form used in other recent U.S. income tax treaties. Article 30 of the United States – France Income Tax Treaty states the general rule that a resident of a Contracting State, any one of which suffices to make such resident a so-called “derivative benefits” test under which certain categories of income may qualify for benefits. Article 30 of the treaty sets forth the active trade or business test, under which a person not entitled to benefits under paragraph Article 30 may nonetheless be granted benefits with regard to certain types of income. Article 30 of the treaty limits the benefits available under the other provisions of the treaty involving the issuance of “tracking stock” and similar instruments.
Article 30 of the United States- France Income Tax Treaty provides that individual residents of a Contracting State will be entitled to all treaty benefits. If such an individual receives income as a nominee on behalf of a third country resident, benefits may be denied under the respective articles of the treaty by the requirement that the beneficial owner of the income be a resident of a Contracting State.
Article 30 of the United States- France Income Tax Treaty applies to two categories of companies: publicly traded companies and subsidiaries of publicly traded companies. Article 23(c)(i) generally provides that a company will be a qualified person (for purposes of the United States- France Income Tax Treaty) if the principal class of its shares is listed on a recognized U.S. or French stock exchange and is regularly traded on one or more recognized stock exchanges.
The term “recognized stock exchange” is defined as the NASDAQ System owned by the National Association of Securities Dealers and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purpose of the Securities Exchange Act of 1934; (2) the London Stock Exchange and any other recognized investment exchange within the meaning of the Financial Services Act 1986 or the Financial Services and Markets Act 2000; 3) the Irish Stock Exchange, the Swiss Stock Exchange, and the stock exchanges of Amsterdam, Brussels, Frankfurt, Mamburg, Johannesburg, Madred, Milan, Paris, Stockholm, Sydney, Toronto, and Vienna.
The term “principal class of shares” is defined to mean common shares of the company representing the majority of the aggregate voting power and value of the company. If the company does not have a class of ordinary or common shares representing the majority of the aggregate, a majority of the voting power and value of the company.
A company resident in a Contracting State is entitled to the benefits of the United States- France Income Tax Treaty if five or fewer direct and indirect owners of at least 50 percent of the aggregate vote and value of the company’s shares are publicly traded companies. Article 30 of the United States- France Income Tax Treaty sets forth a derivative benefits test that applies to all treaty benefits. In general, a derivative test entitles the resident of a Contracting State to treaty benefits if the owner of the resident would have entitled to the same benefit had the income in question flowed directly to that owner. Article 23(3) of the United States- France Income Tax Treaty provides a derivative benefits test under which a company that is a resident of a Contracting State may be entitled to the benefits of the treaty with respect to certain items of income. To qualify under this paragraph, the company must meet an ownership test and a base erosion test.
Under the ownership test, seven or fewer equivalent beneficiaries must own shares representing at least 95 percent of the aggregate voting power and value of the company. Ownership may be direct or indirect. The term “equivalent beneficiary” may be satisfied in two alternative ways. The first requirement (despite NAFTA and Brexit), the person must be a resident or a Member State of the European Community, a European Economic Area state, or a party to the North American Free Trade Agreement (collectively, “qualifying States”). If a company has only one class of shares, it is only necessary to consider whether the shares of that class meet the relevant trading requirements. If the company has more than one class of shares, it is necessary as an initial matter to determine which class or classes constitute the “principal class of shares.” The term “principal class of shares” is defined to mean the ordinary or common shares of the company representing the majority of the aggregate voting power and the value of the company. If the company does not have a class of ordinary or common shares representing the majority of the aggregate voting power and value of the company, then the “principal class of shares” is that class or any combination of classes of shares that represents, in the aggregate, a majority of the voting power and value of the company. Although in a particular case involving a company with several classes of shares it is conceivable that more than one group of classes could be identified that account for more than 50 percent of the shares, it is only necessary for one such group to satisfy the requirements of this subparagraph in order for the company to be entitled to benefits.
A company whose principal class of shares is regularly traded on a recognized stock exchange will nevertheless not qualify for benefits if it has a disproportionate class of shares that is not regularly traded on a recognized stock exchange. A company has a disproportionate class of shares if it has outstanding a class of shares that is subject to terms or other arrangements that entitle the holder to a larger portion of the company’s income, profit, or gain in the other Contracting State than that to which the holder would be entitled in the absence of such terms or arrangements. Thus, for example, a company resident in France has a disproportionate class of shares if it has outstanding a class of “tracking stock” that pays dividends based upon a formula that approximates the company’s return on its assets employed in the United States.
The following example illustrates this result.
Example. FCo is a corporation resident in France. FCo has two classes of shares: Common and Preferred. The Common shares are listed and regularly traded on a designated stock exchange in France. The Preferred shares have no voting rights and are entitled to receive dividends equal in amount to interest payments that FCo receives from unrelated borrowers in the United States. The Preferred shares are owned entirely by a single investor that is a resident of a country with which the United States does not have a tax treaty. The Common shares account for more than 50 percent of the value of FCo and for 100 percent of the voting power. Because the owner of the Preferred shares is entitled to receive payments corresponding to the U.S. source interest earned by FCo, the Preferred shares are a disproportionate class of shares. Because the Preferred shares are not regularly traded on a recognized stock exchange, FCO will not qualify for benefits under the United States- France Income Tax Treaty.
The second requirement of the definition of “equivalent beneficiary” is that the person must be entitled to equivalent benefits under an applicable treaty. To satisfy the second requirement, the person must be entitled to all the benefits of a comprehensive treaty between the Contracting State from which benefits of the treaty are claimed under a qualifying State. For this purpose, however, if the treaty in question does not have a comprehensive limitation on benefits article, this requirement only is met if the person would be a “qualified person” test discussed in Article 30 of the treaty. Thus, a French individual will be an equivalent beneficiary without regard to whether the individual would have been entitled to receive the same benefits if it received the income directly. A resident of a third country cannot qualify for treaty benefits. However, if certain ownership requirements are satisfied, the “equivalent beneficiary” test may be satisfied. Thus, for example, if 90 percent of a French company is owned by five companies that are residents in member states of the European Union and 10 percent of the French company is owned by a U.S. or French individual.
Finally, Article 30 sets forth the general rule that a resident of a Contracting State engaged in the active conduct of a trade or business in that State may obtain the benefits of the United States- French Income Tax Treaty with respect to an item of income, profit, or gain derived in that other Contracting State. The item of income, profit, or gain, however, must be derived in connection with or incident of that trade or business.
The term “trade or business” is not defined in the treaty. Accordingly, the Internal Revenue Service (“IRS”) will refer to the regulations under Internal Revenue Code Section 367(a) for the definition of the term “trade or business.” In general, therefore, a trade or business will be considered to be a specific unified group of activities that constitute or could constitute an independent economy and an independent economic enterprise carried on for profit. Furthermore, a corporation generally will be considered to carry on a trade or business only if the officers and employees of the corporation conduct substantial managerial and operational activities. A business activity generally will be considered to form a business activity conducted in the State of source if the two activities involve the design, manufacture or sale of same products or types of products, or provisions of similar services. The following examples illustrate this rule.
USCo is a corporation resident in the United States. USCo is engaged in an active manufacturing business in the United States. USCo owns 100 percent of the shares of FCo, a company resident in France. FCo distributes USCo products in France. Because the business activities conducted by the two corporations involve the same products, FCo’s distribution business is considered to form a part of USCo’s manufacturing business.
The facts are the same as in Example 1, except that USCo does not manufacture. Rather, USCo operates a large research and development facility in the United States that licenses intellectual property to affiliates worldwide, including FCo. FCo and other USCo affiliates then manufacture and market the USCo-designated products in their respective markets. Because the activities conducted by FCo and USCo involve the same product lines, these activities are considered to form a part of the same trade or business.
For two activities to be considered to be “complementary,” the activities to be “complementary,” the activities need not relate to the same types of products or services, but they should be part of the same overall industry and be related in the sense that the success or failure of one activity will tend to result in success or failure for the other. Where more than one trade or business is conducted in the State of source and only one of the trades or businesses forms a part of or is complementary to a trade or business conducted in the State of residence, it is necessary to identify the trade or business to which an item of income is attributable.
Americair is a corporation resident in the United States that operates an international airline. FSub is a wholly-owned subsidiary of Americanair resident in France. FSub operates a chain of hotels in France that are located near airports served by Americair Flights. Americair frequently sells tour packages that include air travel to France and lodging at FSub hotels. Although both companies are engaged in the active conduct of a trade or business. Therefore FSub business does not form a part of Americair’s business. However, FSub’s business is considered to be complementary to Americair’s business because they are part of the same overall industry (travel), and the links between their operation tend to make them interdependent.
The facts are the same as in Example 3, except that FSub owns an office building in France instead of a hotel chain. No part of Americair’s business is conducted through the office building. FSub’s business is not considered to form a part of or to be complementary to Americair’s business. They are engaged in distinct trades or businesses in separate industries, and there is no economic dependence between the two operations.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty (such as the United States- France Income Tax 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.