By Anthony Diosdi
The major purpose of an income tax treaty is to reduce or eliminate the impacts of international double taxation by residents of one treaty country from sources within another treaty country. Because tax treaties often reduce U.S. and/or foreign tax consequences associated with a cross-border transaction, anyone involved in international transactions or commerce must consider utilizing an applicable income tax treaty. This article is designed to provide the reader with a broad overview as to how an income tax treaty can be used by U.S. residents and nonresidents to reduce their exposure to global income taxation.
Many of the income tax treaties to which the United States is a party are similar to the United States Model Income Tax Convention of November 15, 2006 (“U.S. Model Treaty”). Because many of the income tax treaties to which the United States is a party is based on the U.S. Model Treaty, this article will use the U.S. Model Treaty as a reference when discussing the application of treaties to certain sources of income. With that said, the reader should keep in mind that each tax treaty to which the U.S. is a party is separately negotiated and therefore each tax treaty is unique. Consequently, it is extremely important to carefully review the protocols of each applicable tax treaty in order to determine the impact of the treaty to a specific situation.
Anyone involved in treaty planning must consider when the treaty was negotiated along with the enactment of recent legislation. This is because the Supremacy Clause of the United States Constitution treats treaties entered into with foreign countries and federal legislation equally. This means that if a treaty provision conflicts with Internal Revenue Code or other legislation, whichever is later enacted will prevail.
Common Treaty Provisions
Definition of Resident and Treaty Tie-Breaker Provisions
Anyone considering utilizing a tax treaty should know that the tax exemptions and reductions from each treaty are typically only available to a resident of one of the treaty countries. Under the U.S. Model 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. See Article 4(1) of the U.S. Model Treaty. With that said, a resident does not include a person who is subject to tax in the country only with respect to income derived from sources in that country. In other words, a resident is someone who is in a country by virtue of citizenship or residence, as opposed to taxation on the basis of the source of income. Whether a person is a resident of a particular country for treaty purposes is determined by reference to the internal tax laws of the specific country.
Because each country has its own unique definition of residency, a person could be a resident in more than one country. For example, an alien may be green card by the U.S. immigration authorities and simultaneously qualify as a resident of a foreign country under its definition of residency. This may result in an individual being taxed by two or more countries at the same time. To resolve these issues, the United States has included tie-breaker provisions in many of its income tax treaties. In certain cases, U.S. income tax treaties that provide tie-breaker provisions could be used to treat a U.S. tax resident as a non-resident. Under Article 4(3) of U.S. Model Treaty, a tie-breaker provision may be applied to the individuals:
1. The taxpayer is a resident of the country in which he or she has available a permanent home.
2. If the taxpayer has a permanent home available in both countries, the taxpayer is a resident of the country in which his or her personal relations are closer.
3. If the country in which the taxpayer’s center of vital interests cannot be determined or if the taxpayer does not have a permanent home available to him or her in either state, the state is a resident of the country in which he or she has a habitual abode.
4. If the taxpayer has a habitual abode in both countries in which he or she is a citizen.
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.
Article 4(3) and (4) of the U.S. Model Treaty also provides for tie-breaker rules for corporations and other types of entities.
Anyone considering utilizing a treaty-tie breaker provision from any income tax treaty must consider the so-called savings clause provisions discussed in all tax treaties. Under the savings clause provisions, a treaty country saves the right to tax its own citizens as though the treaty did not exist. See Article 1(3) of the U.S. Model Treaty. An example of a savings clause provision is clearly illustrated in Article 1(3) of the income tax treaty between the United States and the United Kingdom. Under Article 11(1), interest received by U.K. residents is exempt from U.S. taxation. However, under Article 1(3) of that treaty, the United States reserves the right to tax the payee if a U.K. resident also is a U.S. citizen. As a consequence, in this case, the United States and United Kingdom tax treaty does not impede the right of the United States to tax the worldwide income of U.S. citizens.
Business Profits and Permanent Establishment
A central tax issue for anyone exporting goods or services outside the United States is whether they will be subject to taxation by the importing country. Most countries assert taxing jurisdiction over all of the income derived from sources within their borders, regardless of the citizenship or residence of the individual receiving the income. However, there are limits to these rules. Most countries have included permanent establishment provisions in their applicable income tax treaties. Whether or not U.S. businesses selling goods or services in a foreign country will be subject to local tax on that income depends on whether or not it has established a permanent establishment in that country.
Under a permanent establishment provision in the U.S. Model Treaty, the business profits of a resident of one treaty country are exempt from taxation by the other country unless those profits are attributable to a permanent establishment located within the host country. See Article 7(1) of the U.S. Model Treaty. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory, or a 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. See Article 5(1) and (2) of the U.S. Model Treaty. If a resident of one country has a permanent establishment in the other treaty country, the importing country may tax the taxpayer’s business profits, but only to the extent those business profits are attributable to the permanent establishment. See Article 7(1) of the U.S. Model Treaty.
Personal Services Income
As a general rule, when an employee of a business performs services on behalf of his or her employer in a foreign country, income from those services is subject to tax by the host country. However, most tax treaties exempt an employee’s income from taxation by a host country if the following requirements are satisfied:
1. The employee is present in the host country for 183 days or less;
2. The employee’s compensation is paid by, or on behalf of, an employer which is not a resident of the host country; and
3. The compensation is not borne by a permanent establishment or a fixed base which the employer has in the host country.
Below, please see Illustration 1 which demonstrates how a typical tax treaty taxes an employee performing services in a host country.
Acme is a company incorporated in foreign country A, which has an income tax treaty with the United States identical to the U.S. Model Treaty. Acme is in the software business. Due to the high demand for programming services in the United States for the last week in December, Acme sends Tom Jones, a citizen of country A to serve clients in the United States. During that week, Tom Jones assists 15 different clients of Acme. The compensation that Acme pays Tom Jones is $100,000.
Tom Jones is not taxed on his $100,000 of compensation for services her performs in the United States pursuant to the treaty because: 1) Tom Jones is in the United States for only seven days (less than 183 days); 2) Tom Jones is paid by Acme which is not a resident of the United States; and 3) Tom Jones’ compensation is not the result of a permanent establishment or fixed place of business Aceme has in the United States.
Many tax treaties also contain a separate independent services provision that governs the taxation of personal services income derived by self-employed professionals, such as accountants, doctors, engineers, and lawyers. Such income is exempt from host country taxation unless the services are performed in the host country and the income is attributable to an office or other fixed base of business that is located in the host country and is regularly available to the taxpayer for the purposes of performing the services. This provision allows self-employed professionals to provide services abroad without local taxation as long as they do not maintain an office or other fixed base of business without the host country.
Dividends, Interests, and Royalties
Similar to the United States, many foreign countries assess a flat rate withholding income tax on dividends, interest, and royalties. For federal tax purposes, the United States imposes a statutory withholding tax rate in the amount of 30 percent for nonresident aliens and foreign corporations. See IRC Section 871(a) and 881(a).
Most income tax treaties provide for a reduction of withholdings on dividends, interest, and royalties as long as the income is not attributable to a permanent establishment of the taxpayer. In cases of dividends, most tax treaties reduce the withholding tax rate to 15 percent or less. For royalties, tax treaties typically reduce the withholding tax rate to less than 10 percent. Under Article 12(1) of the U.S. Model Treaty, all royalties are exempt from withholding. A royalty is any payment for the use of, or the right to use, the following:
1. Any copyright of literary, artistic, or scientific work;
2. Any patent, trademark, design, model, plan, secret formula or process, or other like right or property;
3. Any information concerning industrial, commercial, or scientific experience, or
4. Any gains derived from the disposition of any right or property described in (i) through (3), where the proceeds are contingent upon the future productivity, use, or disposition of that property. See Article 12(2).
Below, please see Illustration 2 which illustrates the U.S. withholding rules for royalties.
Acme is a foreign company incorporated in country A, which has a tax treaty with the United States identical to the U.S. Model Treaty. Acme licenses a program as part of a video game to unrelated licensees in the United States. Because Acme is entitled to the benefits of the treaty, the licensees do not have to withhold on the royalty payments to Acme.
Gains from the Disposition of Property
Many tax treaties allocate gains from the sale of property to the country in which the seller resides. This is the position followed by the U.S. Model Treaty. Under Article 13(6) of the U.S. Model Treaty, gains from the disposition of property, such as capital gains on the sale of stock and securities, generally are taxable only by the country in which the seller resides.
Below, please see Illustration 3 which demonstrates how the U.S. Model Treaty taxes gain from the disposition of property.
Acme is a foreign corporation incorporated in country A, which has a tax treaty with the United States identical to the U.S. Model Treaty. Acme owns all the shares of its U.S. subsidiary, Wile E Coyote, Inc. When Acme sells the Wile E Coyote, Inc., shares to a purchaser, because the gain on the sale is taxed only on the country of Aceme’s residence, country A under the treaty, the United States does not tax these gains.
There are a number of exceptions to this general rule for real estate holdings, partnership interests, and inventory.
Income from Real Property
As a general rule, tax treaties do not offer any reductions for income generated from the rental of real estate. Consequently, individuals holding real estate investments abroad are taxed by both the home and the host country. This rule applies to rental income, as well as gains from the sale of real property. However, if real property rental income of a resident of one treaty country is taxed by the other treaty country, that individual can elect to have its income taxed on a net basis at the normal graduated rates applicable to business profits, rather than having its income taxed on a gross basis through flat rate withholding taxes. See Article 6(5) of the U.S. Model Treaty. This election allows an individual who owns rental property in a foreign jurisdiction to offset the gross rental income with the related rental expenses, such as depreciation, interest, insurance, and maintenance expenses.
Related Entities and Transfer Pricing
Tax treaties also play a role in complex Section 482 transfer pricing cases. By way of background, Section 482 was enacted to ensure that related corporations report and pay tax on their actual share of income arising from controlled transactions. The regulations under Section 482 adopt an arm’s-length standard for evaluating the appropriateness of a transfer price. Under this standard, a taxpayer should realize the same amount of income from a controlled transaction as an uncontrolled party would have realized from a similar transaction under similar circumstances. Tax treaties allow associated entities to allocate profits between two related businesses, as if their financial relations were unrelated.
Anti-Treaty Shopping Provisions
Because tax treaties provide lower withholding tax rates on dividend, interest, and royalty income, some multinational corporations may be able to reduce its foreign withholding taxes by owning its subsidiaries through strategically located holding companies. This practice is known as “treaty shopping.”
Anti-treaty shopping provisions are also known as limitation on benefits (“LOB”) provisions. The principal target of a LOB provision is a corporation that is organized in a treaty country by a resident of a non-treaty country merely to obtain the benefits of that country’s income tax treaty. A LOB denies such corporations the benefits of the treaty. Therefore, even if a corporation qualifies as a resident of the treaty country, that corporation is not entitled to treaty benefits unless it also satisfies the requirements of the treaty’s LOB provision. For example, under the LOB provision found in Article 22 of the U.S. Model Treaty, a corporation that is a resident of a treaty country generally is entitled to treaty benefits only if the corporation meets one of the following additional requirements: 1) more than 50 percent of the corporation’s stock is regularly traded on a recognized stock exchange (i.e., the corporation is a publicly traded company) and the corporation’s primary place of management is in its country of incorporation; 2) the corporation is a 50 percent or more owned by five or fewer companies entitled to treaty benefits; or 3) the corporation meets both a stock ownership test (at least 50 percent of the corporation’s stock is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50 percent of the corporation’s gross income is used to make deductible payments to persons who are not residents of either treaty country).
Below, please see Illustration 4 which demonstrates how a LOB provision is used.
Acme, a foreign company incorporated in foreign country A, owns all the shares of its U.S. subsidiary, Arco. Acme is owned by Tom Jones, a citizen of foreign country A, and 55 percent by Sing, a Singaporean individual. The United States has a tax treaty with country A similar to the U.S. Model Treaty, but does not have a tax treaty with Singapore. Arco pays a dividend to Acme. although Acme would be entitled to withholding at only a 5 percent rate under the treaty, the dividend from Arco is not entitled to the benefits of the treaty and the withholding will instead be 30 percent of the dividend. This is a result of Acme falling to satisfy the LOB provision. Acme failed to satisfy the LOB provision of the treaty because less than 50 percent of Acme shares are owned by a resident of country A.
It should be noted that not all tax treaties to which the United States is a party contains LOB provisions. For example, the United States Hungarian tax treaty does not contain a LOB provision. This has allowed multinational corporations and a number of individual taxpayers to “treaty shop” and use the U.S. Hungarian tax treaty to dramatically reduce their U.S. income tax liabilities. Anyone considering “treaty shopping” and utilizing the U.S. Hungarian tax treaty or any other tax treaty must consider the Tax Court’s opinion in Aiken Industries, Inc. v. Commissioner, 56 TC 925 (1972) and Internal Revenue Code Section 7701(a). In Aiken Industries, Inc, the Tax Court denied treaty benefits to a taxpayer who attempted to use back-to-back loan arrangements. The Internal Revenue Service (“IRS”) has used Section 7701(a) to disregard the existence of an intermediary or conduit entity with respect to treaty shopping that results in the avoidance of U.S.
Treaty Positions Must be Properly Disclosed on a Tax Return and on Form 8833
Any individual or corporation that claims the benefits of a tax treaty that is in conflict with the Internal Revenue Code must disclose that position on his or her tax. 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. See Treas. Reg. Section 301.6114-1(a)(2)(i). A taxpayer reports treaty based positions either by attaching a statement to its return or by using Form 8833. The income tax regulations describe the items that must be disclosed on a Form 8833. Failure to properly disclose a treaty position can subject an individual taxpayer to a $1,000 penalty and a corporate taxpayer to a $10,000 penalty.
The United States currently has income tax treaties with nearly 60 countries around the world. Because tax treaties often substantially modify U.S. and foreign tax consequences, we provide our clients with comprehensive advice which treaty should be considered to the income tax consequences of any outbound or inbound transaction. We also defend treaty positions before the IRS and in court if necessary. We provide international and domestic tax advice to numerous U.S.-based and foreign-based clients, including publicly traded and closely held entities.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. 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.