Because tax treaties provide lower withholding tax rates on dividend, interest, and royalty income, some multinational corporations can reduce U.S. withholding taxes by establishing a subsidiary in a jurisdiction that has a favorable tax treaty with the United States. This type of planning is often referred to as “treaty shopping.” Because of a concern of treaty shopping, the United States insists that any newly negotiated tax treaty contain an anti-treaty shopping provision known as a limitation on benefits (or “LOB”) provision. This article discusses typical LOB provisions contained in U.S. tax treaties.
An Overview of an LOB Provision
The principal target of a LOB provision is a corporation that is organized in a treaty country by a resident of a non-treaty country merely to obtain the benefits of that country’s income tax treaty. A LOB provision denies such corporations the benefits of the treaty. In order to qualify for the benefits under an income tax treaty that contains a LOB, a foreign individual or entity must not only be a resident of one of the countries party to the treaty, but also satisfy additional restrictions set forth in a LOB article contained in the treaty. LOB articles typically require a corporation who is a resident of a contracting state to also satisfy one of the article’s corporate tests before such a corporation can claim benefits under the treaty. Among these tests are the “publicly traded company test,” the “ownership-base erosion test,” and the “derivative benefits test.” A corporate resident needs to meet only one of these tests. The tests are generally designed to ensure that there is sufficient nexus between the corporation and its country.
LOB Corporate Tests under the Treaties
Although the LOB articles of the income tax treaties entered into by the U.S. vary (and in some cases quite significantly), the general provisions of the three LOB corporate tests mentioned above are set forth in the 2016 U.S. Model Income Tax Treaty, which are summarized below.
Under the publicly traded company test, a corporation must be a “publicly traded company” which is defined as a corporation whose principal class of shares is “regularly traded” on one or more recognized stock exchanges and either 1) such shares are also primarily traded on one or more recognized stock exchanges located in the contracting state where the corporation is a resident or 2) the corporation’s primary place of management and control is in the contracting state where the corporation is a resident.
The second test, referred to as the ownership-base erosion test, consists of two parts, both of which must be satisfied. The first part addresses the composition of the corporation’s owners and requires that at least 50 percent of the aggregate voting power and value of the corporation’s shares be owned, directly or indirectly, by owners who are residents of the same contracting state where the corporation is a resident. These owners must own their shares in the corporation for a period of time equal to at least one-half of the corporation’s taxable year, and each such owner must be either an individual, a contracting state (or subdivision), a publicly traded company, or a qualified pension fund or tax-exempt organization. The second part of the ownership-base erosion test addresses erosion of the corporation’s tax base. Specifically, this second part provides that certain payments made by the corporation in the taxable year must not total 50 percent or more of its gross income for such year. A payment is subject to this 50 percent limitation if it is deductible for tax purposes in the contracting state where the corporation is a resident and if such payment is made by the corporation to a restricted recipient. Restricted recipients include 1) recipients who are not residents of either contracting state and are not entitled to the benefits of the treaty as an individual, a contracting state (or subdivision), a publicly traded company, or a qualified pension fund or tax-exempt organization and 2) recipients who are connected to the corporation (by at least a 50 percent ownership interest) and benefit from a special tax regime with respect to the deductible payment. The payments limited by this second part of the test do not include arm’s-length payments made in the ordinary course of business for services or tangible property.
The third test is the derivative benefits test. Its purpose is actually to expand treaty benefits to a corporate resident in either contracting state with respect to an item of income. This test applies to closely held corporations that cannot otherwise qualify for treaty benefits to obtain treaty relief. Similar to the ownership-base erosion test, the derivative benefits test also consists of two parts, both of which must be satisfied. The first part requires at least 95 percent of the aggregate voting power and value of the corporation be owned, directly or indirectly, by seven or fewer shareholders who are equivalent beneficiaries. An “equivalent beneficiary” is a person who is the resident of another country that has entered into its own bilateral income tax treaty with the U.S. and who is entitled to the benefits of that other treaty as either an individual, a contracting state (or subdivision), a publicly traded company, or a qualified pension fund or tax-exempt organization within the meaning of the other treaty. However, the benefits afforded to the person by the other treaty (or by any domestic law or other international agreement) must be at least as favorable as the ones afforded by the current treaty under which the person is an equivalent beneficiary. For example, if the other treaty subjects the person to a rate of tax on dividends, interest, or royalties that is higher than the rate applicable under the current treaty, then the person would be disqualified from being an equivalent beneficiary under the current treaty.
The second part of the derivative benefits test mirrors that of the ownership-base erosion test in that it too limits the corporation’s payments that are deductible for tax purposes in the contracting state where the corporation is a resident to be less than 50 percent of its gross income for the taxable year. However, the second parts of both tests differ in who they define to be a restricted recipient of the deductible payment. In the case of the derivative benefits test, restricted recipients include 1) recipients who are not equivalent beneficiaries, 2) recipients who are equivalent beneficiaries only because they function as a headquarters company for a multinational corporate group consisting of the corporation and its subsidiaries, and 3) recipients who are equivalent beneficiaries that are connected to the corporation (by at least a 50 percent ownership interest) and benefit from a special tax regime with respect to the deductible payment. Like the ownership-base erosion test, the payments limited by this second part of the test do not include arm’s-length payments made in the ordinary course of business for services or tangible property.
“Equivalent Beneficiaries” under the Derivative Benefits Test of Various Treaties
The following U.S. income tax treaties contain a derivative benefits provision in their LOB articles: Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Ireland, Jamaica, Luxembourg, Malta, Mexico, the Netherlands, Sweden, Switzerland, and the United Kingdom.
Each of these treaties has a specific “equivalent beneficiary” definition. For example, the U.S. treaties with Canada and Jamaica, like the 2016 U.S. Model Income Tax Treaty, broadly allow residents of any jurisdiction that has an income tax treaty with the U.S. to be treated as equivalent beneficiaries. In contrast, the U.S. treaties with Belgium, Sweden, and Finland limit equivalent beneficiaries to residents of a country in the EU or EEA, residents of a NAFTA country, and residents of Switzerland. The U.S. treaty with Mexico is even narrower, limiting equivalent beneficiaries to residents of a NAFTA country.
In addition to these country residency requirements, each treaty has other requirements that the equivalent beneficiary must satisfy in order to meet the derivative benefits test. For example, the derivative benefits tests in most treaties are similar to the one in the 2016 U.S. Model Income Tax Treaty in that they require the equivalent beneficiary to be entitled to the benefits under the other bilateral income tax treaty as an individual, a qualified contracting state (or subdivision), a publicly traded company, or a pension fund or tax-exempt entity within the meaning of that other treaty. As a consequence, a person who is an equivalent beneficiary under such a derivative benefits test in one treaty cannot be counted as a qualifying owner under the ownership-base erosion test in the same treaty (and also cannot meet the active trade or business test, in any, in such treaty). Treaties that contain this requirement include the U.S. treaties with Belgium, Denmark, France, Germany, Iceland, Malta, Mexico, the Netherlands, Sweden, and Switzerland.
Moreover, these treaties provide that if another country’s tax treaty with the United States lacks a LOB provision, then a person resident in that other country can still be an equivalent beneficiary under the current tax treaty if such person would otherwise qualify as an individual, a contracting state (or subdivision), a publicly traded company, or a pension fund or tax exempt entity within the meaning of the current tax treaty.
The income tax treaty with Luxembourg allows an equivalent beneficiary to satisfy the derivative benefits test by qualifying as an equivalent beneficiary to satisfy the derivative benefits test by qualifying under the active trade or business test (as well as by qualifying as one of the four types of persons described above). For example, assume residents of a country that does not have a tax treaty with the United States establish a U.K. company that has an active trade or business in the U.K. Also assume that the U.K. company establishes a subsidiary in Luxembourg that owns intellectual property that is licensed to the U.S. The combined rate of withholding on royalties under both the U.S.- Luxembourg and U.S.-U.K. income tax treaties is zero. Luxembourg has a favorable regime for taxation of intellectual property resulting in an effective corporate income tax rate of approximately 5 percent.
The royalties paid from the U.S. to Luxembourg may potentially qualify for the 0 percent withholding rate under the U.S.-Luxembourg income tax treaty because the U.K. company could potentially be an equivalent beneficiary, despite the fact that it is owned by nonresidents of the U.K., is not publicly traded in the U.K., is not a subdivision of the U.K. government, and is not a U.K. pension fund or tax-exempt organization. This provides a significant opportunity for certain foreign investors from countries that do not have a tax treaty with the United States to potentially qualify for Luxembourg’s favorable regime on the taxation of intellectual property when they desire to license intellectual property to the United States, so long as a lower rate of withholding on the royalties is not already being obtained.
Provisions that May Deny Treaty Benefits
Anytime tax treaty planning takes place utilizing an “equivalent beneficiary,” the conduit financing regulations must be considered. These regulations permitted the Internal Revenue Service (“IRS”) to disregard the participation of one or more “intermediate entities” in a “financing arrangement” where such entities are acting as conduit entities. The regulations define a financing arrangement as a series of financing transactions by which one person (the financing entity) advances money or other property, or grants rights to use property, and another person (the financed entity) receives money or other property, or rights to use property, if the advance and receipt are effected through one or more other persons (intermediate entities). The regulations grant the IRS discretion to disregard, for purposes of Internal Revenue Code Sections 871, 881, 1441, and 1442, the participation of one or more “intermediate entities” in certain “financing arrangements” involving multiple parties. A financing transaction included a debt, lease or license.
Conclusion
The United States began including LOB provisions in treaties in the 1980s in order to combat treaty shopping. LOB provisions are designed to establish that the person or company claiming treaty benefits has a nexus with the contracting state beyond residence. Thus, LOB provisions require that the person or company claiming treaty benefits fit within one of a series of specified categories. Any multinational corporation that seeks to reduce its U.S. withholding taxes by owning a subsidiary through strategically located holding companies should consult with a qualified international tax attorney.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.