By Anthony Diosdi
The U.S. is the world’s largest recipient of foreign direct investment. Much of this investment is in the form of foreign owned intellectual property. Creators of foreign owned intellectual property typically will transfer some or all of their intellectual property rights through an inbound U.S. licensing agreement. Under U.S. domestic laws, a foreign person generally is subject to 30 percent U.S. federal tax on the gross amount of U.S. source income received from a licensing agreement. This is because all persons (“withholding agents”) making U.S.-sourced fixed, determinable, annual, or periodical or (“FDAP”) payments to foreign persons generally must report FDAP payments, such as royalties. Withholding agents are permitted to withhold at a lower rate if the beneficial owner of the intellectual property certifies their eligibility for the lower rate allowed under the Internal Revenue Code or a tax treaty.
Effect of Treaties on Royalty Withholding Taxes
The U.S. has entered into various bilateral income tax treaties in order to avoid double taxation. Tax treaties generally reduce or eliminate withholding taxes on specified items of U.S.-source royalty income that is not attributable to a permanent establishment in the United States. A right to exploit the intellectual property right of another person would be classified as a royalty. Tax treaties usually reduce the withholding tax rate on royalties to 10% or less. In some treaties, royalty payments have been exempted from the withholding tax altogether. See, e.g., United States- Germany Tax Treaty; United States- United Kingdom Tax Treaty.
In order to qualify for the benefits under an income tax treaty, a foreign individual or entity that holds intellectual property must not only be a resident of one of the countries party to the treaty, but also satisfy additional restrictions set forth in a limitation of benefits (“LOB”) article contained in the treaty. LOB articles have arisen in tax treaties to curtail the practice of “treaty shopping.” In the corporate context, most treaties deem a corporation that is organized under the laws of the country party to the bilateral treaty as a resident of that country. Historically, being a resident of a contracting state was all that was needed for a corporation to claim treaty benefits. This single requirement, together with the relative ease with which corporations could be formed and operated under the laws of many jurisdictions, led companies to form corporate entities in a third country specifically chosen to take advantage of that country’s favorable tax treaty. For this reason, LOB articles require a corporation who is a resident of a contracting state to also satisfy one of the article’s corporate tests before such 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 public test, 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 qualifying 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 qualifying 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 not be equal to, or more advantageous than, the ones afforded by the current treaty under which the person is an equivalent beneficiary. For example, if the other treaty entities the person to a rate of tax on dividends, interest, or royalties that is equal to or less 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 allows 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 satisfies to meet the derivative benefits. 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 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 cannot meet the active trade or business test in such treaty). Treaties that contain this 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 countries’ tax treaty with the United States lacks a LOB provision, then a 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 within the meaning of the current tax treaty.
The income tax treaties with Luxembourg and Ireland allow an equivalent beneficiary to satisfy the derivative benefits test by qualifying under the active trade or business test (as well as qualifying as one of the four types of persons described above). For example, assume residents of Hungary 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 are zero. Luxembourg has a favorable regime for the taxation of intellectual property resulting in an effective corporate income tax rate of approximately five percent.
The royalties paid from the U.S. to Luxembourg would qualify for the zero percent withholding rate under the U.S.- Luxembourg income tax treaty because the U.K. company would 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.
Provisions that May Deny Treaty Benefits
As discussed above, to qualify for a treaty to reduce a 30 percent withholding tax on U.S. source royalties, a non-U.S. person or non-U.S. entity must either be a resident of a particular treaty jurisdiction or qualify for treaty benefits as an equivalent beneficiary. The problem is that many owners of foreign intellectual property are not residents of a jurisdiction with which the U.S. has an income tax treaty and they cannot qualify as an equivalent beneficiary under another treaty. This has resulted in foreign owners attempting to estate “fiscally transparent” entities under the laws of the U.S. and/or other jurisdictions to claim treaty benefits.
The regulations under Internal Revenue Code Section 894(c)(2) deny income tax treaty benefits on items of U.S. royalty source income to the extent such income is not “derived” by a treaty resident. For example, U.S.-source royalties paid to a disregarded Cayman Islands entity that is wholly owned by a U.K. parent will not be eligible for benefits under the U.S.-U.K. income tax treaty, even though the U.S. treats the royalties as being paid directly to the U.K. parent.
In addition, the conduit financing regulations enacted Internal Revenue Code Section 7701(1) prevent claiming treaty benefits with respect to royalty payments. The Treasury was authorized under Internal Revenue Code Section 7701(1) to issue regulations that would allow multi-party financing arrangements to be reclassified as transactions directly between any two or more parties involved. In accordance with Section 7701(1), the Treasury introduced regulations in 1995 to clarify when the IRS can recharacterize multi-party financing transactions for U.S. withholding tax purposes. Under these regulations, the IRS can ignore the involvement of an intermediate entity in a multi-party financial arrangement for withholding tax purposes if the intermediate entity is deemed to be a conduit entity. A conduit entity is an entity whose participation in the financing arrangement is designed to minimize U.S. withholding tax liability and is part of a tax avoidance plan, and is one that is either related to the financing/financed entity or entered into the transaction as a result of the financing entity.
These regulations permitted the 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). See Treas. Reg. Section 1.881-3(a)(2)(i)(1)(A). 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. See Treas. Reg. Section 1.881-3(a)(2)(ii)(A).
Prior to the enactment of the 2017 Tax Cuts and Jobs Act, with certain exceptions, under the conduit regulations, an instrument that was classified as equity for U.S. tax purposes did not constitute a financing transaction.Thus, it was common for non-U.S. persons and non-U.S. entities to utilize hybrid instruments (an instrument treated as debt for foreign tax purposes but equity for U.S. purposes) to capitalize an intellectual property holding company that would hold intellectual property. The intellectual property company would then license the intellectual property to a U.S. person in exchange of a royalty payment. The payment of the royalties to the foreign holding company was classified as interest for foreign income tax purposes and a dividend for U.S. income tax purposes. These structures were not subject to the conduit financing rules because the subsequent payment by the intellectual holding company was treated as a dividend.
Recently, the IRS and Treasury issued final and proposed anti-conduit regulations. These regulations will cause the conduit financing regulations to expand the types of equity interests that are treated as financing transactions. The regulations will include a financing transaction of so-called hybrid instruments. As a result, a non-U.S. taxpayer is prevented from claiming treaty benefits in situations similar to the one described above.
Potential Planning Option Utilizing the Portfolio Interest Rules
Although the conduit financing regulations prevent strategies involving the capitalization of intellectual property holding companies, a foreign intellectual property owner may potentially utilize a strategy in which there is a leveraged purchase of intellectual property by a foreign licensor. The leveraged purchase of intellectual property is then followed by a license of such intellectual property to the U.S. As noted above, a loan followed by a license typically would be treated as a conduit financing arrangement. This is because both transactions are treated as financing transactions.
Where a royalty payment is followed by an interest payment, the royalty is recharacterized as interest. The question is whether these transactions should be carved out from the conduit financing regulations if the interest payment would have been eligible for an exemption from U.S. withholding tax. An exception to the U.S. withholding tax is under the portfolio interest rules. Portfolio interest received by a foreign corporation or nonresident alien individual is exempt from U.S. withholding tax. See IRC Sections 1441(c)(9) and 1442(a). Generally speaking, portfolio interest is any U.S.-source interest (other than interest effectively connected with the conduct of a U.S. trade or business) paid or accrued on debt obligations. Congress has enacted various restrictions in order to protect against the unauthorized use of the portfolio interest exemption by U.S. persons. In the case of registered debt obligations, the exemption applies only if the U.S. withholding agent has received a statement that the beneficial owner of the obligation is not a U.S. person.
In the case of unregistered or bearer debt obligations, the exemption applies only if the following requirements are satisfied:
1) There are arrangements reasonably designed to ensure that the obligation will be sold or resold to persons who are not U.S. persons;
2) Interest on the obligation is payable only outside the U.S. and its possessions;
3) There is a statement on the face of the obligation that any U.S. person who holds the obligation will be subject to limitations under the U.S. income tax laws. See IRC Sections 871(h)(2)(A), 881(c)(2)(A), and 163(f)(2)(B).
In addition, the following types of foreign lenders do not qualify for the portfolio interest exemption:
1) Interest received by a 10 percent shareholder does not qualify for the portfolio interest exemption. If the borrower is a corporation, the 10 percent shareholder rule requires that the recipient of the interest not own 10 percent or more of the combined voting power of all classes of stock of such corporation. If the borrower is a partnership, the 10 percent shareholder requirement is measured by capital or profits interest.
2) Any interest received by a foreign bank on a loan entered into in the ordinary course of its banking business does not qualify for the portfolio interest exemption.
3) The portfolio interest exemption does not apply to payment of interest to a controlled foreign corporation or (“CFC”) that are considered related person with respect to the borrower. The applicable related party rules in this case are under Internal Revenue Code Section 267(b), and unlike the 10 percent shareholder rules which only consider voting stock, these rules would consider two corporations to be related where a parent corporation owns more than 50 percent of vote or value of the subsidiary corporation. For these purposes, certain attribution rules can apply to attribute stock ownership of a foreign corporation to U.S. persons, especially subsequent to the repeal of Internal Revenue Code Section 958(b)(4) under the Tax Cuts and Jobs Act of 2017.
In the 1995 conduit financing regulations, the IRS noted leveraged leases may be excluded from the definition of a financing transaction because “in substance, the financing arrangement would be the equivalent of a loan from a financing entity entitled to a zero rate of withholding on interest.” See T.D. 8611. The IRS noted in the preamble that, under the 1995 conduit finance final regulations, a “leveraged lease generally will not be recharacterized as a conduit arrangement if the ultimate lender would be entitled to an exemption from withholding tax on interest received from the financed entity, even if rental payments made by the financed entity to the financing entity would have been subject to withholding tax.”See T.D. 8611. (Leveraged lease refers to a lease agreement wherein the lessor acquires an asset partially financed and leases out the same to the lessee for the agreed lease payments). The 1995 conduit financing regulations’ language appears to support the position that a leveraged acquisition of intellectual property by a foreign licensor followed by a license of such intellectual property for use in the U.S. could be exempt from the conduit financing regulations. That is, as long as the ultimate non-U.S. lender would be eligible for an exemption from U.S. withholding tax on the receipt of interest from the financed entity. Therefore, it would seem that so long as the financing entity would be entitled to an exemption from withholding under the portfolio debt rules, the conduit financing regulations should not apply to a leveraged acquisition of intellectual property. See Tax Planning for Inbound Licenses of IP: What is Left After Tax Reform? – The Florida Bar Vol. 95, No. 1 January/February 2021 Pg 51 Jeffrey L. Rubinger and Summer A. LePree.
Denial of Deductions for Royalties Paid
Finally, anyone considering tax planning for inbound licenses of intellectual property must take into consideration Internal Revenue Code Section 267A. Congress enacted Section 267A to prevent erosion of the U.S. tax base through the use of hybrid instruments and entities. Section 267A denies a deduction for any disqualified related party amount paid or accrued as a result of a hybrid transaction or by, or to, a hybrid entity. The statute defines a disqualified related party amount as any interest or royalty paid or accrued to a related party where there is no corresponding inclusion to the related party in the other tax jurisdiction or the related party is allowed a deduction with respect to such amount in the other tax jurisdiction. The statute’s definition of a hybrid transaction is any transaction where there is a mismatch in tax treatment between the U.S. and the other foreign jurisdiction. Similarly, a hybrid entity is any entity which is treated as fiscally transparent for U.S. tax purposes but not for purposes of the foreign tax jurisdiction, or vice versa.
Section 267A primarily targets situations in which a U.S. taxpayer makes a deductible payment of interest or royalties to a foreign taxpayer and no income inclusion results for foreign tax purposes and equity in the foreign corporate parent’s local country. Assuming the foreign corporate parent’s local country has a participation exemption for dividends, this transaction would result in a deduction in the U.S. and no income inclusion in the foreign country.
A number of common planning options have been eliminated as a result of the enactment of Section 267A. A common approach was to capitalize a foreign licensor with a hybrid instrument and then cause the foreign licensor to license the intellectual property for use in the U.S. The result was a royalty deduction in the U.S. and an inclusion in the hands of the licensor that was offset by an interest payment or accrual that would be treated as an exempt dividend in the hands of the holder of the hybrid instrument. The so-called “disqualified imported mismatch rules” contained in the Section 267A regulations disallows these types of structures.
This article is intended to acquaint readers with some of the principal tax planning issues associated with inbound licenses of intellectual property. This area is relatively complex and is constantly evolving with Congress entertaining new tax laws, the IRS issuing new regulations and interpretations and courts rendering new rulings in this area. As a result, it is crucial that non-U.S. investors consult with a qualified international tax attorney when planning to invest in a U.S. business or real estate. This is to ensure that the proposed investment is appropriate given the investor’s tax circumstances and that no developments have arisen in the area that can impact the investment’s tax objectives. With careful, individualized planning, non-U.S. investors may be able to substantially reduce the U.S. estate and gift tax consequences of their U.S. investments that affect not only themselves but their heirs and beneficiaries as well.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.