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- Japan 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- Japan Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Japan income tax treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The determination of an individual’s country of residence is important because the treaty only applies to residents of the United States and Japan.
The term “resident of the United States” means: 1) a business entity formed in the United States, or 2) any other person (except a corporation or any entity treated under United States law as a corporation) resident in the United States for purposes of United States tax, but in the case of an estate or trust only to the extent that the income derived by such person is subject to United States tax as the income of a resident. Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.
In contrast to the U.S. law, an individual’s Japanese citizenship is not a basis for taxation; instead, residence is dispositive. An individual is considered a resident if he or she has resided in Japan continuously for one year or more. Individuals who have lived in Japan for less than one year and who are not domiciled in Japan are considered nonresidents and are subject to tax only on certain categories of income. A corporation is considered a resident of Japan if either its headquarters or principal office is located in Japan.
An individual who is a resident of both Contracting States shall be deemed to be resident of that Contracting State in which he maintains his permanent home. If he has a permanent home in both Contracting States or in neither Contracting State, he or she shall be deemed to a resident of that Contracting State with which his or her personal and economic relations are closest (center of vital interests).
While Article 2 of the treaty looks to each country’s laws to define the term “resident,” Article 4 of the treaty limits who may benefit from the provisions of the treaty- even if they can be classified as a resident of a Contracting State. In particular, Article 4 provides a limitation on the use of fiscally transparent entities when an item of income is derived through an entity inconsistent by the source or residence state. A hybrid entity is one that is characterized as a corporation in one jurisdiction and as a transparent entity in another. For example, an entity organized in a foreign country may be treated as a corporation under the laws of that country, but may be treated as a partnership under U.S. tax law. The reverse situation (often called a “reverse hybrid”) may also occur in which an entity is treated as a corporation under U.S. tax law, but as a transparent entity under the laws of a foreign country. Such situations may lead to opportunities for cross-border arbitrage in which the tax laws of the different countries are exploited for multiple advantages in ways that may be deemed excessive. The increased frequency of such situations is at least in part attributable to the check-the-box regulations that permit taxpayers in many instances to choose how certain business entities will be characterized for U.S. tax purposes.
The existence of hybrid entities may impact the administration of income tax treaties. For example, suppose that a foreign entity is treated as a partnership for U.S. tax purposes. It is organized in Country A, with which the United States has no income tax treaty. One of the partners, Partner X, is a citizen and resident of Country B, with which the United States has a tax treaty that is identical to the U.S. Model Treaty. However, the entity is treated as a corporation under the laws of Country A and Country B. The foreign entity, organized in Country A, realizes U.S.-source interest income, a portion of which is allocable under U.S. law to Partner B. U.S.-source interest payments to corporations organized in Country A are subject to a withholding tax of 30 percent. U.S.-source interest payments to Partner X, as a resident of Country B, would be exempt from tax under the treaty with Country B.
Internal Revenue Code Section 894(c) expressly limits the availability of treaty benefits in certain hybrid situations and authorizes the promulgation of regulations to defend against perceived treaty abuse in other hybrid situations.
Section 894(c)(1) denies treaty benefits for income derived through a partnership or other entity treated as transparent for U.S. tax purposes in certain situations even though the partner is a resident of a foreign treaty country. The application of the provision depends largely upon the law of the treaty country. The application of the provision depends largely upon the law of the treaty country. Withholding tax reductions or exemptions provided in a treaty will be denied to a partner, even if the entity is treated as a partnership or other transparent entity under U.S. tax law, if the item of income is not treated under the tax law of the treaty country as income of the partner, the treaty itself contains no provision addressing its applicability in the case of income derived through a partnership and the foreign treaty country does not tax the distribution of such item of income from the partnership to the partner. In the example described above, since Partner X is not subject to tax in Country B (the treaty country) on income realized by the entity (because it is treated as a corporation under the laws of Country B), Section 894(c)(1) applies and Partner X is not entitled to the treaty exemption for interest payments from U.S. sources.
Extensive regulations have been promulgated by the Internal Revenue Service (“IRS”) under the authority of Internal Revenue Code Section 894(c)(2). The regulations clarify the application of treaty benefits in a number of situations. If the entity is classified as a partnership under U.S. tax law, the availability of treaty benefits will normally depend upon whether the entity is classified as a transparent entity under the laws of its place of organization and, if so, whether the laws of the place of residence of an interest holder in the foreign entity treat that entity as a transparent entity. If the entity is not classified as a transparent entity in the foreign country in which it is organized, the company will be treated as the entity itself and any treaty benefits applicable to a resident of the country of organization will be available. Treaty benefits will also be available when there is a treaty between the United States and the interest holder’s country and if laws of that country characterize the entity as a fiscally transparent entity. In any case, an item of income paid directly to a type of entity specifically identified in a treaty as a resident of a treaty country is treated as derived by a resident of the treaty country entitled to treaty benefits. See Treas. Reg. Section 1.894-1(d)(1).
The regulations also provide that treaty benefits will not be available to foreign interest holders of an entity classified as a corporation under U.S. law, even though the entity may be classified as a transparent entity under the laws of a treaty country (the reverse hybrid situation). See Treas. Reg. Section 1.894-1(d)(2)(i). Income items paid by a domestic entity classified as a corporation under U.S. law will be treated as income to interest holders regardless of the classification of the entity under foreign law and the character of the income will be determined by applying U.S. legal standards. Section 1.894 regulations address situations in which a payment is made from a domestic entity to a related reverse hybrid entity (treated as a corporation under U.S. law but transparent under foreign law) which in turn makes a payment to a related foreign interest holder. For these purposes a person (individual or entity) is treated as related by reason of the ownership requirements of Section 267(b). In such situations, payments from the reverse entity will be treated as dividends.
The above discussed regulations can be demonstrated as follows: A reverse hybrid entity receives dividend payments from a related U.S. corporation. The reverse hybrid entity then in turn makes payments, such as interest, to a foreign related interest holder that would be deductible to the reverse hybrid entity itself. Such a transaction is suspect because the reverse hybrid entity (treated as a corporation for U.S. tax law) is making a payment that reduces its U.S. income tax liability, but the payment is not taxed in the foreign country (where it is treated as a transparent entity) to the interest holder. In such situations, the regulations require that the portion of the payment from the reserve hybrid entity to the foreign interest holder attributable to the dividend received from the related U.S. corporation be treated as a dividend. Furthermore, the payment is not deductible by the hybrid entity.
The United States- Japan Income Tax Treaty attempts to resolve the problem of fiscally transparent entities with Article 4. The relevant provisions of the United States- Japan Income Tax Treaty deals with fiscally transparent entities in a way not provided in any U.S. bilateral tax treaty currently in force. Article 4(6) of the treaty establishes the general rule that one must look to the internal tax laws of the residence state- not the State from which the income is sourced- to determine whether or not an entity is fiscally transparent and who is actually liable to tax. It is the residence state characterization that counts, and in almost all cases one is to ignore the source state’s characterization (or a third state’s characterization) of the entity if it conflicts. The primary operational rule of the treaty with respect to fiscally transparent entities is that when an item of income is derived from a Contracting State (i.e., the Source State) through an entity organized in a second Contracting State (i.e., the Residence State), and that entity is treated as fiscally transparent under the internal tax laws of the Residence State (e.g., as a partnership or tax transparent trust), the entity will be entitled to treaty benefits only to the extent its beneficiaries, members, partners, or participants are residents of that second Contracting State and otherwise qualify for treaty benefits under other provisions of the treaty. See The Japan-U.S. Income Tax Treaty: Signaling New Norms, Inspiring Reforms, or Just Tweaking Anachronisms in International Tax Policy, Pamela A. Fuller, The International Lawyer, Vol. 40, No. 4.
We will now discuss the operative articles of the United States- Japan Income Tax Treaty.
Business Profits and Permanent Establishment
As a general rule, a nonresident alien or foreign corporation that conducts a U.S. trade or business will be subject to the usual (individual or corporate) U.S. tax rates on net (i.e., taxable) income “effectively connected with the conduct of a trade or business within the United States. Tax treaties generally provide, however, that such income will not be taxed unless attributable to a “permanent establishment” maintained by the foreign person in the United States. If the foreign corporation or nonresident alien receives U.S.-source income that is not “effectively connected” with the U.S. trade or business, a different taxing regime usually applies that may result in the imposition of a flat tax of 30 percent (or lesser treaty rate) on gross income.
Income tax treaties to which the U.S. is a party typically contains a provision that exempts a foreign person’s business profits from U.S. tax unless those profits are attributable to a permanent establishment in the United States. A permanent establishment includes a fixed place of business, unless the fixed place of business is used solely for auxiliary functions or activities of a preparatory nature. A permanent establishment also exists if employees or other dependent agents habitually exercise in the U.S. an authority to conclude sales contracts.
Article 7(1) of the United States- Japan income tax treaty states that profits are taxable only in the Contracting State where the enterprise is situated “unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein,” in which case the other Contracting State may tax the business profits “but only so much of them as [are] attributable to the permanent establishment.” The concept of permanent establishment is a key term to this and any bilateral tax treaty. Article 5 of the United States- Japan Income Tax treaty defines permanent establishment as a “fixed place of business” – including a place of management, a branch, an office, a factory, mine, or place of extraction of natural resources.
Independent Personal Services
Independent personal services (a term commonly used in tax treaties) are personal services performed by an independent nonresident alien contractor as contrasted with those performed by an employee. The U.S.-Japan tax treaty provides that a contracting state may tax the income from personal services of a nonresident individual acting as an independent contractor (and not as an employee or “dependent agent”) only if 1) the individual has a fixed base in the contracting state that he uses regularly in performing the services, in which case the contracting state may tax income attributable to such fixed base, or 2) the individual is present in the contracting state for a total of more than 183 days in the taxable year, in which case the contracting state may tax the income from personal services performed in the contracting state during that period.
Dependent Personal Services
Dependent personal services are services performed as an employee in the United States by a nonresident alien. The U.S.-Japan tax treaty provides that a contracting state may tax the income employment income derived by a nonresident to the extent the employee services are performed in the Contracting State unless 1) the employee is present in the Contracting State less than 183 days during a taxable year; 2) the wages are paid by, or on behalf of, an employer that is a nonresident of the Contracting State.
Dividends
Under Article 10 of the United States- Japan income tax treaty, the Source State can impose a gross withholding tax of 10 percent on all types of cross-border dividends. The treaty specifically discusses portfolio dividends and provides the 10 percent withholding rate when such dividends are received by a resident of the other Contracting State when the resident qualifies as the beneficial owner of the dividend on the date when entitlement to the dividend is determined. If the beneficial owner of the dividend is a company that owns, directly or indirectly (through tiers of entities), at least 10 percent of the voting stock of the payor company, then the Source State can impose a gross withholding tax of no more than 5 percent. Notwithstanding these provisions, the treaty provides for a zero percent withholding rate for dividends paid if the beneficial owner of the dividend is a company that has owned, directly or indirectly, greater than 50 percent of the voting stock of the company paying the dividend during the 12-month period ending on the date on which the entitlement to the dividend is determined, and one of three alternative tests is satisfied. Under the additional requirement, the payee company must either: 1) meet the “publicly traded” test set forth in the limitation on Benefits (“LOB”) article; 2) meet both the “publicly traded” test discussed in the LOB article; or 3) be granted express eligibility by the competent authorities pursuant to the LOB article.
Certain tax-exempt pension funds are also eligible for the zero percent withholding rate on cross-border dividends, provided the dividends are not derived from the carrying on of a business, directly or indirectly, by the pension fund. Article 10(4) provides special rules to dividends paid by a U.S. Regulated Investment Company (“RIC”) or a U.S. Real Estate Investment Trust (“REIT”), and their Japanese counterparts.
Branch Profits Tax
In an attempt to equalize the tax treatment of using U.S. subsidiaries and branches, Internal Revenue Code Section 884 was adopted as part of the Tax Reform Act of 1986. Section 884 imposes a withholding tax, called a “branch profits tax,” of 30 percent on the deemed remittance of profits by a U.S. branch of a foreign corporation. Foreign corporations operating a branch in the United States will be subject to an additional 30 percent (or lesser treaty rate) tax on branch earnings not invested in branch assets or withdrawn from such investment. See IRC Section 884. The U.S.-Japan tax treaty generally permits the U.S. to impose a branch tax at a maximum rate of 5 percent (rather than 30 percent) of business profits that are effectively connected with a U.S. trade or business and either attributable to a permanent establishment in the U.S. or attributable to income and gains on U.S. real property.
Interest
Article 11 of the United States- Japan income tax treaty allows the source state to impose a withholding tax of 10 percent if paid to a resident of the other Contracting State that beneficially owns the interest. However, Article 11(3) of the treaty eliminates source-state withholding tax on broad categories of interest. The most significant of these is the elimination of source-state withholding tax for interest earned by financial institutions. This provision in the treaty is due to the highly-leveraged nature of financial institutions, imposition of a withholding tax on interest received by such enterprises could result in taxation that actually exceeds the net income from the transaction. Article 11(3)(c) provides that interest falling within this exemption includes interest beneficially owned by a resident bank, an insurance company, a registered securities dealer, or a qualified deposit-taking entity. In addition, Article 11(3)(d) exempt interest earned by pension funds from source-state withholding tax.
Article 11(5) defines interest fairly broadly to include “income from debt-claims of every kind…whether or not carrying a right to participate in the debtor’s profits.”
As with royalties, transfer pricing principles are also reflected in Article 11 of the treaty. Article 11 provides that in cases involving a “special relationship between the payor and the beneficial owner,” where the amount of interest paid exceeds the amount that would otherwise have been agreed upon in the absence of the special relationship, then the treaty rate applies “only to the last-mentioned amount” – that is, the “arm’s length interest payment,” as it is referred to in the Technical Explanation to the United States- Japan Income Tax Treaty. The treaty does not define the term “special relationship,” but the Technical Explanation states that the determination of whether such a relationship exists turns on the definition of control as it is interpreted within the context of Internal Revenue Code Section 482.
The U.S.-Japan tax treaty applies the U.S. “anti-conduit” rules when dealing with the deduction of interest payments.
Congress in 1993 added Section 7701(l) to the Internal Revenue Code. Section 7701(l) authorizes the Department of Treasury and the Internal Revenue Service (“IRS”) to promulgate regulations which allow for the “recharacterization” of multi-party financing transactions as a transaction directly among two or more of the parties to it if such characterization “is appropriate to prevent avoidance of any tax ***.” The IRS has implemented this authority by issuing “anti-conduit” regulations. The result of the anti-conduit regulations is that intermediate entities (“conduits”) are disregarded in the determination of U.S. taxes on international financing arrangements, which may include loans, leases, and licenses. The key factors that will result in the recharacterization of a conduit entity are:
1) The participation of the intermediate entity or entities which reduces the tax imposed by Section 881 of the Internal Revenue Code Section 881(a) imposes a 30-percent tax on “interest, dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income”)..
2) Such participation is “pursuant to a tax avoidance plan,” and either
3) The intermediate entity is related to the financing or financed entity or would not have participated in the financing arrangement but for the fact that the financing entity engaged in the transaction with the intermediate entity. See Treas. Reg. Section 1.881-3(a)(4).
The anti-conduit regulations identify factors that will determine whether there is a tax-avoidance purpose:
1) Is there a “significant reduction” in the tax otherwise imposed under Section 881?
2) Did the conduit have the ability to make the advance without advances from the related financing entity?
3) Did the financing transactions occur in the ordinary course of business of the related entities? See Treas. Reg. Section 1.881-3(b)(2).
The regulations establish a rebuttable presumption in favor of the taxpayer if the conduit entity “performs significant financing activities with respect to the financing transactions forming part of the financing arrangement.” Such activities might include the earnings of rents and royalties from the active conduct of a trade or business or active risk management by the intermediate entity. See Treas. Reg. Section 1.881-3(b)(3).
The effect of invoking the anti-conduit regulations is that the payments will be deemed to be paid directly by and to the entities other than the conduit. The role of the conduit will be disregarded. If these provisions were invoked in the case of a finance subsidiary, for example, the interest payment by a U.S. corporation that borrowed money from a foreign lender through the use of a financing subsidiary in a tax treaty country would be treated as if the interest were paid directly to the foreign lender. The treaty would not apply, and the 30-percent withholding tax would be imposed unless the true lender were a resident of another treaty country where the withholding rates on interest were reduced or eliminated.
The operation of the anti-conduit rules can be illustrated by the following examples.
Example 1. A, a U.S. resident, holds a debt-claim against X, a Japanese company, that entitles A to interest of 10x each year. B, a resident of a third country that does not have a tax treaty with Japan, owns a debt-claim against A that entitles B to interest of 10x each year and otherwise has terms that are equivalent to the terms of the debt-claim held by A. A would not have established its debt-claim against X if B did not hold a debt-claim against A. X pays interest of 10x to A, which pays interest of 10x to B. A will not be considered the beneficial owner of the interest from X, and therefore is not entitled to treaty benefits with respect to the interest from X.
Example 2. The facts are the same as the facts of Example 1, except that, instead of owning a debt-claim against A, B holds preferred stock in A that entitles B to 10x each year to the extent of A’s earnings in that year. A pays dividends of 10x to B. The anti-conduit rules do not apply to deny treaty benefits with respect to the interest from X.
Internal Revenue Code Section 267A should also be considered for any treaty positions involving an interest payment. Section 267A disallows deductions for interest to disqualified related party pursuant to a hybrid transaction, or by, or to, a hybrid entity. A hybrid transaction is generally any transaction in which payment treated as interest for U.S. tax purposes is not so treated for purposes of the tax law of the recipient’s foreign country.
Royalties
Article 12 of the United States- Japan Income Tax Treaty completely eliminates source-state taxation of royalty income “beneficially owned by a resident of the other Contracting State.” In other words, the United States- Japan Income Tax Treaty allocates the right to tax royalties solely on the residence state, which will tax them on a net basis in the same manner as other business income. Although beneficial ownership is a critical prerequisite to claiming a treaty-position for royalty income, the text of the United States- Japan Income Tax Treaty does not define the term “beneficial owner.” Rather, the Technical Explanation to the United States- Japan Income Tax Treaty states that one must look to the internal law of the source country to define these terms.
Article 12(2) of the treaty defines “royalties” broadly to include:
“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 including cinematograph films or tapes for radio or television broadcasting, any patent, trademark, design or model, plan, or secrete formula or process, or for information concerning industrial, commercial or scientific experience.”
The United States- Japan Income Tax Treaty bringings transfer pricing concepts into the royalty article of the treaty. Article 12(4) provides that in cases where there is a non-arm’s length relationship between the payor and the beneficial owner of the royalty, then the zero percent withholding rate is available “only to the extent the royalties would have been paid absent such special relationship(s).” Any excess amount of royalty income may be taxed at the source state rate at up to 5 percent.
The anti-conduit limitations discussed in Article 11 applying to interest also apply to royalty payments. Internal Revenue Code Section 267A disallows deductions
Gains from the Alienation of Property
With a few exceptions, Article 13 of the United States- Japan income tax treaty provides for exclusive resident state taxation of gains from the alienation of property. An exception to this general rule are gains from the sale of real property and gains from the sale of shares or other interests in certain real property holding companies. In these cases, gains may be taxed in the country where the property is located and by the owner’s home country.
Income from Employment and Stock Options
Article 14 of the United States- Japan income tax treaty apportions taxing jurisdiction over the remuneration derived by a resident employee between Japan and the United States. Under Article 14, employee services are taxed in the jurisdiction where the employment services are performed. For example, if a Japanese citizen earns wages while working in the United States, the United States may tax the wages. Employee stock options or ESOPs are a form of compensation which are governed under Article 14. Article 14 provides that stock options are fairly apportioned between the two Contracting States, either through the operation of the treaty or through a mutual agreement procedure.
Pensions and Annuities
Article 23 of the United States- Japan income tax treaty provides a basic rule for cross-border taxation of pensions and annuities. Article 23 of the U.S.- Japan income tax treaty provides-
(1) Except as provided in Article 21, pensions and annuities paid to an individual who is a resident of a Contracting State shall be taxable only in that Contracting State, (2) The term “pensions,” as used in this article, includes periodic payments made after retirement or death in consideration for services rendered, or by way of compensation for injuries received, in connection with past employment, including the United States and Japanese social security payments.
The term “pensions” is not defined in the United States- Japan income tax treaty. Since this term is not defined in the treaty or its technical explanations, the Organization for Economic Cooperation and Development (“OECD”) commentary may be utilized to interpret this term. The OECD defines the word “pension” under the ordinary meaning of the word that covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 18. See OECD 2014 Commentary, Art 18. The definition of a periodic pension payment made on or after the cessation of employment may include an IRA or 401K plan.
Other Income
Article 21 of the United States- Japan Income Tax Treaty applies to “other income.” This article applies to income not otherwise dealt with in other articles of the treaty. Examples of the types of income that fall under Article 21 are income received from covenants not to compete, punitive damage awards, gambling income, and income received from certain financial instruments.
Limitation on Benefits
The United States- Japan income tax treaty contains detailed rules intended to limit its benefits to persons entitled to such benefits by reason of their residence in a Contracting State. The rules are specifically intended to eliminate “treaty shopping” whereby, for example, a third-country resident could establish an entity in a Contracting State and utilize the provisions of the treaty to repatriate funds under favorable terms. To eliminate this potential abuse, the full benefits of the treaty are available to only a specified class of persons, limited treaty benefits are provided to an additional class of persons, and a facts and circumstances test provides discretion to make the treaty provisions available to others.
Under Article 22(i)(f), a resident is entitled to all the benefits of the treaty only if it can be described as one of the following: an individual resident, certain government entities; including central banks; a company that is publicly traded or has a parent company that is publicly traded, as defined; certain charities and tax exempt organization; a pension fund provided that more than 50 percent of its beneficiaries are individual residents of either Contracting State; or an entity that satisfies both a resident-owner test and a base-erosion test. Under Article 22(2), even if a resident does not meet one of the above descriptions, the resident may be able to claim treaty benefits for some items of income to the extent the resident can establish the items are sufficiently connected to an active trade or business in the resident’s own Contracting State. Residents who do not meet any one of the above tests, including an active trade or business test, may still be able to claim treaty benefits if the Competent Authority of the Contracting State from which the benefits are claimed determines that it is appropriate to grant benefits in that case.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
Wherever a U.S. person claims a position under the U.S.-Japan tax treaty, the treaty position must be accurately reported on Form 8833.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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.