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- Mexico 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- Mexico Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Mexico 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 1) the treaty only applies to residents of the United States and Mexico; 2) the treaty often addresses double taxation issues by specifying certain tax treatment based upon an individual’s country of residence; and 3) an individual may be a resident of both countries under their domestic income tax laws.
Under Article 4(a) of the United States- Mexico Income Tax Treaty, an individual is considered a resident of the United States or Mexico if the individual is subject to tax in such country by reason of domicile, residence, place of management, place of incorporation, or any criterion of a similar nature. However, the term “resident” does not include persons subject only to tax on income sourced in the United States or Mexico. Under the protocol to the United States- Mexico Income Tax Treaty, Mexico does not consider U.S. citizenship or “green card” status alone sufficient to establish U.S. residency; instead, such person must also have a “substantial presence” in the United States or must be a resident of the United States and not another country under the treaty’s tie-breaker rules.
Under Article 4(2) of the United States- Mexico Income Tax Treaty, if an individual would be a resident of both the United States and Mexico, then: 1) the individual is deemed a resident of the country in which he has a permanent home; or he has permanent homes in both countries, he is deemed a resident of the country in which his personal and economic relations are closer (the individual’s center of vital interests); 2) if the center of vital interests cannot be determined, or if he has no permanent home in either country, then he is deemed a resident of the country in which he has a habitual abode; 3) if he has a habitual abode in both countries or neither country, then he is deemed a resident of the country of his nationality; or 4) in any other case, the competent authorities will settle the question.
The tie-breaker rules are available only for individuals. Thus, if a company is a resident of both countries under the general rule, e.g., a U.S. corporation effectively managed in Mexico, then the company is considered a resident of either country. This result renders any of the benefits of the treaty unavailable to the dual resident entity.
According to Article 7(1) of the United States- Mexico Income Tax Treaty, an enterprise that is a resident of either the United States or Mexico is not taxable upon its business profits in the other country (i.e., its net income as opposed to gross receipts, asset value, etc) unless those profits are “attributable to” a “permanent establishment” in the other country. In general, under Article 5(1), a “permanent establishment” is defined as a “fixed place of business through which the business of an enterprise is wholly or partly carried on.” Under Article 5(2), the term specifically includes a place of management; a branch; an office; a factory; a workshop; or a place of extraction of natural resources. Article 5(3) also includes certain construction sites and natural resource exploration sites lasting more than six months in the term. Article 5(4) also provides that a nonresident may carry out certain designated activities without creating a permanent establishment. The use or maintenance of installations for storage or exhibition of goods; the use or maintenance of facilities for storage or exhibition of goods to be processed by another; the use of a place of business to buy goods or obtain information; the use of a facility to carry on preliminary or auxiliary activities such as advertising, research, or preparation for the arrangement of loans; and the physical deposit of goods in a general deposit warehouse.
Income from Immovable Property
The United States- Mexico Income Tax Treaty permits a Contracting State in which immovable property (such as real estate) is located to tax income derived from such property.
Article 7 of the United States- Mexico Income Tax Treaty prescribes the circumstances under which a Contracting State may tax the “business profits” of a nonresident (as opposed to imposing withholding tax on foreign-source income of a nonresident). Although the term “business profits” is not defined in the treaty, the treaty does provide that where “business profits” include items specifically addressed by other provisions of the treaty such other provisions will override the general rules for calculating “business profits.” A Contracting State can only tax the “business profits” of a nonresident if the nonresident carries on business through a permanent establishment in the taxing country. Even then, the taxing country can tax only so much of the business profits of the nonresident as 1) are “attributable to” the permanent establishment itself or, 2) under a “force of attraction rule,” are attributable to sales of goods in a Contracting State of a like kind as those that are sold through the permanent establishment.
If related persons who are residents of a Contracting State participate in transactions that are not arm’s length, the treaty grants authority to the Contracting State to adjust the income and tax liability of the persons to reflect the economic reality of the transactions. In particular, a Contracting State is permitted to adjust the income or loss of a resident to reflect income that would have been taken into account had “associated enterprises” utilized arm’s-length terms for their commercial or financial relations. An “associated enterprise” is defined as: 1) an enterprise of a Contracting State participates directly or indirectly in the management, control, or capital of an enterprise of the other Contracting State; or 2) the same persons participate directly or indirectly in the management, control, or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State. Thus, the U.S. will be able to apply its intercompany pricing rules under Section 482 of the Internal Revenue Code and its rules relating to the allocation of deductions.
Independent Personal Services
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 a twelve month period, in which case the Contracting State may tax the income from personal services performed in the Contracting State during that period. “Personal services” for these purposes “includes especially scientific, literary, or artistic activities, educational or training activities, as well as independent activities of physicians, lawyers, engineers, architects, dentists, and accountants.,
Dependent Personal Services
A Contracting State may tax 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 twelve month period; 2) the wages are paid by, or on behalf of, an employer that is a nonresident of the Contracting State; and 3) the wages are not “borne by” a permanent establishment or fixed base of the non-resident employer in the Contracting State.
Article 10 of the United States- Mexico Income Tax Treaty provides rules for the taxation of dividends paid by a company that is a resident of one Contracting State to a beneficial owner that is a resident of the other Contracting State. The Article provides for full residence country taxation of such dividends and a limited source-State right to tax. Under Article 10(4), “dividends” are defined as income from shares or other rights (not being debt-claims), participation in profits, and income from other corporate rights that is subject to the same tax treatment as income from shares under the laws of the Contracting State of which the company making the distribution is a resident. However, a distribution by a limited liability company is not characterized by the United States as a dividend and, therefore is not a dividend for purposes of Article 10, provided the limited liability company is not taxable as a corporation under U.S. law. If a dividend is paid to a resident of the other Contracting State owning at least ten percent of the payor (a direct-investment dividend), the maximum withholding rate is 5 percent of the gross dividend payment (10 percent in cases of dividends paid by RIC or REITS discussed below).
Article 10(3)(3) of the treaty provides for a tax rate to zero on dividends beneficially owned by a company that has owned directly 80 percent or more of the voting power of the company paying the dividend for the 12-month period ending on the date the dividend is declared. Eligibility for the zero rate of withholding is subject to additional restrictions which states that companies qualifying for treaty benefits by virtue of the active trade or business, ownership-base erosion or subsidiaries of a publicly traded NAFTA company test must have acquired shares representing 80 percent or more of the voting stock of the company paying the dividends. These tests are discussed in more detail in the limitation of benefits discussion. Below, please find an illustration how the zero percent withholding on dividends applies for purposes of the treaty.
Assume that ThirdCo is a company resident in a third state. ThirdCo owns directly 100 percent of the issued and outstanding voting stock of USCo, a U.S. company, and of MEXCo, a Mexican company. MEXCo is a substantial company that manufactures widgets; USCo distributes those widgets in the United States. If ThirdCo contributes to MEXCo all the stock of USCo, dividends paid by UDCo to MEXCo would qualify for treaty benefits under the active trade or business test of Article 17. However, allowing ThirdCo to qualify for the zero rate of withholding tax, would not be available to it under the third state’s tax treaty with the United States. (if any), would encourage treaty-shopping.
In order to prevent this type of treaty-shopping, the treaty imposes an additional holding requirement on companies that qualify for benefits only under paragraphs 1(c)(the active trade or business test), 1(d)(iii) (the subsidiaries of a publicly traded NAFTA company test) or 1(f) (the ownership-base erosion test) of Article 17.
Accordingly, in the example above, MEXCo will not qualify for the zero rate of withholding tax. The results would be different under the “ownership-base erosion” test of Article 17(1)(f). For example, assume MEXCo is a passive holding company owned by Mexican individuals. If the Mexican individuals sold their stock in MEXCo to FWCo, MEXCo would lose all the benefits accorded to residents of Mexico under the treaty (including the zero rate of withholding tax on dividends) because the company would no longer qualify for benefits under Article 17.
Other methods of qualifying under Limitation on Benefits do not raise the same concerns. If a Mexican resident company meets the listing and trading requirements of Article 17(1)(d)(i) or (ii) of the United States- Mexico Income Tax Treaty, it will be entitled to a zero percent withholding rate on dividends. If a company does not qualify for the zero rate of withholding tax under any of the foregoing tests, it may request a determination from the relevant competent authority pursuant to Article 17(2).
The treaty also modifies the application of the maximum withholding rates for distributions by U.S. Regulated Investment Companies (“RICs) or Real Estate Investment Trusts (“REITSs”) by including distributions from these vehicles in a 10 percent withholding rate category, unless, in the case of the REIT, the dividend recipient owns ten percent or more of the REIT, in which case the domestic-law 30 percent withholding rate applies. Article 10(4)(b) provides that the maximum of 10 percent rate of withholding tax will apply in cases of dividends paid by RIC or a REIT. However, pursuant to Article 10(4)(c)(i), a pension plan will qualify for the zero rate of withholding tax with respect to dividends paid by REITs, provided that the pension plan holds an interest of not more than 10 percent of the REIT. Other investors will qualify for the 10 percent rate of withholding tax.
Branch Profits Tax
The U.S. imposes a 30 percent branch profits tax on the “dividends equivalent amount” of a foreign corporation engaged in a trade or business in the U.S., where the “dividend equivalent amount” is roughly equal to the taxable income of the branch, less income of the branch, less income tax paid by the branch and less amounts retained in U.S. operations. The treaty generally permits the U.S. to impose a branch tax at a maximum rate of 5 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. In certain cases, the United States is permitted to impose a branch-level tax on interest of 10 percent.
Article 11A of the United States- Mexico Income Tax Treaty also provides that the branch profits tax will not be imposed if certain requirements are met. In general, these requirements provide rules for a branch that parallel the rules for when a dividend paid by a subsidiary will be subject to exclusive residence-country taxation. Accordingly, the branch profits tax may not be imposed in the case of a company which, before October 1, 1998, was engaged in activities constituting a permanent establishment or to income or gains. In addition, the branch profits tax does not apply to a company which is a qualified person by reason of the limitation on benefits test.
Article 11(1) and (2) of the United States- Mexico Income Tax Treaty permits a Contracting State to tax interest income received by its residents from nonresidents without restriction, but imposes limitations on the maximum withholding rate at which each Contracting State can tax interest income paid to a resident of the other Contracting State. “Interest” for purposes of the treaty includes income from debt-claims of every kind, irrespectively of whether the debt is secured or carries a right of participation in profits. Under the treaty, source country withholding tax on interest cannot exceed 4.9 percent of the gross interest from 1) loans by banks and insurance companies, and 2) bonds or securities that are regularly and substantially traded on a recognized exchange. Source country tax on interest cannot exceed 10 percent of 1) the gross interest paid by banks, and 2) the gross interest paid on seller financing of machinery and equipment. The treaty completely exempts from source country withholding tax any interest payments 1) if either the beneficial owner or the payor is a Contracting State, a political subdivision of a Contracting State, or a local authority of a Contracting State, 2) the beneficial owner of the interest is an employee benefit plan the income of which is exempt from tax under the laws of the Contracting State in which it is a resident, or 3) the interest is in respect of certain loans by government import-export banks. The treaty provisions do not apply to back-to-back loans or to interest paid to a resident of a Contracting State acting as a nominee for a third person who is not a resident of either Contracting State.
Article 12(1) of the United States- Mexico Income Tax Treaty states that a Contracting State may impose withholding tax at a maximum rate of 10 percent on royalties paid to residents of the other Contracting State. The Treaty defines a “royalty” as a payment for the use of, or right to use, “any copyright of literary, artistic, or scientific work, including motion picture films and works on firm or tapes or other means of reproduction for use in connection with television, any patent, trademark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial commercial, or scientific experience as well as for the use of or the right to use industrial, commercial, or scientific equipment not constituting immovable property.
Pensions, Annuities, Alimony, and Child Support
Article 19 of the United States- Mexico Income Tax Treaty provides three basic rules. First, private pensions and annuities in consideration of past employment can be taxed only by the country of residence of the recipient. Second, social security benefits or other public pensions paid by a government of one Contracting State to a resident of the other Contracting State may be taxed only by the Contracting State paying the pensions. Because this rule prevents a Contracting State’s taxation of its own residents, it is an exception to the general savings clause of Article 1(3). Finally, alimony and child support payments may only be taxed by the country of residence of the payor. This rule also is an exception to the savings clause.
Limitation on Benefits
The United States- Mexico 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 17(1) of the United States- Mexico Income Tax Treaty, the full benefits of the treaty are available to any individual who is a resident of either Contracting State, to any Government Entity, and to any entity satisfying one of four tests: the “active business test,” the “ownership base erosion test,” the “publicly-traded company test,” or the “derivative benefit test” for NAFTA country residents.
Under Article 17(1)(c),treaty benefits are available to an entity that is a resident of a Contracting State if it is engaged in the active conduct of a trade or business in its country of residence and the income derived from the other country is connected with or incident to such trade or business. In the case of Mexico, “active trade or business” includes activities carried on through a permanent establishment as defined under Mexican tax law. The United States will ascribe to this term the meaning that it has under the law of the United States. Accordingly, the United States competent authority will refer to the regulations issued under Section 367(a) of the Internal Revenue Code for the definition of the term “trade or business.” In general, a trade or business will be considered to be a specific unified group of activities that constitute or could constitute an independent economic enterprise carried on for profit. Furthermore, a corporation generally will be considered to carry on a trade or business only if the officers and employees of the corporation conduct substantial managerial and operational activities. See IRC Section 367(a)(3) and the regulations thereunder.
To qualify for the benefits of the United States-Mexico Income Tax Treaty under the ownership base erosion test, a company must satisfy two requirements. First, the “ownership test” specifies that more than 50 percent of the beneficial interest in the company (including more than 50 percent of each class of stock) must be owned, directly or indirectly, by individual residents of the Contracting States, “publicly-traded companies,” Government Entities, or certain “tax-exempt entities.” Second, the “base erosion rule” requires that less than 50 percent of the gross income of the company be used, directly, or indirectly, to meet liabilities to persons other than those named with regard to the ownership test.
A company that is a resident of a Contracting State and the principal class of stock of which is traded on a recognized securities exchange, or wholly owned subsidiary of such a publicly-traded company, will be entitled to the benefits of the treaty. A “recognized securities exchange” includes the NASDAQ system, national securities exchanges under the Securities Exchange Act of 1934, stock exchanges authorized under the terms of Mexico’s Stock Market Law of January 2, 1975 (Mercado de Valores), and any other exchange designated by the competent authorities of the Contracting States.
The treaty contains a specific provision that modifies the benefit limitation requirements “to take into account the economic flows anticipated in the proposed free trade area.” Thus, a company that is a resident of a Contracting State qualifies for full benefits under the treaty if 1) it is owned entirely by companies that are residents of NAFTA countries under the treaty if 1) it is owned entirely by companies that are residents of NAFTA countries (i.e., Mexico, the U.S. or Canada) and 2) it is more than 50 percent owned by a Contracting State resident company that satisfies the general-traded company definition. The benefits of the treaty also apply to a not-for-profit entity that is exempt from income tax in its Contracting State of residence, provided more than half of the members or beneficiaries of the entity are eligible for the benefits of the treaty.
An entity that fails all of the foregoing tests for complete treaty coverage nevertheless can qualify for the benefits if it satisfies four conditions. First, more than 30 percent of the beneficial interest in the entity must be owned directly or indirectly, by any combination of Contracting State individual residents, publicly-traded companies as described above, Governmental Entities, or tax-exempt entities as described above. Second, more than 60 percent of the beneficial interest in the entity must be owned, directly, or indirectly, by persons resident in a NAFTA signatory country, as long as such country has an income tax treaty with the country from which the income is derived and such treaty imposes no less favorable a rate on the item of income in question than does the treaty. Third, no more than 70 percent of the gross income of the entity can be used, directly, or indirectly, to meet liabilities to persons other than persons constituting qualified owners under the first requirement. Finally, no more than 40 percent of the gross income of the entity may be used, directly or indirectly, to meet liabilities to persons other than persons constituting qualified owners under the first requirement above and other residents of NAFTA countries. The competent authority of a Contracting State in which income arises may also grant treaty benefits to persons who cannot meet the above tests but can demonstrate that they should be granted such benefits.
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.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: email@example.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.