Most practitioners know that to qualify for benefits under a U.S. tax treaty, an entity or an individual must be a resident of the other treaty country (“treaty country”). But it is sometimes overlooked that it also must meet the requirements of at least one of the tests set forth in the Limitation on Benefits article (“LOB”) of that treaty. Almost all of the U.S. treaties include an LOB article, containing requirements that can be difficult to understand and apply in practice. Although the bilateral country negotiations of a U.S. tax treaty begin with a version of the U.S. Model Income Tax Convention (the “Model”), the final LOB version often varies in some respects from the Model due to the particular economic or tax interests of the treaty country.
The LOB also serves the function of determining whether a dividend paid by a foreign corporation to a U.S. tax-resident individual will constitute qualified dividend income subject to capital gains tax treatment under IRC § 1(h)(11). This will be the case if the foreign corporation is eligible for benefits of a U.S. comprehensive income tax treaty that includes an exchange of information program. A list of such treaties is included in a series of continually updated IRS Notices, the latest of which is Notice 2011-64, but it is often overlooked that eligibility for benefits under tax treaties must be tested.
Qualifications for Benefits Under U.S. Tax Treaties
The alternative tests under a typical LOB are described below. Although, as mentioned, the Model is the starting point for treaty negotiations, and the various LOB provisions may differ in their specifics, the general purpose of the LOB provision are the same in all treaties – to prevent a taxpayer from “treaty shopping” by becoming a resident of a treaty jurisdiction with respect to which the taxpayer does not have a sufficiently strong economic nexus.
Qualified persons
A resident of a treaty country that is determined to be a “qualified person,” as defined under the LOB, qualifies for all the benefits granted under the treaty (terms in quotations below are either defined in the particular treaty or by reference to certain rules or regulations in the U.S. tax law). These benefits generally include reduced or eliminated withholding on dividends, interest and royalties, and a higher nexus threshold for U.S. net basis taxation – permanent establishment rather than income effectively connected to a U.S. trade or business. A qualified person fits into one of the following categories, for the reasons described below:
- An individual. An individual’s tax residence is considered to be sufficient nexus.
- The treaty country government, government of a political subdivision or local authority of that country, or entity owned directly or indirectly by one of these, that is not carrying on a business. A treaty country government, or arm of that government, performing government functions is sufficient nexus to that country.
- A publicly traded company, if its “principal” class of shares is listed on a “recognized stock exchange” and is “regularly traded” on one or more recognized stock exchanges. A public company whose stock is regularly traded in that treaty country or region specified in the treaty has sufficient nexus to its residence country.
- A 50%-or-more directly or indirectly owned subsidiary of a publicly traded company that qualifies under the preceding paragraph. If a public company has nexus as noted above, so should its subsidiaries and joint ventures.
- A pension plan, employee benefits plan operated to provide tax-exempt benefits to employees, or a tax-exempt organization. These entities must also be residents of the treaty country, as defined under the treaty, and often must meet certain quantitative residence thresholds for participants. These connections constitute sufficient nexus for these types of entities.
- An entity that meets the following 2 requirements (the “base erosion test”):
- On at least one-half the days of the taxable period, at least 50% of the aggregate voting power and value of the entity is owned by qualified persons described above in 1-5; and
- Less than 50% of the entity’s gross income for the taxable period is paid or accrued to nonresidents of either treaty country in the form of payments deductible in the treaty country. This does not include payments that are in the ordinary course of business and payments with respect to bank loans that are generally taxable to the bank by either treaty country.
- The purpose of these rules is to ensure that sufficient company ownership consists of qualified persons, and that a company will not qualify for treaty benefits if it is reducing the treaty country tax base through payments of deductible interest or royalties.
- A trust that meets the following 2 requirements:
- On at least one-half the days of the taxable period, at least 50% of the beneficial interests are held by persons who are either qualified persons described above in 1-5, or are “equivalent beneficiaries,” (an equivalent beneficiary is a resident of certain defined economic areas such as the European Community or a party to NAFTA / USMCA, who is not a resident of the treaty country but who would qualify for “all the benefits” under the treaty of its resident country); and
- Less than 50% of the trust’s gross income for the taxable period is paid or accrued to nonresidents of either treaty country in the form of payments deductible in the treaty country. This does not include payments that are in the ordinary course of business and payments with respect to bank loans that are generally taxable to the bank by either treaty country.
- The purpose of these rules is to ensure that the trust beneficiaries have sufficient nexus to the treaty country and that the trust will not qualify for treaty benefits if it is reducing the treaty country tax base through payments of deductible interest or royalties.
Other Limitations on Benefits (LOB) Tests
A person that is not a qualified person may still qualify for treaty benefits under the LOB if it meets one of three special tests described below. Not all of these tests appear in every U.S. tax treaty. These tests are targeted at specific benefits and meeting one of these tests does not generally translate into receiving “all the benefits” of a particular treaty. These special tests are:
- The derivative benefits test, entitling benefits for a company resident in a treaty country with respect to an item of income. This test applies to closely held companies owned by shareholders living in an economic region. It is worthwhile to note that this test may no longer apply to the UK post-Brexit.
- Seven or fewer equivalent beneficiaries (as defined above) own, directly or indirectly, at least 95% of the aggregate voting power and value of the company; and
- Less than 50% of the entity’s gross income for the taxable period is paid or accrued to persons who are not equivalent beneficiaries, in the form of payments deductible in the treaty country. This does not include payments that are in the ordinary course of business and payments with respect to bank loans that are generally taxable to the bank by either treaty country.
- This test attempts to expand fairly the base erosion test to owners resident in a specific economic region, but outside the treaty country.
- The active trade or business test, which is meant to qualify items of income for integrated businesses in the U.S. and treaty country. There are a number of definitional rules relating to this test:
- If a resident of a treaty country is engaged in the “active conduct of a trade or business” in that treaty country (i.e., through its employees), an item of income derived from the other treaty country will qualify for treaty benefits if the item is “derived in connection with,” or is “incidental to,” that trade or business.
- If no other LOB tests are successful, a resident of a treaty country may be granted benefits with respect to an item of income if the U.S. competent authority (i.e., the IRS) determines that the establishment, acquisition or maintenance of the resident and the conduct of its operations does not have as one of its principal purposes the obtaining of benefits under the treaty.
Discuss Tax Treaty Claims With A Trusted Tax Advisor
The discussion above illustrates that the qualifications for benefits under a U.S. tax treaty are both bright line and extremely detailed. Specificity as to tax treaty and LOB provision of that treaty is also required on the relevant forms when making most treaty claims to the IRS. It is important to understand the details relating to a taxpayer’s qualification for treaty benefits before filing a claim. In many, if not all, cases, a foreign taxpayer with a treaty claim should discuss it in advance with a reputable U.S. international tax advisor, preferably as part of the taxpayer’s planning for the transaction or legal structure.
Please contact us with any questions.