IRS Concludes That Dividends Paid by Cypriot Corporation Qualify under Section 1 (h) (11)
In a Chief Counsel Advice memorandum, CCA 201343019, issued September 10, 2013, the Office of Associate Chief Counsel (International) considered whether a dividend paid by a Cypriot corporation to a U.S. shareholder was “qualified dividend income” (QDI) for purposes of section 1(h)(11). The CCA is significant because Cypriot corporations are common in many private equity (as well as other investment) structures, and the government previously had not addressed how to apply section 1(h)(11) to dividend paid by a foreign corporation that has no U.S. source income.
Section 1(h)(11) was added to the Internal Revenue Code in 2003 by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27, 117 Stat. 752). Section 1(h)(11) provides, inter alia, that the "qualified dividend income" (QDI) of a "qualified foreign corporation” (QFC) is treated as a net capital gain. A QFC is defined as “any foreign corporation if— (I) such corporation is incorporated in a possession of the United States, or (II) such corporation is eligible for benefits of a comprehensive income tax treaty with the United States which the Secretary determines is satisfactory for purposes of this paragraph and which includes an exchange of information program.” In addition, dividends paid by a foreign corporation that does not satisfy the preceding definition qualify for the benefits of section 1(h)(11) if the stock of the foreign corporation is "readily tradable on an established securities market in the United States.” Finally, a corporation that would otherwise be a QFC is not treated as such if “for the taxable year of the corporation in which the dividend was paid, or the preceding taxable year, [the corporation] is a passive foreign investment corporation (as defined in section 1297).”
The conference report to the 2003 act provides in addition:
The conferees further intend that a corporation will be eligible for benefits of a comprehensive income tax treaty within the meaning of this provision if it would qualify for the benefits of the treaty with respect to substantially all of its income in the taxable year in which the dividend is paid.
The IRS has issued various notices providing additional guidance as to how to apply section 1(h)(11): Notice 2003-69, Notice 2003-79, Notice 2004-70, Notice 2006-101 and Notice 2011-64. Notice 2011-64 discusses how to determine whether a foreign corporation is a QFC. This notice states that for purposes of determining whether a foreign corporation satisfies any applicable limitation on benefits (LOB) provision and therefore is eligible for the benefits of a comprehensive income tax treaty:
a foreign corporation is treated as though it were claiming treaty benefits, even if it does not derive income from sources within the United States. See H.R. Conf. Rept. No. 108-126 at 42 (2003) (stating that a corporation will be treated as eligible for treaty benefits if it “would qualify” for benefits under the treaty).
Notices 2003-69 and 2006-101 list the countries that the IRS has determined have income tax treaties that are satisfactory for purposes of section 1(h)(11). Cyprus is on the list.
Facts of the CCA
The facts stated in the CCA are sparse. The Cypriot corporation considered in the CCA was a holding company, and the taxpayer was a U.S. resident owning a portion of the shares of the Cypriot corporation. The remainder of the shares were owned by persons who are not residents of either the United States or Cyprus. The Cypriot corporation owned an operating company in a third jurisdiction. The CCA states that the Cypriot corporation “never earned US-source income or claimed any benefit under the [US-Cyprus Income Tax] Treaty.” There is no discussion as to the reasons the Cypriot corporation was formed or its ongoing purpose for existence.
Qualification for Benefits under the US Cyprus Treaty
In order to be a QFC, the Cypriot corporation had to be a resident of Cyprus and qualify for the benefits of the treaty under Article 26 (Limitation on Benefits). A Cypriot corporation is a resident of Cyprus for treaty purposes.
Paragraph 1 of Article 26 (Limitation on Benefits) denies the benefits of the treaty to a corporation resident in one state unless (i) more than 75% of each class of its voting shares is owned by individual residents of that state and (ii) the corporation satisfies a base erosion test. The Cypriot corporation described in the CCA failed to qualify under paragraph 1. Paragraph 2 of Article 26 provides, however, that paragraph 1 does not apply if: “it is determined that the establishment, acquisition and maintenance of such person and the conduct of its operations did not have as a principal purpose obtaining benefits under the Convention.”
Without analysis, the CCA states that the Cypriot corporation “was established in Cyprus, and is being maintained for reasons unrelated to the Treaty. [The Cypriot corporation] qualifies under paragraph 2 of Article 26 because there was no “principal purpose” of obtaining benefits under the treaty.” Although the CCA does not say this explicitly, presumably the fact that the Cypriot corporation earned no U.S. source income and never claimed treaty benefits was critical to the conclusion that the corporation was established for reasons unrelated to the treaty. The CCA also does not discuss the “substantially all” requirement mentioned in the conference report.
The CCA concludes that the Cypriot corporation “is a ‘qualified foreign corporation’ for purposes of section 1(h)(11), and dividend income that [the US] taxpayer received from [the Cypriot corporation] qualifies for the applicable net capital gain tax rate set forth in section 1(h)(11).”
Although a CCA is written for the government’s internal purposes and therefore has no precedential value, the conclusion is nonetheless heartening. The CCA was written by Branch 1 of the Office of the Associate Chief Counsel (International). In the author’s experience, this branch has typically been extremely cautious in providing formal guidance to taxpayers on treaty matters.
The analysis in the CCA strongly suggests that the government will not challenge taxpayers claiming the benefit of section 1(h)(11) in similar fact patterns. Dividends paid by a Cypriot holding company that simply satisfies corporate formalities should be eligible for the benefit under section 1(h)(11). This follows because the benefit provided by section 1(h)(11) is not a treaty benefit.
The LOB provision in the treaty with Cyprus is relatively simple, so the full meaning of the statement in Notice 2011-64 has not yet been elucidated. For example, how would the LOB test in Notice 2011-64 be applied to a Dutch holding company paying a dividend when the Dutch corporation earns no U.S.-source income? That treaty has a much more complex LOB article that includes a discretionary relief provision tied to principal purpose. How would the government decide which LOB test in the Dutch treaty should be satisfied? And what does it mean to satisfy an LOB test when the corporation earns no U.S. source income?
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