IRS Issues Guidance on Discretionary Grant of Benefits under Income Tax Treaties
In Rev. Proc. 2015-40, issued August 13, 2015, the IRS provides guidance to taxpayer, including residents of other countries, requesting competent authority assistance under U.S. income tax treaties. The revenue procedure includes guidance on the circumstances in which the U.S. competent authority will consider granting discretionary relief under the limitation on benefits article of a U.S. income tax treaty. The guidance, is consistent with recently announced proposed amendments to the 2006 U.S. Model Income Tax Treaty. Significantly, the guidance also introduces a “purpose test” which is a new, and relatively undefined, concept for U.S. income tax treaties.
In order to qualify for the benefits of a U.S. income tax treaty, a tax resident of a country with which the United States has an income tax treaty must generally qualify under one of the tests in the Limitation on Benefits (“LOB”) article of the treaty. Although these tests vary by treaty, recent U.S. income tax treaties generally include (i) an active trade or business test, (ii) and ownership-base erosion test, (iii) a derivative benefits test, and (iv) a test for publicly traded companies and their subsidiaries. Also, certain residents qualify without regard to satisfying one of these tests, e.g., individuals, pension funds and certain tax exempt entities.
When a resident of a treaty country cannot satisfy at least one of these tests, the LOB article provides a resident (the “applicant”) may approach the U.S. competent authority and request a ruling that, in the discretion of the competent authority, the applicant qualifies for the benefits of the treaty. Prior guidance, provided in Rev. Proc. 2006-54, offered virtually no guidance as to the circumstances in which the United States would grant benefits. Moreover, when relief was granted, the IRS did not disclose the facts or the government’s rationale for providing relief.
Rev. Proc. 2015-40
Discretion is absolute
Rev. Proc. 2015-40 offers significant insights as to when the U.S. competent authority will exercise its discretion in favor of an applicant. It also makes clear that, in the government’s view, the competent authority’s decision is not subject to appeal or review. The revenue procedure states that “a decision by the U.S. competent authority not to grant discretionary benefits is final and not subject to administrative review.” It further states that “an applicant that does not qualify for the requested benefits under the relevant LOB provisions of the applicable U.S. tax treaty may not claim those benefits, either at source or through a refund claim, unless it has received a favorable determination from the U.S. competent authority exercising its discretion to grant benefits.” With this, the IRS is saying that should a request for relief be denied, the applicant may not, nevertheless, claim treaty benefits by arguing that the IRS abused its discretion in denying it such benefits. This position also would appear to foreclose bringing suit in court to compel the IRS to grant benefits. (Although a court may well decide to take jurisdiction of such a case, notwithstanding the IRS’s position).
Substantial non-tax nexus
Consistent with current policy, the applicant must first demonstrate that it does not qualify for benefits under the relevant LOB provisions of the applicable U.S. income tax treaty. This typically will entail discussing the relevant facts and demonstrating that under each of the tests the applicant fails to qualify.
Once this is done, the next step is to present the applicant’s reasoning as to why relief should be granted. The IRS expects the resident to demonstrate certain facts. First, the applicant must have a “substantial non-tax nexus to its country of residence.” This includes a discussion of the resident’s trade or business activities in its country of residence. There must also be a discussion of the resident’s trade or business activities in the United States.
The following factors are considered as to both U.S. and resident country activities: customer base, capital assets, employees, income and sources of supply. As all facts and circumstances are considered in making the determination, weaknesses in some metrics likely can be overcome by strengths in others. Moreover, the revenue procedure uses the term “trade or business” and not “active trade or business’ which implies a lower threshold of activity than is found in an LOB article’s active trade or business test. It therefore should include consideration of the activities of agents and service providers. Thus, a purchasing office, a logistics center, a quality control function or a marketing office may create sufficient nexus in the applicant’s country to support relief. The revenue procedure states that taking advantage of favorable domestic law or the resident country’s network of income tax treaties will not establish the required nexus.
The revenue procedure introduces a concept new to U.S. income tax treaties – a purposes test. The applicant must demonstrate that, if relief is granted, nether the resident nor its direct or indirect owners will use the treaty “in a manner inconsistent with its purposes.” The revenue procedure does not define the critical term “purposes.”
The revenue procedure does offer some guidance of the factors that will be considered in applying the purposes test. These include the country of residence of the applicant’s owners, any changes in the ownership structure of the applicant and its U.S. operations, and the history of the applicant’s trade or business activities in its country of residence and the United States. Thus, the competent authority may consider direct or indirect owners resident in a non-treaty country as a negative factor and as well as changes to U.S. operations or its U.S. corporate structure (e.g., an inversion) that reduces the U.S. tax base.
As the purposes of income tax treaties are generally understood to be to avoid double taxation (and double non-taxation) and prevent fiscal evasion, the revenue procedure may to be expanding the purposes of income tax treaties beyond those purposes commonly understood by treaty negotiators. Perhaps future treaties will explain the term further. In the author’s view, the competent authority would have a stronger position if it does not seek to read into a treaty a purpose that is not negotiated and well understood. Such a position facilitates an abuse of discretion lawsuit by a rejected applicant.
Circumstances in which relief typically will not be granted
The revenue procedure also provides three fact patterns that typically will not qualify for relief:
- The applicant or any of its affiliates is subject to a “special tax regime” in its country of residence with respect to the item of income for which relief is sought.
- The applicant bases its request solely on the fact that it is the direct or indirect subsidiary of a publically traded company and the relevant withholding rate provided by the treaty between the United States and the applicant’s country of residence is not lower than the rate under the treaty between the United States and the country of residence of the parent company or any intermediate owner.
- No or minimal tax would be imposed on the item of income in the applicant’s country of residence and the country of source taking into account both domestic law and the relevant income tax treaty.
Likely cases for relief
There is anecdotal evidence that the U.S. competent authority has been willing to grant relief in at least two types of cases. First, when a business structure is established for non-tax reasons, the structure qualifies for treaty benefits and later ceases to qualify because the business is sold to new owners. In some cases the new owners have been granted relief. The second case occurs when an applicant fails to qualify under one of the objective tests in the LOB by a small margin. The IRS has been willing to relax the rules in some cases and grant benefits. This case is more compelling if the failure to qualify is due to a business driven constraint rather than a tax imperative.
 A few treaties do not contain a limitation on benefits article, e.g., the U.S. income tax treaties with Hungary and Poland. The Treasury is negotiating new treaties with those countries; however, they have not yet entered into force. Section 3.08 provided: “[C]ertain treaties provide that the competent authority may, as a matter of discretion, determine the availability of treaty benefits where the prescribed requirements are not met. Requests for assistance in such cases should comply with this revenue procedure and any other specific procedures that may be issued from time to time. A request may be with respect to an initial discretionary determination, a renewal or a redetermination. The request should take the form of a letter as described in section 4.04 of this revenue procedure, except that if the requester does not file federal tax returns and cannot identify a person authorized to sign such returns, the letter may be dated and signed by any authorized representative or officer of the requester.” These facts may also be relevant in establishing a substantial nexus. For a discussion of special tax regimes, see the Treasury’s proposed amendments to the 2006 U.S. Model Income Tax Treaty, available at http://www.treasury.gov/press-center/press-releases/Pages/jl10057.aspx./
KEYWORD: Income Tax Treaties
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