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  • Treasury Releases Proposed Amendments to its U.S. Model Income Tax Treaty
    May 2015

    On May 20, 2015, the U.S. Treasury released a group of proposed changes to the 2006 U.S. Model Income Tax Convention of November 15, 2006 (the “Model Treaty”).[1] The Model Treaty usually is the opening position of the United States in income tax treaty negotiations with other countries. In general, the Treasury’s proposed changes, if implemented, would significantly restrict the circumstances in which the U.S. is willing to grant treaty benefits to residents of another country. However, the news for U.S. treaty partners is not all bad; the Treasury now, as a general matter, is willing to offer “derivative benefits” to all potential treaty partners.
    Expand the triangular rule
    In general, the United States has been willing to grant a reduction in U.S. tax at source to various types of income paid to a qualified resident of a treaty partner, whether the income is paid to the resident directly or to a permanent establishment of the resident in a third country.  However, beginning with the 1992 Netherlands-USA Income Tax Convention, the United States has restricted treaty benefits when certain income is paid to a permanent establishment of the treaty resident if the income is taxed at a reduced rate compared to the rate of tax applicable had the income been paid to the resident directly. This is commonly referred to as the “triangular rule.” For example, the triangular rule in the Dutch treaty provides that U.S. source royalties paid to a permanent establishment of a Dutch company in a third country are subject to a U.S. tax of 15 percent if the royalties are subject to an aggregate rate of tax in the Netherlands and the third jurisdiction that is less than 60 percent of the rate of Dutch corporate tax that would be due if the royalties were paid to the Netherlands directly.
    The Treasury’s proposal would generalize the current triangle rule to apply to all income derived by a permanent establishment in a third country. The change would be effected by adding a new paragraph to Article 1 (General Scope) of the Model Treaty.
    The rule, which would use the same 60 percent threshold as current U.S. treaties,[2] is more stringent than the typical triangular rule in several respects. Not only is the rule broader, applying to all types of income, but, when it applies, the affected income is denied treaty benefits entirely and taxed under the domestic law of the source state. In addition, if the country in which the permanent establishment is located does not have an income tax treaty with the source state (e.g., the United States), the income is denied treaty benefits by the source state, unless the residence state includes the income attributable to the permanent establishment in its tax base.
    Revise the limitation on benefits article
    Beginning in 1992, U.S. income tax treaties have included a comprehensive limitation on benefits article. This article provides a list of bright-line rules, at least one of which a resident must satisfy in order to be entitled to treaty benefits.  The new version of the limitation on benefits article generally follows the 2006 version.  Thus, there is a test for publicly-traded companies, an active trade or business test and an ownership-base erosion test.[3]  Consistent with the Model Treaty, there also is a provision allowing the competent authority to grant treaty benefits if a resident otherwise fails to qualify under any of the bright line rules.
    The most notable proposed change is with respect to derivative benefits. The 2001 U.K.-U.S. Income Tax Convention introduced the derivative benefits test. Under the derivative benefits test, a U.K. company owned by residents of another country that is a member of the European Community or the European Economic Area is a qualified resident and entitled to U.S. treaty benefits if at least 95 percent of the company’s shares (measured by vote and value) are owned by seven or fewer persons who are “equivalent beneficiaries” and the U.K. company does not make deductible payments of more than 50 percent of its gross income to persons who are not “equivalent beneficiaries.”
    In general, an “equivalent beneficiary” is a resident of an EC or EEA country with a comprehensive income tax treaty in effect with the source state and, with respect to interest, dividends and royalties, the source state’s tax on that item of income under the equivalent beenficiary’s treaty is at least as low as the rate of tax applicable under the treaty of the company claiming derivative benefits.
    The U.S. Model does not include a derivative benefits test. The Treasury now has proposed offering derivative benefits when the treaty partner is not a member of an economic group. Thus, an entity or individual resident in a third treaty country would need to satisfy only a rate disparity test in order to be an equivalent beneficiary.  Asian and Latin American countries therefore should be eligible to negotiate a derivative benefits test into their treaties with the United States.
    Deny certain treaty benefits to an expatriated entity
    The Obama Administration has taken various steps to discourage corporate inversions,[4] including proposed legislation, revised regulations and, most recently, Notice 2014-52 announcing additional regulations aimed at restricting the tax benefits of an inversion.  The Treasury is now proposing to deny an expatriated entity (as defined in section 7874(a)(2)(B)) a reduced rate of U.S. tax at source on interest, dividends and royalties for 10 years following expatriation. This income would, instead, be taxed under U.S. domestic law.  Thus, U.S. source royalties, dividends, interest and other income not attributable to a U.S. permanent establishment would be taxed at a 30 percent rate if earned by an expatriated entity.
    Deny treaty benefits to “special tax regimes”
    The proposed changes to the Model Treaty introduce the term “special tax regime,” which is employed to deny treaty benefits as described below. The term means “with respect to an item of income or profit . .  . . any legislation, regulation or administrative practice that provides a preferential effective rate of taxation to such income or profit, including through reductions in the tax rate or the tax base.” The term includes notional deductions that are allowed with respect to equity.[5]  The definition does not offer guidance as to how much lower the preferential tax rate must be than the general tax rate.[6]
    The term “special tax regime” is used in Articles 11 (Interest), 12 (Royalties), and 21 (Other Income).  When the beneficial owner of such income benefits from such a regime in its residence country, the source state retains its right to tax the income under its domestic law. The term “special tax regime” also is used in Article 22 (Limitation on Benefits) for the purposes of the “derivative benefits” test.  
    The Treasury explains that application of the term “special tax regime” in Articles 11, 12 and 21 is consistent with the tax policy considerations that are relevant to the decision to enter into a tax treaty, or to amend an existing tax treaty, as articulated by the Commentary to the OECD Model, as amended by the Base Erosion and Profits Shifting initiative.  When a Contracting State imposes no tax or a low rate of tax on income, the risk of double taxation is reduced and so the need for an income tax treaty.
    Address subsequent changes in law
    The statutory tax rates of OECD member countries have, on average, declined over the last 20 years while the U.S. corporate income tax rate has remained constant. This change has been noted and discussed. [7]
    The Treasury is concerned that this competition in rate cutting may continue.  Should a treaty partner lower its corporate tax rate below 15 percent or  provide an exemption from taxation to resident companies for substantially all foreign source income (including interest and royalties) then the domestic law of the source state would apply to tax interest, dividends, royalties and other income.  The Treasury explains that in these cases double taxation is not a significant concern so treaty benefits should be curtailed. A similar rule would apply if the individual tax rate was lowered below 15 percent.
    [2] The explanation accompanying the proposed changes states that the principles of section 954(b)(4) (the subpart F high tax exclusion) would be utilized to determine the effective tax rate.
    [3] The proposal includes two variations on the ownership-base erosion test.
    [4] Generally, an inversion occurs when a foreign entity acquires, pursuant to a plan, substantially all of the properties of a U.S. corporation (or a domestic partnership), (ii) the foreign corporation and its “expanded affiliated group” do not have substantial business activities in its country of incorporation (compared to the business activities of the expanded affiliated group outside such country), and (iii) there is a continuing interest by shareholders of the U.S. corporation (or domestic partnership) in the foreign acquirer.
    [5] The definition includes exclusions for “any legislation, regulation or administrative practice :
     i) the application of which does not disproportionately benefit interest, royalties or other income, or any combination thereof;
    ii) that, with regard to royalties, satisfies a substantial activity requirement;
    iii) that implements the principles of Article 7 (Business Profits) or Article 9 (Associated Enterprises);
    iv) that applies principally to persons that exclusively promote religious, charitable, scientific, artistic, cultural or educational activities;
    v) that applies principally to persons substantially all of the activity of which is to provide or administer pension or retirement benefits;
    vi) that facilitates investment in entities that are marketed primarily to retail investors, are widely-held, that hold real property (immovable property), a diversified portfolio of securities, or any combination thereof, and that are subject to investor-protection regulation in the Contracting State in which the investment entity is established; or
    vii) that the Contracting States have agreed shall not constitute a special tax regime because it does not result in a low effective rate of taxation;”
    [6] The Treasury has some discretion in applying this provision, so presumably a small preference would not trigger a denial of treaty benefits.
    [7] See Jane G. Gravelle, International Corporate Tax Rate Comparisons and Policy Implications (January 6, 2014); Jane G. Gravelle, Corporate Tax Reform: Issues for Congress (January 26, 2014).  Both reports are available at