Proposed Revision to U.S. Model Income Tax Treaty
By Michael L. Schler & Andrew M. Carlon
Posted: 19th August 2015 09:31The U.S. Model Income Tax Treaty (Model Treaty) is the announced “starting point” for the U.S. negotiation of income tax treaties. On 20 May 2015, the U.S. Treasury Department proposed significant amendments (the Proposals) to the Model Treaty that could limit the future availability of treaty benefits in significant ways. Treasury officials have stated that they intend to finalise the Proposals before the end of 2015.
The Treasury has stated that the Proposals are designed to protect the United States tax base. They provide insight into the United States’ international tax priorities and are motivated by many of the same concerns underlying the OECD BEPS project.
Tax treaties generally provide benefits to persons who are “residents” of the contracting states, and the benefits generally extend to a permanent establishment (PE) of a resident located in a third jurisdiction. The Proposals would deny treaty benefits in the source jurisdiction to such a PE if either:
- the income of the PE is not included in the tax base in the residence jurisdiction, and the PE is located in a third jurisdiction that does not have an income tax treaty with the source jurisdiction, or
- the profits of that PE are not subject to a combined tax rate (in both the residence state and state in which the PE is located) that is at least 60% of the general tax rate of the country of residence.
For example, in the case of a U.S. treaty with country X, this provision would disallow a treaty reduction of U.S. withholding tax on payments made to a PE of a resident of X located in a tax haven jurisdiction Y, unless X included the income of the PE in its tax base. Also, and perhaps surprisingly, U.S. treaty benefits would not apply even if jurisdiction Y had a high tax rate, if the U.S. did not have a treaty with Y and jurisdiction X did not include the income in its own tax base.
Limitations on Benefits
The Proposals would revise the “limitation on benefits” (LOB) provision in the existing Model Treaty and in recent U.S. tax treaties. LOB articles limit the availability of treaty benefits to residents of the treaty jurisdiction that have a sufficient connection with the country of residence. The Proposals make a number of changes to the model LOB article, in most cases making it harder to satisfy. The Proposals would also for the first time add a derivative benefits provision to the Model Treaty, under which a treaty resident otherwise failing the LOB provision can be eligible for treaty benefits if its shareholders are in jurisdictions that would have entitled them to treaty benefits. Derivative benefit provisions have been included in U.S. tax treaties with European countries and the Proposal would broaden the availability and scope of this provision.
Special Tax Regimes and Changes in Tax Law
The Proposals would deny exemptions from U.S. withholding tax (currently at a rate of 30%) on U.S.-source interest, dividends, royalties and “other income” if those payments are paid to a related person and are subject to a “special tax regime” in the payee’s jurisdiction. A “special tax regime” is a preferential effective rate of taxation, including through reductions in the tax rate or the tax base. The reduced tax rate can arise not only through laws of general applicability, such as statutes or regulations, but also through an “administrative practice”, including a practice of granting favorable private tax rulings. The definition of special tax regime includes a number of exemptions and contemplates a protocol under which the contracting parties would identify specific tax law features that would not constitute special tax regimes. The denial of benefits operates on an item-by-item basis—residents of a jurisdiction with a special tax regime for royalties, for example, may still be eligible for an exemption from U.S. withholding on interest.
In addition, either country could eliminate all benefits with respect to dividends, interest, royalties and other income paid to a resident of the other country if the other country reduces its general rate of tax below 15% or adopts a territorial system which exempts “substantially all foreign source income” from domestic taxation. Treasury officials have subsequently suggested that they are considering, instead of a fixed 15% floor, a rate that is the lesser of 15% or 60% of the source country’s general tax rate. This provision is designed to give the United States additional flexibility in the event of subsequent changes in tax law or practice in the counterparty state, beyond outright termination of the treaty.
These changes are aimed at “stateless” income that is subject to tax in neither the source nor residence jurisdiction. The Treasury notes that the stated purpose of nearly all income tax treaties is the prevention of double taxation. Where the residence jurisdiction does not impose more than de minimis tax, either on specific items of income or on foreign-source income generally, however, the risk of double taxation is outweighed by the risk that the income will never be subject to tax.
The Treasury proposal would also deny treaty benefits on dividends, interest, royalties and other income for “expatriated entities”—former U.S. corporations that have redomesticated abroad by merging with non-U.S. corporations in transactions in which the former U.S. corporation shareholders received 60%–80% of the combined company—for 10 years after expatriation. This is one of several proposals announced in the past year that target so-called “inverted” companies.
The Proposals are unlikely to become effective in the near future. Even if they are incorporated into the Model Treaty, they must still be agreed to by countries entering into tax treaties with the U.S., and those treaties must be ratified by the U.S. Senate. Many countries may object to these provisions on the ground that they interfere with domestic law, and in any event the U.S. Senate has not ratified any tax treaties for the last several years (a separate story in itself). Nevertheless, tax advisors engaged in long-term cross-border tax planning should bear in mind the potential for these or similar changes to be put into effect at some point in the future.
In addition, the policies behind the Proposals may have “real world” effects even before ratification of new tax treaties. For example, the Model Treaty and most U.S. tax treaties contain a provision stating that the U.S. competent authority can grant discretionary relief to a resident of a treaty jurisdiction that would otherwise violate the LOB provisions, if certain conditions are satisfied. On 13 August 2015, the Internal Revenue Service issued new guidelines for the grant of competent authority relief, and these guidelines incorporate several of the principles contained in the Proposals.
Finally, the relationship between the Proposals and the forthcoming final BEPS proposals on tax treaties is not clear. If the final version of the Proposals is materially different than the final BEPS proposals, some of the U.S. tax positions could be outliers, and future negotiations of U.S. tax treaties could be quite difficult.
Michael L. Schler is a retired tax partner and of counsel, and Andrew M. Carlon is a Tax Senior Attorney, to Cravath, Swaine & Moore LLP in New York City. Their practices include the tax aspects of domestic and international mergers and acquisitions, spinoffs, joint ventures, private equity transactions, and financings.
Cravath has long been known as one of the premier U.S. law firms. Each of its practice areas is highly regarded, and its lawyers are recognised internationally for their expertise and commitment to client interests. Cravath is by design not the largest law firm measured by number of offices or lawyers. Its goal is to be the firm of choice for clients for their most challenging legal issues, most significant business transactions, and most critical disputes.
The Firm's Tax Department is primarily engaged in complex U.S. and international corporate transactions, including public and private mergers and acquisitions, spin-offs, joint ventures, private equity transactions, financial transactions, real estate transactions, and debt and equity offerings.