23 March 2018
2010 marks a time of considerable change in the income tax treaty network of the United States (US). During 2010, new income tax agreements with Italy and France have become effective, protocols to six other treaties were signed, and negotiations to revise several treaties are either commencing or expected to begin.
The common threads running through these treaty developments are (i) reduction of withholding rates, (ii) strengthening of limitation on benefit provisions to limit treaty shopping, (iii) increased exchange of information, and (iv) tax classification of fiscally transparent entities for purposes of determining whether income is derived by a resident. In addition, several agreements contain either less common or unique provisions such as the mandatory arbitration clause found in the US-France Protocol and the withholding tax rate reset, services permanent establishment, and capital gain tax provisions set forth in the US-Chile Treaty.
NEW TREATIES IN FORCE EFFECTIVE 2010
US-Italy Income Tax Treaty
On December 16, 2009, the US and Italy exchanged instruments, thereby bringing into force (with effect as of January 2010) an income tax treaty signed by the US and Italy in 1999.
The US-Italy Treaty lowers withholding on interest (reduced to 10% from 15%) and royalties (generally reduced to 8%, with a special 0% rate and a 5% rate for certain types of royalties). It also lowers the ownership percentage to 25% to qualify for 5% withholding on intercompany dividends. In addition, the Treaty includes specific withholding provisions for registered investment companies (“RICs”) and real estate investment trusts (“REITs”) providing generally a 15% withholding rate. Finally, the Treaty includes a comprehensive limitation on benefits provision that generally is based on the 1996 US model tax treaty.
Another major change is that the Treaty allows for a branch profits tax of 5%. This equalizes the treatment of branches and subsidiaries of Italian corporations doing business in the US.
Though the Treaty generally took effect as of the beginning of 2010, it also contains grandfathering provisions that enable taxpayers to elect to apply the prior treaty for one year (i.e., generally until December 31, 2010).
For a comprehensive discussion of the significant changes in the US-Italy Treaty, please refer to our US-Italy Tax Treaty Alert published in July 2009.
US-France Protocol Amending 1994 Income Tax Treaty
On December 23, 2009, a Protocol to the 1994 US-France income tax treaty, as amended in 2004, entered into force.
The US-France Protocol lowers withholding tax rates and includes a 0% rate on qualifying intercompany dividends paid by 80%-owned subsidiaries (on stock held for at least 12 months) as well as on all royalties and a 15% rate for certain qualifying REIT dividends. In addition, the Protocol includes new provisions allowing treaty benefits with regard to income of fiscally-transparent entities to the extent the income is treated under the tax law of the other country where the entity is formed (or if formed under the laws of a third country if such country has an exchange of information agreement with the source country) as realized by the entity’s beneficial owners provided the latter qualify as tax residents under the treaty. The Protocol further contains modern limitation on benefits and exchange of information provisions, both generally consistent with the 2006 US Model Treaty.
Finally, the Protocol contains a mandatory arbitration clause making it the fourth US treaty with mandatory arbitration.
The Protocol with France is generally fully effective as of taxable years beginning on or after January 1, 2010. In contrast to the new treaty with Italy, there is no grandfather provision that allows taxpayers to elect to continue applying prior Treaty provisions.
For a more comprehensive discussion of the US-France Protocol, please refer to our US-France Tax Treaty Alert published in October 2009.
US-Liechtenstein Tax Information Exchange Agreement (TIEA)/ QI Status
A new TIEA between the US and Liechtenstein entered into force on December 4, 2009 with effect beginning 2010.
In addition, the US has renewed treatment of Liechtenstein as an eligible “qualified intermediary” or “QI” jurisdiction for purposes of the US federal withholding tax provisions for a six-year term through 2015.
TREATIES ON THE HORIZON
Highlighted below are a number of important new treaties or protocols that are presently progressing through the six-stage process – i.e., negotiation, initialization, executive branch signature, Senate advice and consent, ratification, and entry into force.
The US during 2010 signed new treaty agreements with Chile, Hungary, Malta, New Zealand, Switzerland, and Luxembourg.
Six New Treaty Agreements
1. First Treaty with Chile:
Signed on February 4, 2010, upon enactment this treaty would become only the second US treaty since the US-Venezuela Treaty in 1999 with a South American country. The Chile treaty is unique in several respects, including its withholding provision rate change and reset features, sourcing of royalties, treatment of services as a permanent establishment, and taxation of capital gain. The treaty is currently pending the US Senate’s advice and consent.
The new Chile treaty provides a transitional rate of 15% withholding on interest for the first five years that would thereafter reset at 10%. In addition, interest payable to lenders primarily engaged in the finance business is taxed at a 4% rate (with no transitional rate) but subject to a protective kick-out rule for backto- back loans made through an active business lender to circumvent the regular rate. Royalties are generally subject to a 10% withholding rate though a 2% rate applies to royalties paid for use of certain equipment. The Chile treaty, however, adopts a sourcing rule for royalties based on the residence of the payor contrary to the general sourcing principle based on geographic use.
A 5% rate would apply to intercompany dividends paid to a 10% or greater owner, in lieu of the general 15% rate, as well as to branch profits (although this new provision will not affect dividends paid by a Chilean corporation that remain subject to a Chilean withholding tax of 35% against which there is a credit for the Chilean corporate-level tax incurred at 18%). Dividends earned by pension funds are entirely exempt. Uniquely, the withholding tax rates for interest, royalties and dividends would reset to match a lower rate that Chile adopts in a treaty with another country.
A permanent establishment includes services rendered by individuals physically located for greater than 183 days in any 12-month period, regardless of existence of an office or place of business and authority to execute contracts, contrary to long-standing principles also reflected in the US Model Treaty. Permanent establishment status based on services alone is found in US treaties with Canada and Bulgaria.
The treaty with Chile also unusually permits taxation of capital gain and provides that a tax rate of up to 16% may apply though exemptions are provided for pension funds, mutual funds and institutional investors. The capital gain provision is significant because Chile taxes capital gain on sale of shares or other equity interest in a Chilean corporation at rates ranging from 17 to 35%, enforced through a withholding tax regime.
The treaty contains a limitation on benefit provision substantially similar to the US Model Treaty with public company, public company subsidiary, base erosion and active business tests; the treaty limitation on benefit provision also includes a headquarters test. Further, a protocol to the treaty directly addresses eligibility for treaty benefits of owners of interests in fiscally transparent entities with respect to income derived by the entity. If an entity is treated as transparent under the tax law of the US or Chile, its income is eligible for treaty benefits to the extent that under such tax law it is treated as income of a resident of such country. Finally, there are exchange of information provisions which provide for the full exchange of information including bank information.
2. New Treaty with Hungary:
Though negotiations began in 2001, a new treaty with Hungary was signed on February 4, 2010 that would replace the currently in force 1979 treaty. The new treaty reflects various US tax law changes since 1979 including taxation of branch profits and foreign investment in US real property, exemption of portfolio interest, and taxation of expatriates and is largely based on the 2006 US Model Treaty.
The most noteworthy change in the new Hungary treaty is the inclusion of a comprehensive limitation on benefits provision comparable to those entered into with other European states (determining qualified residence status under public company, ownership/base erosion, active trade or business, derivative benefits, and headquarters tests). The 1979 treaty with Hungary is one of the last US treaties with no limitation on benefits provision.
The limitation on benefits provision in the new Hungary treaty (unlike the US Model treaty) has a “triangular” provision governing eligibility for treaty benefits of income derived by an enterprise in one contracting state from the other contracting state that is attributable to a permanent establishment in a third state. Under the triangular provision, treaty benefits will be denied to the extent that profits of the permanent establishment are subject to a combined aggregate effective tax rate (in the first-mentioned state and third state) that is less than 60% of the general rate of company tax in the first state.
The new treaty lowers withholding tax on intercompany dividends to 5% for 10% or greater owners and generally exempts royalties and interest (except that contingent interest may be taxed at 15% withholding tax). The Protocol also treats income of entities that are transparent under the treaty country’s tax laws as derived by the resident beneficial owner except that unlike most newer US treaties fiscal transparency cannot be present if the entity is not organized in the US or Hungary.
Lastly, the Treaty provides for the exchange of information including bank information. It is expected that the amended US-Hungary Treaty will enter into force by the end of 2010 and become effective in 2011 (subject to a limited grandfather election to continue to apply the current treaty the end of 2010).
3. New Treaty with Malta:
This treaty, which was signed on August 8, 2008 and ratified by the Senate on July 15, 2010, would end a 13-year period without a governing treaty between the US and Malta (since the 1980 Treaty was terminated in 1997). The treaty will take effect once the governments exchange the instruments of ratification.
The Malta treaty has withholding rates on interest and dividends that are generally higher and a stricter limitation on benefits provision that makes it more difficult for third country residents to treaty shop by locating in Malta, an attractive low-tax jurisdiction. The higher limitation of benefit standards in the new US-Malta treaty are reflected, in part, by (i) the publicly-traded test that contains an additional “base erosion” requirement ensuring that less than 25% of the company’s gross income is paid or accrued to non-residents; (ii) a 75% share ownership by residents requirement applicable to non-publicly traded companies (in contrast to the typical 50% ownership test that applies along with the regular “base erosion” test) and (iii) a “triangular” provision applicable to third country permanent establishments (similar to the new treaty with Hungary).
The new treaty provides for a 10% withholding rate on interest and a 15% rate for contingent interest and an excess inclusion from a residual interest in real estate mortgage investment conduits (“REMICs”). Royalty payments are also generally subject to a 10% withholding tax. In addition, the Treaty provides for reduced withholding rates of 15% on dividends, generally, and 5% for certain intercompany dividends and 5% branch profits taxation.
4. Protocol with New Zealand:
The Protocol, of particular note, will reduce withholding tax rates on dividends to 5% for dividends received from a 10%-owned company and to 0% for dividends received from an 80%-owned subsidiary. It will also eliminate withholding tax on certain interest payments and reduce withholding on royalties to 5%.
The Protocol imposes a stricter limitation on benefits provision generally consistent with the 2006 Model Treaty. The limitation on benefits provision would allow treaty benefits only where the resident is also a “qualified person” which includes publicly traded companies (and their subsidiaries) as well as entities that meet an ownership and base erosion test or have an active business in the respective country. Finally, there is also a “triangular” provision that covers the case of income earned through permanent establishments in third countries. The Protocol also provides rules to determine whether treaty benefits apply with regard to income earned by a fiscally transparent entity, identical to those contained in the 2006 Model Treaty and most new treaties, regardless of whether the fiscally transparent entity is organized in a treaty or third country.
5. Protocol with Switzerland:
Signed on September 23, 2009, the sole purpose of this Protocol— expected to be before the US Senate for its advice and consent to ratification in 2010 — is to provide for the full exchange of information, including bank information.
6. Protocol with Luxembourg:
Signed on May 20, 2009, this Protocol — expected to be before the US Senate in 2010 — provides for the full exchange of information, including bank information.
Current and Anticipated Negotiations
The US is expected to start or has begun to negotiate new agreements with multiple new countries.
Some of the most promising are Poland, Israel Spain, Korea, and Colombia as discussed below:
Poland: negotiations centered on updating the existing treaty, particularly to reflect a comprehensive limitation on benefits provision (that like the case of Hungary, will impact Poland’s present attractive treaty country status due to its lack of a comprehensive limitations on benefit provision). Although the US has made completion of the Treaty a priority, it is considered unlikely that the Treaty will be effective before 2012.
Israel: negotiations expected to begin early 2010.
Spain: negotiations scheduled for 2010.
Korea: negotiations scheduled for 2010.
Colombia: negotiations scheduled for 2010.