2013-Issue 22 — Over the past few decades, the United States has entered into numerous bilateral income tax conventions with foreign governments. A primary purpose of these conventions is to ease the burden of double taxation on individuals and companies resident in each of the contracting states. The ultimate goal of these treaties is to ease barriers to international business and transactions by making the establishment of business activities as attractive, predictable and simple as possible to potential cross-border investors of the participating parties.
Limitation on Benefits Clauses
With the rise of these bilateral income tax conventions came the need to ensure the benefits granted under the conventions were restricted to the intended parties. To restrict benefits, a limitation on benefits clause has been included in the tax conventions and treaties to which the United States is a party. Limitation on benefits clauses are drafted with the intention of avoiding treaty shopping, whereby a third-party national or corporation sets up a shell company in a contracting state through which income will be passed by the owners in an attempt to achieve a minimal tax rate, or to eliminate tax on the income altogether with no expense or real investment. The shell companies have no legitimate business purpose beyond minimizing tax exposure.
The limitation on benefits clause in each treaty contains certain tests to determine the applicability of the treaty to international transactions. While limitation on benefits clauses vary from treaty to treaty, they all have some common elements. In the corporate context, the most common test applied is the publicly traded corporation test. Where a corporation is privately held, the test applied becomes the active trade or business test. The active trade or business rules are often where the treaties diverge.
Active Trade or Business
Several common aspects of the active trade or business test appear in most, if not all, of the bilateral tax treaties:
- The active trade or business does not include the making or management of investments.
- For something to be an active trade or business, the activities taken in the company's country of residence must include all the steps in the process that gives rise to the income, or the activities must be complementary to the trade or business.
- The item of income must either be connected to the trade or business activities of the person and substantial in relation to the resident's activities in the other country, or must be incidental to the trade or business being conducted in the other contracting state.
- Income is incidental to a trade or business if the production of income in one state facilitates the conduct of trade or business in the other state.
The treaties do not, however, agree on what constitutes substantial income.
The Dutch, Luxembourg, and Swiss treaties with the U.S. are good examples of varying limitation on benefits clauses in their treaties with the United States. Each contains a definition of substantial income. While there are some common elements, each definition includes unique requirements that must be met in order to benefit from the individual treaties with the United States.
The Swiss treaty provides a facts and circumstances test to determine substantial income. The treaty merely states that the active trade or business must be substantial. The memorandum of understanding signed on the same day as the treaty provides a bit more clarity by giving examples of substantiality. The U.S. Treasury technical explanation provides that whether the trade or business of the income recipient is substantial will depend on all the facts and circumstances. The technical explanation further states that the determination will take into account the comparative sizes of the trade or businesses, the nature of the activities performed in each state and the relative contributions made to the trade or business in each state. Far from creating absolute certainty, the memorandum of understanding and technical explanation to the U.S.-Swiss treaty give a vague, but strict, standard for determining substantiality.
Similar to the Swiss treaty, the Dutch treaty determination of whether income is substantial turns on the facts and circumstances. Instead, the text of the Dutch treaty merely states that income from the active trade or business must be substantial in order to benefit from the treaty. As with the Swiss treaty, whether a business activity is substantial in the Netherlands is made by comparing the Dutch activities to U.S. activities. The current definition of substantial income in the Dutch treaty is a result of the 2004 protocol; previously, the treaty had contained a mathematical test.
The U.S.-Luxembourg treaty also considers the facts and circumstances and also provides a three-part factor test that acts as a safe harbor guideline. Under the ratio test, income earned by the Luxembourgian entity is considered substantial if the value of assets held by the entity, the gross income derived from the active trade or business, and the payroll expense related to the trade or business is at least 7.5 percent in the preceding year when compared against the U.S. trade or business. The average of all three factors must exceed 10 percent in the preceding year. The Luxembourgian treaty allows for the use of ratios from the preceding three years should one of the factors fail to meet the test. Each ratio will be calculated to the extent that each item is connected to the trade or business, and will be adjusted for the proportionate ownership of the resident.
In all cases, regardless of the definition, the treaty partner must conduct a business in the treaty country in order to benefit from the tax treaty with the United States. The business must be conducted with employees and be run on a real basis based on the business income earned.
Applying the Active Trade or Business Provision
Lux Limitation on Benefits Clause
Consider the following example. Company X owns its intellectual property in IPCo, a wholly owned subsidiary located in Country Y. Country Y has a bilateral treaty for the prevention of double taxation that is similar to the Luxembourg treaty described above. In particular, the treaty includes a limitation of benefits clause that contains a numerical test identical to the Luxembourg treaty. IPCo will hold the IP and license it to Company X for use in the trade or business. Development of the IP will be done cooperatively through two subsidiaries of Company X; the subsidiaries will be compensated by IPCo for their assistance.
Option 1: IPCo does nothing but hold the IP. IPCo has no employees of its own, nor does it have a service provider engaging in outsourced trust services in Country Y. The Board of Directors spends minimal to no time in Country Y, and decisions are made remotely or by Company X. Under this structure, Company X would not benefit from the lower tax rates and other preventative measures found in the tax treaty as the active trade or business in Country Y would not rise to the level of substantial in relation to the U.S. activities.
Option 2: IPCo has several higher-level employees (including finance, legal and an IP expert). The Board of Directors meets three times per year in Country Y, where they make major decisions for IPCo, receive reports from subsidiaries of Company X on IP development and review compliance with intercompany agreements. The rest of the year, the Board resides elsewhere. Under this scenario, the activities in Country Y would likely rise to the level of substantial in relation to the U.S. trade or business. Therefore, Client X would likely benefit from the Treaty. However, care should be given to ensure IPCo passes the ratio tests in the treaty.
Switzerland and Dutch Limitation on Benefits
The facts are the same as above. However, Country Y has a bilateral treaty for the prevention of double taxation that is similar to the Swiss and Dutch treaties described above. In particular, explanations to the treaty require consideration of all the facts and circumstances to determine if a business activity generating income is substantial. IPCo will hold the IP and license it to Company X for use in the trade or business. Development of the IP will be done cooperatively through two subsidiaries of Company X; the subsidiaries will be compensated by IPCo for their assistance.
Option 1: IPCo does nothing but hold the IP. IPCo has no employees of its own, nor does it have a service provider. The Board of Directors spends minimal to no time in Country Y, and decisions are made remotely or by Company X. Again, because of the lack of substance in the Country Y entity, this IPCo will not satisfy the substantiality test under the Swiss and Dutch limitations on benefits.
Option 2: IPCo has several higher-level employees (including finance, legal and an IP expert). The Board of Directors meets three times per year in the capital of Country Y, where they make major decisions for IPCo, receive reports from subsidiaries of Company X on IP Development and review compliance to any intercompany agreements. The rest of the year, the Board resides elsewhere. This structure will likely satisfy the Switzerland and Dutch limitations on benefits requirements for substantiality as long as Company X continues to minimize remote attendance of meetings by directors, and as long as agreements between entities are complied with. Because there is no concrete mathematical test that can be used to ensure IPCo meets the standard, Client X will need to make sure that IPCo functions as a company that could reasonably hold and direct activities related to the IP. More key-level functions and employees will be required to meet the substantiality test.
Alvarez & Marsal Taxand Says:
Upfront planning for international structures is crucial to ensure coverage under bilateral tax treaties. Failure to carefully scrutinize and comply with requirements found in the limitation on benefits clause in these treaties could result in a loss of valuable benefits, and can render the structure ineffective. Additional care should be shown when applying the active trade or business substantial income provision under the limitation on benefits clause to ensure activities and income rise to the definitions provided by the treaties. To achieve optimal results, immediate business concerns of the client should be carefully balanced with long-term goals to ensure the establishment of activities in the most favorable environment.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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