On 17 July 2023, the OECD released the model tax treaty provisions to implement the Subject-to-Tax Rule (STTR). The STTR is part of the OECD’s Pillar 2 project, but unlike the GloBE Rules is not limited to multinationals with a consolidated revenue of at least EUR 750 million. The STTR allows source jurisdictions to “tax back” in case treaty (withholding) tax reductions are claimed on cross-border payments (e.g., interest and royalties), whereas the recipient benefits from low or no taxation in the other jurisdiction. This publication outlines the mechanics of the STTR and possible relevance for real estate funds in Europe.

Rule – The STTR allows source jurisdictions to levy a top-up tax on defined categories of cross-border payments that are subject to a tax rate below 9% in the jurisdiction of the recipient, provided domestic taxation rights of the source jurisdiction have been limited under the applicable tax treaty.

Covered payments – In a real estate fund context, the STTR most notably applies to interest and financing fees, and servicing fees.

Tax rate below 9% – The tax rate in the recipient jurisdiction is in principle tested by looking at the statutory tax rate applicable to the income arising from the cross-border payment (i.e., typically the nominal corporate income tax rate). However, if the recipient benefits from a ‘permanent preferential adjustment’ (e.g., an exemption, partial exemption or exclusion directly linked to the income or that arises from a preferential tax regime for mobile income), such statutory tax rate is lowered with the effect of that preferential adjustment. The competent tax authorities must notify each other about the applicable tax rates and other features of their tax laws that are relevant to the STTR.

Carve-outs – Specific carve-outs exist for cross-border payments to, amongst others, recognized pension funds, regulated insurance companies and investment funds, REITs and their qualifying subsidiaries. Cross-border payments by and to individuals are outside the scope of the STTR, as well as payments between entities that are not ‘connected’. An entity shall be considered connected to another entity if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same entity or entities. Control is in principle defined as an interest of more than 50%.

Materiality threshold – The STTR only applies if the aggregate sum of cross-border payments between connected entities from the source jurisdiction to the recipient jurisdiction is at least EUR 1 million (or EUR 250,000 for jurisdictions with a GDP below EUR 40 billion). This is tested per fiscal year.

Mark-up threshold – The STTR only applies to cross-border payments (other than interest and royalties) where the amount of the cross-border payment exceeds the costs incurred in earning that income plus a mark-up of 8.5%. Specific rules apply when calculating this mark-up threshold.

Top-up taxation – The STTR top-up tax is levied on the gross amount of the cross-border payment. The STTR top-up tax rate is 9% which is reduced by (a) the tax rate in the recipient jurisdiction and (b) the rate at which the source jurisdiction is already allowed to tax the gross amount of the payment under the applicable tax treaty.

Implementation – A multilateral instrument will be made available as of 2 October 2023 to facilitate the implementation of the STTR into existing tax treaties. Jurisdictions can also choose to implement the STTR through bilateral tax treaty negotiations.

Compliance – The tax compliance process will need to be implemented by each of the participating jurisdictions. The OECD proposes a self-assessment through the filing of an STTR tax return in the source jurisdiction. The STTR tax return would need to be filed after the end of the fiscal year.

Interaction GloBE Rules – The STTR is creditable and takes priority over the GloBE Rules (i.e., top-up tax levied under the GloBE Rules is not relevant when testing the recipient’s tax rate under the STTR).

Targeted anti-avoidance rule – A specific anti-avoidance rule can apply if a payment is made to an unconnected intermediary (or a connected intermediary that is subject to a tax rate of at least 9%) and such intermediary within a year, directly or indirectly, pays an amount equal to (substantially) all of the original payment to an entity that is connected to the entity making the original payment. That connected entity would need to be subject to a tax rate below 9% and not eligible to a carve-out.

A&M Says

The impact of the STTR seems limited for European real estate funds and investment structures.

Lack of tax treaty application – Tax treaties are typically not applied to reduce interest withholding taxes, as jurisdictions either do not levy interest withholding tax or have implemented the EU’s Interest-Royalty Directive in their domestic tax legislation. As such, the STTR would have no relevance.

Territorial tax systems – Interest payments to entities in jurisdictions with a territorial tax system that exclude foreign-source interest income are most likely to be in scope as this would lead to a tax rate below 9% by virtue of a preferential tax regime. However, even then such interest payments would need to benefit from a withholding tax reduction under a relevant tax treaty in the source jurisdiction. If that is not the case, the STTR should still not be relevant.

Broad carve-outs – There are broad carve-outs that can be claimed by qualifying investment funds and REITs. Interest paid to fund vehicles that are tax transparent would, however, warrant a look-through to the investors under the STTR. For interest payments to such investors to be in scope would, amongst others, require the investor to be entitled tax treaty benefits on such interest and to be ‘connected’ to the payer in the source jurisdiction (e.g., a central investment company owned by the tax transparent fund vehicle). This is an unlikely scenario. If it applies, the investor would also need to be subject to a tax rate below 9%, whereby individuals, recognised pension funds, regulated insurance companies and investment (fund of) funds would generally be carved-out from the STTR.

Back-to-back financing – The targeted anti-avoidance rule could theoretically be triggered when interest is paid to a central investment company in a fund structure that on-pays the interest to a tax transparent fund vehicle (warranting a look-through to the investors). In such case, the central investment company could be considered an intermediary and therefore possibly in scope of this targeted anti-avoidance rule. However, investors that are carved-out from the STTR should still not be in scope and investors that are not ‘connected‘ should also not be in scope. Moreover, this rule would still require that tax treaty benefits are claimed on the interest payment by the source jurisdiction.

European Union – In the Pillar 2 Directive-proposal dated 22 December 2021, the European Commission explicitly mentions that the STTR is a treaty-based rule which is for jurisdictions to implement individually and that there will be no EU action in relation to the STTR. In our view this makes sense as the STTR does not seem to add anything to the EU’s Interest-Royalty Directive which already requires the recipient to be ‘subject to tax’ and given that there are no EU jurisdictions with a nominal tax rate below 9%.

Although we are still digesting these rather lengthy tax treaty provisions, our initial thinking is that there should not be a major impact for real estate funds in Europe. If you would like to receive more information or discuss the impact, please feel free to get in touch with your usual A&M adviser, Roel de Vries or Nick Crama.