Limitation of Benefits Provisions in Tax Treaties ABA Tax Section Meeting October 17, 2002

1. Limitation of Benefits Provisions in Tax TreatiesABA Tax Section Meeting October 17, 2002 Mark Doets – Loyens & Loeff Rick Reinhold – Willkie Farr & Gallagher Phil West – Steptoe & Johnson

2. Overview • Introduction • Context • Evolution of “LOB” • Description of currently applicable rules • Practical examples • Conclusion

3. Introduction • An evaluation of LOB • Other treaty provisions that limit treaty benefits • Purpose clause • Subject-to-tax • Transparent entities • Dual residents • Special tax regimes • Beneficial ownership • Anti-conduct rules • Anti-dividend stripping provisions • Repos • Methods of elimination of double taxation • Regulations / treaty forms

4. Introduction Secondary sources to consult: • OECD Model Income Tax Commentaries • OECD Revision to Model Income Tax Commentaries • Klaus Vogel on Double Taxation Conventions • Improper use of Tax Treaties (S. van Weeghel) • Article 26-Limitation on Benefits in the new US-NL Tax Treaty (Loyens § Volkmaars)

5. Context • What is it that countries expect to get out of treaties? • Treaty anti-abuse provisions vs domestic anti-abuse provisions • Purpose of limitation on benefits provisions.

6. Evolution in Treaty Policy • Case law

7. AIKEN INDUSTRIES V. COMMISSIONER ECL Bahamas MPI Note MPI Note 9 Notes AIKEN U.S. CCN Ecuador $ MPI U.S. INDUSTRIES Honduras Facts: • MPI borrowed money from ECL in return for a 4% interest rate note • ECL assigned the MPI note to industries for 9 smaller 4% interest rate notes • Industries did not make a profit on the acquisition of the MPI note – it was committed to pay out exactly what it collected

8. Aiken Industries v. Commissioner • Applicable Tax Treaty – No withholding on interest payments between U.S. and Honduras • Issue – should Industries be ignored? • Holding – U.S./Honduras Treaty did not apply to exempt interest paid by MPI since Industries was a “collection agent”, a mere “conduit for the passage of interest payments from MPI to ECL”

9. Del Commercial Properties v. Commissioner DL Shekels Holdings Canada Loan Guarantee Canadian Bank Indirect Sub Delcom Financial Canada $18 million Del Commercial Properties Inc. “DCPI” U.S. $14 million Loan Delcom Holdings Canada Delcom Cayman Cayman Islands $14 million loan $14 million Contribution Delcom Antilles Netherlands Antilles Del BV Netherlands

10. Del Commercial Properties v. Commissioner Facts: • Delcom Financial borrowed $18 million from a Canadian Bank $14 million of which was contributed down the chain to Del BV • Del BV Lent $14 million to DCPI • DCPI guaranteed the loan from the Canadian Bank

11. Del Commercial Properties v. Commissioner • Applicable Tax Treaty – No withholding on interest payments made by a U.S. corporation to a Dutch corporation • Issue – Should the transaction be treated as a loan from Delcom Financial to DCPI? • Holding – U.S. Netherlands treaty did not apply since the payments from DCPI to Del BV were in substance payments to Delcom Financial. Del BV did not serve any role with a “sufficient business or economic purpose to overcome the conduit nature of the transaction”

12. Northern Indiana Public Service Company v. Commissioner • Finance issued notes in the Eurobond market and lent the proceeds to NIPSCO at a small profit. NIPSCO guaranteed the Euronotes NIPSCO U.S. Debt Obligations $ Notes Finance Netherlands Antilles Eurobond Market $ Facts:

13. Northern Indian Public Service Company v. Commisioner • Applicable Tax Treaty – No withholding on interest payments by a U.S. corporation to a Netherlands Antilles corporation • Issue – should the interest on the Eurobonds be treated as paid directly by NIPSCO U.S.? • Holding – Since Finance conducted recognizable business activity and derived a profit, the form of the transaction was respected

14. Bass v. Commissioner • Taxpayer formed Stantus A.G. • Stantus A.G. purchased a % interest in oil and gas leases from Taxpayer • Stantus A.G. received substantial income from its share of the oil and gas produced Taxpayer % interest in oil and gas leases Stantus A.G. Switzerland $ % interest in oil and gas leases Facts:

15. Bass v. Commissioner • Applicable Tax Treaty – Stantus A.G. was not subject to U.S. federal income taxation on its income • Issue – Should Stantus A.G. be disregarded and its income constitute income of the Taxpayer? • Holding – Stantus A.G. carried on sufficient business activity to require its recognition as a separate entity. It was “managed as a viable concern and not as simply a lifeless facade”

16. Evolution in treaty policy • Subjective standard • Cyprus • Modern version • Dutch treaty • U.S. model treaty • Variations • Rejected variations (Italy, Slovenia) • New variation (U.K.) • Future? • Codification of LOB?

17. U.K. Limitation on benefits • To obtain treaty benefits, taxpayer must • Satisfy all requirements specific to the particular benefit involved, • Be a “treaty resident” and • Meet at least one of the LOB tests

18. U.K. Limitation on benefits • Two routes to qualification under LOB (Article 23) • Qualification of the taxpayer generally • Qualification with respect to a particular item of income • Qualification of the taxpayer generally (companies) • Public trading test, or • Ownership/base erosion test • Qualification w/r/t a particular item of income (companies) • Derivative benefits test • Active trade or business test, or • Discretionary determination from the Competent Authority

19. U.K. Limitation on benefits: public trading test • Test can be met by • Publicly traded companies or • Their subsidiaries • Publicly traded companies • The “principal class of shares” is • Listed on a US or UK “recognized stock exchange” and • Regularly traded on a “recognized stock exchange” • Subsidiaries of publicly traded companies • At least 50% of vote and value is owned • By five or fewer publicly traded companies (as defined above) • Ownership may be indirect, as long as intermediate owners are residents of either US or UK

20. U.K. Limitation on benefits: ownership/base erosion test • “Ownership” portion of test: • On at least half the days of the taxable period • At least 50% of the tested party is owned by • Persons meeting one of several LOB tests • Test for public trading (but not subsidiary public trading) or • Certain other tests: • (pension funds, tax exempts, qualified governmental entities or individuals) • Ownership can be direct or indirect, but both vote and value are tested • “Base erosion” portion of test: • Less than 50% of the person’s gross income for the taxable period • Is paid or accrued, directly or indirectly, to nonresidents of US or UK • And is deductible in the tested party’s jurisdiction • Certain arm’s length payments are excluded

21. U.K. Limitation on benefits: derivative benefits test • Ownership portion of test: • > 95% of company is owned by < 7 “equivalent beneficiaries” • Both vote and value are tested • Ownership can be direct or indirect • Base erosion portion of test: • Less than 50% of the person’s gross income for the taxable period • Is paid or accrued, directly or indirectly, to persons who are not “EBs” • And is deductible in the tested party’s jurisdiction • Certain arm’s length payments are excluded

22. U.K. Limitation on benefits: derivative benefits test, definition of equivalent beneficiary • To be an “equivalent beneficiary” • A person must be a resident of • A member state of EC • An EEA state (EU plus Iceland, Liechtenstein, Norway), or • A party to NAFTA • The person also • Must be a company, resident in EC, entitled under an EC Directive to receive free of w/h tax “the particular class” of income for which treaty benefits are claimed or • Would be • Entitled to all benefits of a full double tax treaty between any member of EC or EEA and the country from which benefits are claimed • (but if that treaty does not have full LOB article, the person would have qualified, if they were a “resident” of the U.S. or U.K., under the new treaty’s LOB tests for public trading, ownership/base erosion, or certain others) and • W/R/T dividends, interest or royalties, entitled under that treaty to at least as favorable a w/h tax rate as under the new US/UK treaty

23. A resident of one of the states can qualify with respect to an item of income if the resident is engaged in the active conduct of a trade or business in that state and the income from the other state is either “derived in connection with” or “incidental to” that trade or business Exception for the business of making or managing investments for the resident’s own account, unless the activities are certain activities of a bank, insurance company or reg’d securities dealer The general rule for active trades or businesses will not provide benefits with respect to an item: derived from a trade or business that a resident of the U.S. or U.K. (the “residence” state), or an associated enterprise, carries on in the other state (the “source” state), unless the trade or business in the residence state is substantial in relation to the trade or business activity in the source state. U.K. Limitation on benefits: active trade or business test

24. U.K. Limitation on benefits: discretionary determination • “A resident of a Contracting State that [does not qualify under any other LOB paragraph] shall, nevertheless, be granted benefits of this Convention with respect to [an item of income, profit or gain] if the Competent Authority of the other Contracting State determines that the establishment, acquisition or maintenance of such resident and the conduct of its operations did not have as one of its principal purposes the obtaining of benefits under this convention.”

25. Related rules • U.K. treaty conduit test • U.S. conduit regulations • I.R.C. § 7701(l) • Treas. Reg. § 1.881-3 • U.K. treaty hybrid entity rule • U.S. hybrid entity regulations • I.R.C. § 894(c) • Treas. Reg. § 1.894-1

26. Effect of UK treaty conduit arrangement rule • If income is part of a conduit arrangement, it will not qualify for • Treaty rate reduction on dividend withholding tax • Treaty rate reduction on interest withholding tax • Treaty rate reduction on royalty withholding tax • Treaty-based exemption from US insurance excise tax • Treaty-based exemption from source state taxation of “other income”

27. U.K. treaty conduit test • Income is part of a conduit arrangement if it is paid under, or as part of, a transaction or series of transactions that • Has as one of its main purposes obtaining such increased benefits as are available under the treaty and • Is structured so that • a treaty beneficiary receives income from the other jurisdiction, • but pays, directly or indirectly, • allorsubstantiallyall of that income, • at anytime or in anyform, • to a person who is not a beneficiary of the treaty and who would not be entitled to equivalent or better benefits under a treaty between that person’s jurisdiction and the jurisdiction in which the income arises

28. U.S. conduit regulations • IRS may disregard the participation of a “conduit entity” in a “financing arrangement” and recharacterize it as a transaction directly between the remaining parties for purposes of I.R.C. § 881 • “Financing arrangement” is broadly defined as: • Any series of transactions • By which the financing entity advances money/property (or grants the right to use property) • And the financed entity receives money/property (or grants the right to use property) • Through an intermediary • Where “financing transactions” link the entities • An intermediary is a conduit and will be disregarded if: • Intermediary’s participation reduces tax under I.R.C. § 881; • Intermediary participates pursuant to a “tax avoidance plan”; and • Either: • Intermediary is related to financing or financed entity; or • If not related, intermediary would not have participated in arrangement on these terms but for the fact that financing entity advanced money/property to intermediary • Note: The regulations contain tighteners as well as relief provisions/exceptions

29. U.S. conduit regulations, cont’d • Income tax treaty benefits forfeited • The arrangement is disregarded for purposes of applying a tax treaty • The intermediary may not claim benefits of tax treaty between its country of residence and the United States to reduce its tax • Financing entity may still claim benefits of any tax treaty to which it is a party • Other effects • Intermediary disregarded for purposes of I.R.C. § 881 • The financing arrangement is deemed a transaction directly between remaining parties • Income recharacterized • The payment by the financed entity will be characterized by reference to the character of the payment made to the financing entity (by the intermediary) • Exception: Income is not recharacterized if the payment to the financing entity would not be deductible if actually paid by the financed entity directly to the financing entity

30. U.K. treaty hybrid entity rule • “An item of income, profit or gain derived through a person that is fiscally transparent under the laws of either Contracting State shall be considered to be derived by a resident of a Contracting State to the extent that the item is treated for the purpose of the taxation law of such Contracting State as the income, profit or gain of a resident.” UK Treaty Article 1(8).

31. U.S. hybrid entity regulations • General rule: Reduced treaty withholding rate for U.S. source income is available only if income is “derived by” a foreign recipient “resident” in the applicable treaty jurisdiction. Treas. Reg. § 1.894-3(d) • There are three situations in which the income is deemed to be derived by a resident of a treaty jurisdiction and eligible for treaty benefits: • The entity is not fiscally transparent under the laws of the entity’s jurisdiction; • Regardless of whether the entity is fiscally transparent under the laws of the entity’s jurisdiction, the interest holder establishes that the interest holder is not fiscally transparent under the law of the interest holder’s residence; • The treaty partners have an agreement with respect to the treatment that is specified in the treaty • Similar to the treaty standard, but are there differences in practice?

32. LOB example • Does not meet LOB • Assumes failure under active trade or business test • Result: 30% withholding Saudi Arabia UK Dividend US

33. LOB example: rate comparison under derivative benefits test • Does not meet LOB • Assumes failure under • active trade or business test • Public trading test and • Headquarters company test • The “derivative benefits” provision does not help because the withholding rate on royalties under the U.S.-Japan treaty is 10% • Result: 30% withholding, not 10% Japan UK Royalty US

34. LOB example: no derivative benefits provision • Does not meet LOB • Assumes failure under active trade or business test • A number of important treaties do not have “derivative benefits” provisions • Result: 30% withholding • Note, however, that in this case, a discretionary determination may be available UK Germany Dividend US

35. LOB example: does a U.S. owner qualify under derivative benefits? • Most treaties’ derivative benefits provisions require a comparison with the rate that applies under the treaty between the state whose benefits are at issue (US) and the state of the owner of the putative treaty beneficiary (US, for the 60% owner), but the U.S. does not have a treaty with itself US Germany 60% 40% UK Dividend US

36. LOB example: public trading in derivative benefits context • Under the new U.K. treaty, the derivative benefits test requires that France “would be a qualified person [under the U.S.-U.K. LOB tests for public trading or ownership/base erosion] if such person were a resident of one of the Contracting States. . . .” • The public trading test of the U.S.-U.K. treaty requires that the resident’s shares be listed in the U.S. or U.K. • See PLR 199912028 Public France US Dividend UK

37. Conduit and limitation on benefits: examples • Meets LOB • Use derivative benefits paragraph • Assumes qualification under base erosion portion of test • Assumes 5% rate under U.S.-Italy treaty and under U.S.-U.K. treaty • Test Italy, not Cayman, for “equivalent beneficiary” status (“indirect” owners can qualify) • Italy qualifies under Art. 23(7)(d)(i) • Does Italy qualify under Art. 23(7)(d)(ii)? • Does not meet conduit test • Test Cayman for equivalent benefits under Art. 3(1)(n)(i) • Assumes violation of both main purpose test and “substantially all” requirement Italy Cayman Dividend UK Dividend US

38. Conduit and limitation on benefits: examples • Meets LOB • Same analysis as previous slide • Does not meet conduit test • Test Netherlands for equivalent benefits under Art. 3(1)(n)(i) • U.S.-Netherlands treaty has no derivative benefits provision, so structure would not satisfy LOB under that treaty • Assumes violation of both main purpose test and “substantially all” requirement • Note problem even though payment by UK is not deductible Italy Netherlands Dividend UK Dividend US

39. Conduit and limitation on benefits: examples • Meets LOB • Same analysis as previous slide • Does meet conduit test • Test Luxembourg for equivalent benefits under Art. 3(1)(n)(i) • U.S.-Lux treaty has derivative benefits provision, so structure would satisfy LOB under that treaty • Same result even if main purpose test violated and and substantially all income paid to Luxembourg Italy Luxembourg Dividend UK Dividend US

40. Conduit and limitation on benefits: examples • Conduit? • No under U.S. conduit regs -- the dividend breaks the multi-party financing arrangement • Yes, under the treaty (see analysis of Dutch structure above) Italy Interest Netherlands Dividend UK Interest US

41. Derivative benefits special cases: “looking-up-the-chain” problem • In applying the derivative benefits test to Co 1, when do we stop looking up the chain to determine whether Co 1 is an equivalent beneficiary? • Can we stop at the first owner that is an equivalent beneficiary? • Do we have to stop at the first owner that fails to be an equivalent beneficiary? Public SHs / Private Shs Co 3 Brazil Co 2 UK Co 1 UK Income US

42. Derivative benefits special cases: “looking-up-the-chain” problem, cont’d Public SHs / Private Shs • Does the answer depend on whether the treaty derivative benefits provision states that the payee must be “directly or indirectly,” as opposed to “ultimately,” owned by equivalent beneficiaries (or qualified persons)? • See PLR 200202025 (favorable result when analyzing treaty using “ultimate” owner language) • Compare U.K. treaty Article 23(2)(c)(ii) and French treaty Article 30(6)(a), providing that, for purposes of the public trading test, “directly or indirectly” requires intermediate owners to be “residents” of either Contracting State (or the EU, in the case of the French treaty). See PLR 200046034. Co 3 Brazil Co 2 UK Co 1 UK Income US

43. Derivative benefits special cases: “looking-up-the-chain” problem, cont’d Public SHs / Private Shs • Does the answer depend on the particular LOB test being availed of by the owner of Corp 1 that we are testing for EB status? • Which tests should allow or require us to stop? • Public trading? • Active trade or business? • Which tests should allow or require us to continue looking up the chain? • Ownership/base erosion? • Derivative benefits? Co 3 Brazil Co 2 UK Co 1 UK Income US

44. Derivative benefits special cases: “looking-up-the-chain” problem, cont’d Result? Public 10 individuals Canada Canada UK Income US

45. Derivative benefits special cases: US -Switzerland • Derivative benefits under paragraph 7 of the revised Memorandum of Understanding: “ultimate beneficial ownership” means that any intermediate owners of the company be disregarded and that ownership be traced to a person that is a qualified resident without reference to its owners (See PLR 200202025). • Limited derivative benefits under Article 22(3)(a): “ultimate beneficial ownership” requires direct ownership (See Technical Explanation)

46. Conclusion • Policy issues • Technical issues • Domestic rules • Derivative benefits, discretionary relief • Most favored nation clauses, EU-US treaty?