Accessing Income Tax Treaties Through Competent Authority – A Ray of Hope When All Else Fails

1. ABA Section of Taxation 2006 May Meeting Committee on U.S. Activities of Foreign Taxpayers and Treaties Washington, D.C. May 5, 2006 Accessing Income Tax Treaties Through Competent Authority – A Ray of Hope When All Else Fails Barbara Angus Peter Daub Michael Miller Steve Nauheim

2. Agenda • Introduction • Limitations on Benefits Articles: Overview and Technical Issues • Zero Withholding on Dividends: “Super LOB” Requirements • Discretionary Grant of Treaty Benefits • Trends Regarding LOB Provisions

3. Limitations on Benefits Articles: Overview and Technical Issues Peter Daub Baker & McKenzie LLP Washington, D.C.

4. Limitations on Benefits Articles: Overview and Technical Issues Must be a resident!!

5. Publicly-Traded Corporations and Their Subsidiaries • Underlying concept is that if a corporation is publicly-traded in a jurisdiction, then likely to be owned by persons in that jurisdiction • But what about base erosion?

6. Publicly-Traded Corporations and Their Subsidiaries • The principal class of claimant’s shares is listed on a recognized stock exchange and is regularly traded on one or more recognized stock exchanges, or • Shares representing at least 50 percent of the aggregate voting power and value of the company are owned directly or indirectly by five or fewer companies entitled to benefits under first bullet

7. Publicly-Traded Corporations and Their Subsidiaries • “Recognized stock exchange” generally includes, in the case of a treaty with an EU country, principal stock exchanges in EU countries, but many treaties require listing in US or treaty partner • “Regularly trading” generally broader • Barbados treaty – both in Barbados • Investments by open-end funds that own relatively small percentage interest • Sometimes even more concentrated (than five) ownership required – why? • Residence/qualified residence of intermediate entities

8. Ownership/Base Erosion • 50 percent or more of the aggregate voting power and value owned directly or indirectly by persons who are themselves qualified persons on the basis of residence only (e.g., individuals, governments) and • less than 50 percent of the person’s gross income for that taxable or chargeable period is paid or accrued to persons who are not residents of either Contracting State in the form of payments that are deductible for the purposes residence country tax

9. Ownership/Base Erosion • Most of the issues on base erosion • Almost all US treaties calculate gross income based on source country principles, deductions based on residence country principles • Swedish protocol: both gross income and deductions under residence country principles • How does this work in practice? What if residence country audits return after withholdable amount paid, so base erosion test not met under local law? • Calculated on a single company or affiliated group basis?

10. Derivative Benefits • Entitles the resident of a Contracting State to treaty benefits if the owner of the resident would have been entitled to the same benefit had the income in question flowed directly to that owner • Ownership and base erosion tests • Base erosion test similar to stock ownership/base erosion • Seven or fewer “equivalent beneficiaries” must own shares representing at least 95 percent of the aggregate voting power and value of the company • Employee- and family-owned companies

11. Derivative Benefits • Equivalent beneficiary must be an EC or NAFTA resident • Resident of treaty country with LOB article or, if treaty had an LOB article, would qualify as an individual, government, publicly-traded entity • Dividends, interest, royalties: compare (1) rate under the treaty and (2) the rate of withholding tax that the source State would have imposed if the third State resident received the income directly from the source State.

12. Derivative Benefits • E.g., French publicly-traded company owns UK sub, which derives dividends from US sub • UK sub entitled to zero on dividends, French company would have been entitled to 5 percent, so no derivative benefits. • Does UK company get a 5 percent rate?

13. Derivative Benefits • Some treaties only require that rate that third-country shareholders would have secured if they directly received dividends greater than rate they would have secured if they were residents of the treaty claimant. • E.g., Luxembourg company owned by UK individuals receives US dividends. Since UK individuals would have been entitled to 15 percent rate under UK treaty if they received dividends directly and would have been entitled to 15 percent under the Luxembourg treaty if they were Luxembourg residents, Luxembourg company qualifies for five percent rate udner Luxembourg treaty.

14. Derivative Benefits • If Luxembourg treaty had UK comparison test, no benefits since Luxembourg rate of 5 percent less than UK individuals’ rate of 15 percent. • No reason for this difference

15. Active Trade or Business Test • A resident of a treaty partner engaged in the active conduct of a trade or business in the partner may obtain the benefits of the treaty with respect to an item of income, profit, or gain derived in the source state, provided that the item of income, profit, or gain, is derived in connection with or incidental to that trade or business. • Item by item, not all or nothing • Investing doesn’t qualify, but group finance?

16. Active Trade or Business Test • Focus on “derived in connection with” test • Technical explanations, and sometimes treaties, provide that income satisfies this test if the source country activity to which the income is allocable “forms part of” the residence country trade or business. • When is income allocable? • Is interest paid by source country sub “allocable” to the business of the sub?

17. Active Trade or Business Test • Source country activity can “form part of” residence country trade or businss if parallel, upstream, or downstream • What if source country activity doesn’t rise to the level of a trade or business? • E.g., four percent gross basis tax

18. Active Trade or Business Test • “Forms part of test” applies activity by activity, or trade/business by trade/business • How to divide up – NAICS codes? • Attribution of trade or business • Treaties provide for residence country attribution • Does attribution mean that source country income derived “in connection with” that attributed trade or business? • Nothing on source country attribution

19. Active Trade or Business Test • Residence country trade or business must be substantial in relation to source country activity • Again, test done on trade/business by trade/business basis • Safe harbor – 7.5 percent of each of residence/source property, payroll, sales – 10 percent average • UK treaty doesn’t have safe harbor

20. Zero Withholding on Dividends: “Super LOB” RequirementsMichael MillerRoberts & Holland LLPNew York City, New York

21. U.S.-U.K. Income Tax Treaty:“Super LOB” Requirements for Zero Withholding • Resident has owned 80% or greater voting interest for 12-month period ending on dividend declaration date, and one of the following: • Owned such 80% voting interest, directly or indirectly, prior to October 1, 1998 (“grandfather” rule) • Satisfies any of the following objective tests of the LOB article: • Publicly traded company • Subsidiary of publicly traded company • Derivative benefits • Discretionary grant by competent authority; or • Resident is a pension scheme & dividends not derived from carrying on a business, directly or indirectly.

22. Timing Issue: When Must 80% be Owned? Declaration Date Payment Date UK UK Dividend 75% 85% US US • Intervening Ownership Change • Redemption Treated as a Dividend • See TAM 200048011

23. Applying the 12-Month Requirement: Tack HP of Predecessor in Merger? 4/30/06 5/1/05 5/1/06 UK 2 (Successor) UK 2 UK 1 UK 2 UK 1 Dividend Merge US 2 US 1 US 2 US 2 US 1 US 1 US 1 Dividend Qualifies? Merge US 1 into US 2?

24. Applying the 12-Month Requirement: Tack Transferor’s HP in §351 or B Reorganization? 1/1/05 - 5/1/06 5/1/06 UK 1 UK 1 100% UK HC US 100% 100% Dividend Paid 5/2/06 US Check the Box for UK HC?

25. Applying the 12-Month Requirement: Residency Throughout Required? 5/1/06 3/1/06 12/31/04 FR/UK FR FR/UK Dividend US US US

26. Applying the “Grandfather” Rule: Disregard Intervening Change in Ownership? 5/1/06 9/30/98 12/1/01 UK UK UK Dividend Dividend BV US US US

27. Treatment of Deemed Dividends Under §304 USP US1 UK UK sells US2 to US1 for cash. Deemed dividends by US1 and US2 to UK under §304(a)(1). Deemed Dividend US2 US2 Deemed Dividend Can UK satisfy 80% ownership and other requirements for ZWD? • Rev. Rul. 92-85 allows attribution for purposes of allowing 10% withholding rate. • Rev. Rul. 92-86 allows attribution for §902 (indirect FTC) purposes.

28. Discretionary Grant of Treaty Benefits Steve Nauheim PricewaterhouseCoopers LLP Washington, D.C.

29. Discretionary Grant of Treaty Benefits – Article 26(7) • Article 26(7) of the US/Netherlands Income Tax Treaty (and its equivalents in most US tax treaties with LOB articles) allows a taxpayer not otherwise meeting the LOB criteria to request a discretionary grant of treaty benefits: • A person resident of one of the States, who is not entitled to some or all of the benefits of this Convent ion because of the foregoing paragraphs, may, nevertheless, be granted benefits of this Convention if the competent authority of the State in which the income in question arises so determines.

30. Article 26(7) – Standards to be Applied • In making such determination, the competent authority shall take into account as its guidelines whether the establishment, acquisition or maintenance of such person or the conduct of its operations has or had as one of its principal purposes the obtaining of benefits under this Convention. The competent authority of the State in which the income arises will consult with the competent authority of the other State before denying benefits of the Convention under this paragraph.

31. The "Safety-Valve" • Article 26(7) is described by the Joint Committee on Taxation as: "A 'safety-valve' for a person that has not established that it meets one of the objective tests, but for which the allowance of treaty benefits would not give rise to abuse or otherwise be contrary to the purposes of the treaty.“ • Paragraph XXIV of the Memorandum of Understanding accompanying the signing of the 2004 Protocol (MOU) provides: (b) The competent authorities agree to use reasonable efforts to make a determination pursuant to paragraph 7 within six months of receiving from the taxpayer all necessary information. Further, the competent authorities of both States will meet semi-annually to discuss the status of all cases in which a determination has been requested.

32. Discretionary Access to Zero Withholding on Dividends • Article 10(3) of the Treaty extends the right of taxpayers to seek discretionary grant of treaty benefits specifically to the zero withholding on dividends article: Notwithstanding the provisions of paragraph 2, dividends shall not be taxed in the State of which the company paying the dividends is a resident if the person who is the beneficial owner of the dividends is a company that is a resident of the other State that has owned directly shares representing 80 percent or more of the voting power in the company paying the dividends for a 12- month period ending on the date the dividend is declared and ... (d) has received a determination pursuant to paragraph 7 of Article 26 with respect to this paragraph.

33. Standards to be Applied by the US Competent Authority • The Treasury Technical Explanation (TE) provides the following general guidelines; • In making determinations under paragraph 7, that competent authority will take into account as its guideline whether the establishment, acquisition, or maintenance of the person seeking benefits under the Convention, or the conduct of such person's operations, has or had as one of its principal purposes the obtaining of benefits under the Convention. Thus, persons that establish operations in one of the States with a principal purpose of obtaining the benefits of the Convention ordinarily will not be granted relief under paragraph 7.

34. Standards to be Applied by the US Competent Authority – Restricted Grant • The competent authority may determine to grant all benefits of the Convention, or it may determine to grant only certain benefits. For instance, it may determine to grant benefits only with respect to a particular item of income in a manner similar to paragraph 3. Further, the competent authority may set time limits on the duration of any relief granted.

35. Standards to be Applied by the US Competent Authority • General Guidelines (con’t) • [I]t is also expected that if the competent authority determines that benefits are to be allowed, they will be allowed retroactively to the time of entry into force of the relevant treaty provision or the establishment of the structure in question, whichever is later.

36. Factors List • Paragraph XXVIII of the MOU lists the primary factors that the Competent Authority should consider: • (1) The date of incorporation of the corporation in relation to the date that this Convention entered into force; • (2) The continuity of the historical business and ownership of the corporation; • (3) The business reasons for the corporation residing in its State of residence; • (4) The extent to which the corporation is claiming special tax benefits in its country of residence; • (5) The extent to which the corporation's business activity in the other State is dependent on the capital, assets, or personnel of the corporation in its State of residence; and • (6) The extent to which the corporation would be entitled to treaty benefits comparable to those afforded by this Convention if it had been incorporated in the country of residence of the majority of its shareholders.

37. E.U. Considerations • E.U. Considerations -- The MOU mandates that the U.S. Competent Authority take into account EC legal requirements for the free flow of capita. The TE explains: • The competent authorities will consider the obligations of the Netherlands by virtue of its membership in the European Communities in making a determination under paragraph 7. In particular, the competent authorities will consider any legal requirements for the facilitation of the free movement of capital and persons, together with the differing internal tax systems, tax incentive regimes and existing tax treaty policies among Member States of the European Communities. As a result, where certain changes in circumstances otherwise might cause a person to cease to be a qualified person under paragraphs 2 and 3 of Article 26, such changes need not result in the denial of benefits.

38. E.U. Considerations • TE Explanation (con’t) • The changes in circumstances contemplated include, all under ordinary business conditions, a change in the State of residence of a major shareholder of a company; the sale of part of the stock of a Netherlands company to a resident in another Member State of the European Communities; or an expansion of a company's activities in other Member States of the European Communities. So long as the relevant competent authority is satisfied that those changed circumstances are not attributable to tax avoidance motives, they will count as a factor favoring the granting of benefits under paragraph 7, if consistent with existing treaty policies, such as the need for effective exchange of information.

39. E.U. Considerations • Application of the E.U. Considerations to the discretionary grant of the benefit of zero withholding on dividends. The TE has an example of the E.U. considerations in the context of the zero withholding on dividends. • Example: Dutch company (DuCo) is owned by an equivalent beneficiary (e.g., a UK Co.) and DuCo is receiving dividends from its US subsidiary. The owner of DuCo sells it to a buyer (FWCo) that is resident in the E.U. but in a country whose treaty with the US does not include a zero withholding on dividends provision. • Positive factors for discretionary grant: • FWCo resident in an E.U. jurisdiction • US business a small portion of the total acquired operations

40. E.U. Considerations • Negative factors • FWCo benefited from a tax incentive regime that eliminated any domestic taxation • Indicators that the acquisition was undertaken to acquire the Netherlands- U.S. "bridge." • Substantially all of the business activities acquired consisted of the U.S. business • Existing U.S. operations were restructured in an attempt to benefit from the elimination of withholding tax on dividends • FWCo was owned by residents of a country that is not an EU member • The TE includes as another significant negative factor "if the U.S. competent authority faced difficulties in learning the identity of FWCo's owners, such as an uncooperative taxpayer or legal barriers such as "economic espionage" or other limitations on the effective exchange of information in the country of which FWCo is a resident."

41. Post-Acquisition Transitional Relief • Post-Acquisition Reorganization -- The MOU facilitates the granting of treaty benefits for a reasonable transition period where (i) an acquired group fails the subsidiary of a publicly-traded company test (26(c)(ii)) because the acquired parent is resident in a 3d country and (ii) there is a plan of reorganization to bring the acquired Dutch (or US) subsidiary within the scope of Article 26.

42. Post-September 30, 1998 Structures • Post-September 30, 1998 companies -- Paragraph VIII of the MOU provides with regard to discretionary grant of zero withholding on dividends (and exemption from the Branch Profits Tax): • It is understood that a resident that would qualify for benefits under subparagraph 3 a) of Article 10 (Dividends) or Article 11 (Branch Tax), but does not do so because it acquired the relevant shareholdings on or after October 1st , 1998, is not prevented from requesting a determination from the competent authority pursuant to subparagraph 3 d) of that Article, so long as it also does not meet the requirements of 3 b) and 3 c).

43. Process • The Process for Obtaining a Discretionary Grant of Treaty Benefits Under a Limitation on Benefits Article 1. A Request for Determination is submitted to the Tax Treaty Group within the Office of Competent Authority at the IRS ("TTG") 2. TTG drafts a recommended response, which is sent to the IRS Office of Associate Chief Counsel (International) (Branch 1) for its advice 3. Branch 1 may, at its discretion, informally confer with the Treasury Department's Office of International Tax Counsel if the request raises matters of policy 4. If, as a result of the above process, a negative response is expected, the taxpayer will be given the opportunity for a conference

44. Trends Regarding LOB ProvisionsBarbara AngusAngus & NickersonWashington, D.C.

45. Evolution of LOB Provisions • Recent treaties have included significant modifications in LOB articles • Publicly-traded company test has been refocused and tightened • Response to corporate inversion transactions • Also more general concern about ensuring appropriate nexus with the treaty country • New test can be less objective than simpler test of earlier treaties

46. 2004 U.S.-Barbados Protocol – Publicly-Traded Company Test • Company’s principal class of stock must be listed on a recognized exchange in its country of residence; and • Such stock must be primarily traded on a recognized exchange in company’s country of residence or, in the case of a Barbados company, such stock must be primarily traded on one of the Barbados, Jamaica or Trinidad exchanges; and • Such stock must be regularly traded on one or more recognized exchanges

47. 2004 U.S.-Barbados Protocol – Sub of Publicly-Traded Company Test • In order to qualify under the subsidiary of publicly-traded company test, • at least 50% of company’s principal class of stock must be owned directly or indirectly by companies that meet the publicly-traded test, and • the company must satisfy the base erosion test • In order to be taken into account for this purpose, all indirect owners must satisfy this test

48. 2004 U.S.-Barbados Protocol – Ownership/Base Erosion Test • Barbados protocol tightens the ownership prong of the ownership/base erosion test by requiring that the company be owned by residents of the company’s country of residence • Barbados protocol also tightens the base erosion prong by testing payments that are made to anyone other than a resident of the company’s country of residence

49. 2004 U.S.-Netherlands Protocol –Publicly-Traded Company Test • Principal class of stock must be listed on a recognized exchange in the United States or the Netherlands, and • Such stock must be regularly traded on one or more exchanges, and • Company must not have no substantial presence in its country of residence, determined based on a trading test and a management test

50. 2004 U.S.-Netherlands Protocol – “No Substantial Presence” • Company will have no substantial presence in its country of residence if it fails both the trading test and the management test • A Dutch company fails the trading test if any of the following are true: • The company’s aggregate trading volume on recognized exchanges in the U.S. is greater than aggregate trading volume on recognized exchanges in the Netherlands’ primary economic zone (which is EU and EEA countries) or • The company is not traded on any recognized stock exchange in the Netherlands’ primary economic zone or • The company’s trading on recognized stock exchanges in the Netherlands’ primary economic zone is less than 10% of its total worldwide trading