Tax Treaties, Hybrid Entities and
Tax Planning
International Fiscal Association
New York Region International Tax Seminar
November 17, 2005
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• Moderator
– Peter J. Connors (Orrick, Herrington & Sutcliffe LLP, New York)
• Panelists
–
–
–
–
Rocco V. Femia (Miller & Chevalier Chartered, Washington DC)
Jonathan Hare (PricewaterhouseCoopers LLP, New York)
Klaas-Jan Visser (Stibbe, New York)
Marco Q. Rossi (Marco Q. Rossi & Associates, New York)
2
Agenda
• U.S. history and background
• Italy, Netherlands and U.K. Entity Classification
Rules
• Specific examples involving hybrids and reverse
hybrids
• U.K. Finance Legislation
3
Terminology
• Fiscally transparent entity: Entity whose income is treated
for tax purposes as income of its owners as if the owners
had earned the income directly (e.g., a partnership)
• Hybrid entity: Entity treated as fiscally transparent by one
treaty country, but not the other
• Source country: Treaty country from which the income
arises and whose (withholding or net basis) tax typically is
at issue
• Residence country: Treaty country in which the recipient
of the income with respect to which treaty benefits are
claimed resides
4
General Principles
• In general, the source country should allow treaty
benefits for income earned through a hybrid entity
to the extent the income is subject to tax by the
residence country as the income of a resident
• In general, the source country will not allow treaty
benefits for income earned through a hybrid entity
– To the extent the income is NOT subject to tax by the
residence country as the income of a residence; or
– If the hybrid entity is treated as a non-fiscally
transparent entity, and taxed as a resident, by the source
country (savings clause)
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General Principles - Example
R Parent
R Sub
P/S
Debt
• Interest from S Sub
to P/S is entitled to
treaty benefits if
subject to tax by R
country as the
income of R Parent
• Treatment of P/S by
S country and
country of
organization
irrelevant
S Sub
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General Principles
• These general principles are articulated in:
–
–
–
–
The 1996 U.S. Model Income Tax Treaty
The Commentaries to the OECD Model Treaty
Regulations under I.R.C. sec. 894
Recent U.S. income tax treaties
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1996 U.S. Model Tax Treaty
• “An item of income, profit or gain derived through an
entity that is fiscally transparent under the laws of either
Contracting State shall be considered to be derived by a
resident of a State to the extent that the item is treated for
purposes of the taxation law of such Contracting State as
the income, profit or gain of a resident.” (Art. 4(1)(d)).
• “[T]he terms ‘enterprise of a Contracting State’ and
‘enterprise of the other Contracting State’ . . . also include
an enterprise carried on by a resident of a Contracting State
through an entity that is treated as fiscally transparent in
that Contracting State. . .” (Art. 3(1)(c)).
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1996 U.S. Model Tax Treaty
Technical Explanation
• Provides explanatory guidance with respect
to a number of issues, including
– U.S. entities that are treated as fiscally
transparent
– Application of “subject to tax” test in cases
where income is not actually taxed by the
residence country
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Sec. 894 Regulations
• Generally apply general principles to all
treaties to which the U.S. is a party
• Provides rules concerning payments
received by, and made by, domestic reverse
hybrid entities
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Commentaries to
OECD Model Tax Treaty
• “[P]artners should be entitled, with respect to their share of the
income of the partnership, to . . . benefits . . . to the extent that
the partnership's income is allocated to them for the purposes of
taxation in their State of residence.” Paragraph 5 of
Commentary to Article 1.
• “Where a State considers that . . . the partners are liable to tax in
their State of residence on their share of the partnership's
income, it is expected that that State will apply the . . .
Convention as if the partners had earned the income directly so
that the classification of the income for purposes of the
allocative rules of Articles 6 to 21 will not be modified by the
fact that the income flows-through the partnership.” Para. 6.6 of
Commentary to Article 1.
• Observations by the Netherlands, France, and Portugal.
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2001 U.S.-U.K. Treaty
• “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 purposes of the taxation laws of such
Contracting State as the income, profit or gain of a
resident.” Art. 1(8).
• Technical Explanation provides significant commentary on
the application of the provision and its interaction with the
savings clause
• Diplomatic Notes, which provide guidance regarding the
mitigation of double taxation where both countries tax the
same income as earned by a resident, has been interpreted
by some to allow the countries considerable latitude in
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denying treaty benefits with respect to hybrid entities
2001 U.S.-U.K. Treaty
•
With reference to Article 24 (Relief from Double Taxation):
it is understood that, under paragraph 4 or 8 of Article 1
(General Scope), the provisions of the Convention may permit the
Contracting State of which a person is a resident (or, in the case of
the United States, a citizen), to tax an item of income, profit or
gain derived through another person (the entity) which is fiscally
transparent under the laws of either Contracting State, and may permit
the other Contracting State to tax
(a) the same person;
(b) the entity; or
(c) a third person
with respect to that item. Under such circumstances, the tax paid or
accrued by the entity shall be treated as if it were paid or accrued
by the first-mentioned person for the purposes of determining the
relief from double taxation to be allowed by the State of which that
first-mentioned person is a resident (or, in the case of the United
States, a citizen),
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2004 U.S.-Netherlands Protocol
• Provision, and commentary in Technical Explanation,
virtually identical to 2001 U.S.-U.K. Treaty (Art. 24 (4))
• Diplomatic Notes state that the competent authority may
grant treaty benefits to a resident of the other country even
if that resident is not treated as the recipient of the income
IF the resident would not have been taxed on the income
had it been so treated (Example: exempt pension)
• July 6, 2005 Dutch decree provides that the hybrid entity
provision in the protocol will not apply to a dividend paid
to a FTE under Dutch law that is treated as a corporation
under U.S. law provided the Dutch company that pays the
dividend is engaged in “real” activities in the Netherlands.
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July 2005 Dutch Decree -- Example
US Parent
CV
Dividend
BV
• BV makes dividend
payment through CV to
US P
• CV is treated as an FTE
by Netherlands, but as a
corporation by US
• Decree allows treaty
benefits for dividends
under certain
circumstances
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2003 U.S.-Japan Treaty
• Provides most detailed rules of any U.S. treaty to date
• Provide five fact patterns and results for each (Art. 4 (6))
• Protocol provides specific rule regarding TKs, generally
allowing both countries to apply domestic law
• Technical Explanation provides additional guidance:
– Income should be eligible for treaty benefits available if
income had been earned directly by owner of FTE
– Stock held through an FTE is treated as held directly if
FTE treated as fiscally transparent by BOTH countries
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2005 Comp. Authority Agreement
under 1992 U.S.-Mexico Tax Treaty
• 1992 Protocol provides that “a partnership, estate, or trust
is a resident of a Contracting State only to the extent that
the income it derives is subject to tax in that State as the
income of a resident, either in the hands of the partnership,
estate or trust, or in the hands of its partners or
beneficiaries. . . .” Para. 2(b)
• 2005 Comp. Authority agreement provides that “it is
understood that income from sources within one of the
Contracting States received by an entity that is treated as
fiscally transparent under the laws of either Contracting
State, will be treated as income derived by a resident of the
other Contracting State to the extent that such income is
subject to tax as the income of a resident of the other
Contracting State.”
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Entity Classification Rules
• Italy
–Recent legislation
• Netherlands
- Decrees December 18, 2004
- New corporate partnership legislation: domestic qualification rules
for tax purposes will not change
• U.K.
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Italy
•
Domestic resident entities organized in a legal form that provides for limited
liability, centralized management and unlimited life (typically, joint stock company
- SPA - limited liability company - SRL - and limited partnership with stock
divided by shares - SAPA) are classified as separate entities and are subject to
corporate income tax (i.e., they are corporations in the U.S. tax sense).
•
Domestic resident entities organized in a legal form that provides for unlimited
liability, non-centralized management and limited life (e.g., general partnership SNC - limited partnership - SAS -) are treated as fiscally transparent entities not
subject to tax (i.e., they are partnerships in the U.S. tax sense).
•
Nonresident entities are treated as separate entities (i.e., like corporations in the
U.S. tax sense) in any event, regardless or their legal form, characteristic and tax
treatment under foreign law.
•
Resident corporations are taxed on their worldwide income. Nonresident entities
are subject to tax in Italy only on their Italian source income.
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U.S. LLCs – Example 1
F Parent
US LLC
• If US LLC treated as a
corp for US purposes,
no treaty benefits
(savings clause)
• If US LLC treated as a
FTE for US purposes,
treaty benefits if F
treats income as subject
to tax in the hands of F
Parent
– Contrast Section 894
Regulations and U.K.
and Japan Treaties.
Dividend
US Sub
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U.S. LLCs – Example 2
US Parent
US LLC
Dividend
• If US LLC treated as a
corp for US purposes,
treaty benefits under
general rules
• If US LLC treated as a
FTE for US purposes,
what is the result if F Sub
is UK? Dutch? Italian?
• What if F Sub is checked
for US purposes?
– Is item of income derived
by U.S. parent?
F Sub
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Reverse Hybrids – Example 1
R Parent
R Sub
UK P/S
Debt
• US Sub makes interest
payment to UK P/S that
is treated as a corporation
for US tax purposes
• Interest payment not
eligible for treaty
benefits under U.S.-UK
treaty
• Interest payment may be
eligible for treaty
benefits under U.S.-R
treaty
US Sub
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Reverse Hybrids – Example 2
US Parent
US Sub
UK P/S
Debt
• UK Sub makes
interest payment to
UK P/S that is treated
as a corporation for
US tax purposes
• Interest payment not
eligible for treaty
benefits under U.S.UK treaty
UK Sub
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Reverse Hybrids – Example 3
• Neth BV makes dividend to
Neth CV that is treated as a
corporation for Dutch tax
purposes, but a partnership in
the U.S.
• Compare to 2005 Dutch
Decree Example
US Parent
US Sub
Dividend
Neth CV
Dividend
Neth BV
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Reverse Hybrids – Example 4
• US LLC elects to be a
corporation.
UK Parent
UK Sub
• US Sub pays dividend to US
LLC which is then paid to UK
Sub.
• Dividend withholding at US
LLC level?
Interest
US LP
Dividend
US Sub
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Reverse Hybrids – Example 5
• UK Sub pays dividend to US
UK ULC which is then paid to
US sub.
US Parent
• Dividend withholding at UK
ULC level?
US Sub
Interest
– What if UK Sub/ UK ULC
Cos are Dutch or Italian
equivalents?
UK ULC
Dividend
UK Sub
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U.S. Branch Interest Tax
Interest
UKA
A
UK
UKBB
UK
US LLC
US business
• US LLC conducts a US
business
• US is a partnership for
US purposes, but a
corporation for UK tax
purposes
• Does the US branch
level interest tax apply?
If so, at what rate?
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U.S. Branch Profits Tax
UK A
UK B
UK P/S
US business
• UK P/S conducts a US
business
• UK P/S is a corporation
for US purposes
• UK A and UK B are
individuals
• Does the US branch
profits tax apply? If so,
at what rate?
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Ownership Through Hybrid Entities
Example 1
Netherlands
1
Netherlands
2
50%
>10%
P/S
25%
US Sub
50%
• US S makes a
dividend payment
• Dividends paid on
Netherlands 1 direct
stock are eligible for
direct dividend rate.
What about dividends
paid through P/S?
• What about dividends
paid through P/S to
Netherlands 2?
• Does it matter whether
P/S is a corporation for
U.S. purposes?
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Ownership Through Hybrid Entities
Example 2
UK or Dutch
Co.
100%
Hybrid
Dividend
100%
• US S makes a
dividend payment
• Are dividends eligible
for treaty benefits?
Yes.
• Are dividends eligible
for the zero rate?
– See PLR 200522006
• Does it matter whether
Hybrid is a
corporation for U.S.
purposes?
US Sub
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Ownership Through Hybrid Entities
Example 3
U.S
100%
Hybrid
Dividend
100%
Dutch or Italy
Co
• Dutch or Italy Co
makes a dividend
payment
• Are dividends eligible
for treaty benefits?
Yes.
• Are dividends eligible
for the lowest rate?
• Does it matter whether
Hybrid is a
corporation for Dutch
or Italian purposes?
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Deferred Subscription Arrangement
Step 1
NPV shares
($80)
US Parent
Shares
Nominal cash plus
commitment to pay
balance
UK
Investor
$100 value
in shares
UK Issuer
Step 2
US Parent
$100 repayment/
def. subscription
UK
Investor
UK Issuer
• Intended US result: Loan from
UK Investor to US Parent;
difference b/n $80 and $100 is
deductible interest
• Intended UK result: Sale of
stock subject to subscription
payment obligation; deferred
subscription payments are
nontaxable amounts received in
consideration for issuance of
stock
• What is impact of UK
legislation?
• Are “interest” payments entitled
to treaty benefits even though
they arguably are not “subject to
tax” in the UK?
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UK anti-arbitrage rules
• The UK anti-arbitrage rules contain provisions that can act
to disallow deductions in computing UK tax payable
(s24 F(No. 2)A 2005).
• They deny a UK deduction where four conditions are
met….
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Deduction cases: conditions
• Conditions A to D:
– Condition A is that the transaction to which the company is party
forms part of a scheme that is a ‘qualifying scheme’. A ‘qualifying
scheme’ includes one that involves a hybrid entity. The term
‘scheme’ is broadly defined.
– Condition B is that for the purposes of UK corporation tax an
amount is allowed as a deduction (or is potentially available as a
deduction) in respect of the transaction or an amount relating to the
transaction is set off (or could be set off) against profits in an
accounting period. This can be any deduction it is not limited to
interest.
– Condition C is that the main purpose, or one of the main purposes,
of the scheme is to achieve a UK tax advantage for the company.
– Condition D is that the amount of the UK tax advantage so
achieved is more than a minimal amount.
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Definition of hybrid entity
•
An entity is a “hybrid entity” if –
a.under the tax law of any territory, the entity is regarded as being a
person, and
b.the entity’s profits or gains are, for the purposes of a relevant tax
imposed under the law of any territory, treated as the profits or gains
of a person or persons other than the entity.”
(para 3 Sch 3 F(No2)2005)
•
•
The above requirement will not apply by virtue solely of the
entity’s profits or gains being subject to another territories
Controlled Foreign Company regime.
The following are relevant taxes
– income tax;
– corporation tax; and
– any tax of a similar character to income tax or corporation tax that is
imposed by the law of a territory other than the UK.
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Rule A and Rule B
– Where conditions A to D are met the re-computation
provisions referred to as “Rule A” and “Rule B” set out in
s25 F(No2)A 2005 must then be considered.
Rule A
– Applies where a deduction is claimed for an expense in the
UK and the same expense is deductible for the purposes of
computing income for the purposes of any other tax.
– Impact: The deduction is disallowed in the UK tax
computation equal to the expense that meets the criteria
above.
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Rule A and Rule B (cont)
Rule B
–
–
–
Applies where a deduction is claimed in the UK for a payment and the
recipient of the payment (“the Payee”) is not subject to tax on the receipt.
Payee deemed to be not subject to tax where an amount is deducted against the
receipt as a result of transactions which form part of the qualifying scheme.
Payee deemed not to be not subject to tax on the receipt if either
•
•
The Payee is not liable to tax on any income or gains under the law of any territory;
or
The Payee is not subject to tax on the particular payment as a result of an
“exemption”, where the exemption in question is
 provided under the law of a territory; and
 does not involve the allocation of the income to another person
–
Impact: A deduction is disallowed in the UK tax computation equal to the
income that has not been subject to tax
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Examples
Base case
US Co
Debt
UK DE
– Qualifying scheme using
hybrid entity
– UK tax deduction for interest
– Main purpose?
– Rule B applicable to deny
relief for deductions?
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Examples
Foreign Source Income Generator
US Co1
US Co2
US Co3
UK Co1
Debt
– Qualifying scheme using
hybrid entity
– UK tax deduction for interest
– Main purpose?
– Rule A applies
UK Co2
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