Proposed Changes to US Model Treaty
and
Suggestions for New Technical Explanation
ABA Tax Section
Chicago
September 18, 2015
Peter H. Blessing
Allison Christians
KPMG LLP
phblessing@KPMG.com
McGill University
allison.christians@mcgill.ca
Alan W. Granwell
Quyen Huynh
Sharp Tax Law LLC
agranwell@sharptaxlaw.com
Dept of the Treasury
Quyen.Huynh@treasury.gov
1
Overview
• May 20, 2015 Treasury released five sets of
proposed revisions to the 2006 U.S. Model Income
Tax Convention for comment:
– Special tax regimes
– Subsequent changes in law
– Exempt/triangular permanent establishments
– Expatriated entities
– Limitation on benefits article
• First 3 limit base erosion, 4th to discourage
inverters and last to discourage treaty shopping
2
SPECIAL TAX REGIMES
3
Special Tax Regimes (STRs)
• General Rule:
– Amend Articles 11, 12, and 21 to deny treaty benefits for
related party payments of interest, royalties, or “other
income” if the recipient is subject to a STR w/r/t an item
in that category in its country of residence
• The U.S. proposed substantially the same language for
inclusion by the OECD as part of BEPS Action 6
• Definition of STR:
– Any legislation, reg, or admin practice (including rulings)
that provides a preferential effective rate of taxation to
an “item” of income or profit through a reduction of tax
rate or tax base
• A regime that allows notional interest deductions (“NIDs”)
w/r/t equity is per se treated as an STR.
4
Exclusions from STRs
• Regime that does not disproportionately benefit interest, royalties or other
income. (e.g., accelerated depreciation)
• Royalty regime that satisfies a substantial activity requirement
• Regime that implements the principles of Article 7 (Business Profits) or
Article 9 (Associated Enterprises) - e.g., an APA
• Regime that applies to religious, charitable, other non-profit activities
• Regime that applies to pension/retirement benefits
• Regime that facilitates investment in entities that are marketed primarily to
retail investors, are widely-held, hold real property and/or a diversified
portfolio of securities, and are subject to investor-protection regulation in
the Contracting State where established
– TE states that U.S. RICs and REITs are not STRs
• Regime the Contracting States have agreed shall not constitute an STR
because it does not result in a low effective tax rate (ETR)
– TE: any regime that results in ETR of at least 15% is ok even if targeted
5
Special Tax Regimes – Comments
• Focus is only on interest, royalties and “other income”;
not business income or compensation
• Cliff effect: if fail by a little, benefits lost entirely
– Perhaps to not encourage such regimes/targeted rates
• How fine-tuned will ETR calc be, esp for the 15% safe
harbor? Just headline rate and % base reduction?
• APAs etc that meet arm’s length standards are ok
– Is this determinable with enough precision?
• Notice of STRs in existence when treaty signed? Notice
vs. self-executing re subsequent regimes?
• Exs of such “regimes”? Incl mere interaction of rules?
6
SUBSEQUENT CHANGES IN LAW
7
Subsequent Changes in Law: General Rule
• New Article 28 would allow the source State to deny certain
treaty benefits on dividends, interest, royalties and “other
income” if, after a treaty is signed, the residence State:
(1)Reduces its general corporate or individual tax rates
below 15% with respect to “substantially all” income of
resident companies/individuals, or
(2)Adopts a territorial regime that provides an exemption
from taxation for “substantially all” foreign source income
(FSI) earned by resident companies or individuals
• Not self executing
– Requires written notification through diplomatic
“channels”
– Provision has effect 6 months after written notice
8
Subsequent Changes in Law (Cont’d)
• Like STR rule, first prong focuses on ETR
– Applies to reductions in statutory rate as well as
reductions in tax base
• Relevant ETR is of undistributed earnings
– A tax that applies to a company only upon a
distribution, or to shareholders, does not count
• Second prong focuses on FSI:
– Including e.g. territorial regime exempting 95% of FSI
– The provision would not apply to exemption systems
that exempt only foreign source dividends or
business profits from PEs
9
Subsequent Changes in Law - Comments
• Addresses attempt to use general low rate to
circumvent STR rule
– But Art 28 could apply to Dividends as well
• Safe harbor rate may include a % of existing rate
(to not penalize a Contracting State with a low
rate when treaty is signed)
• Benefits disallowed on both sides
• How deal with gradations btw territorial
exempting full FSI vs selected categories?
• Coordin of STR/SCL with/status of BEPS Act. 7
10
EXPANDED TRIANGULAR PROVISION
11
Triangular PE Provision
 Scenario:
 State A company
 Low-tax State B PE
 U.S.-source income
ForCo
State A
paid by U.S. payor
 No State A tax on foreign
PE income per State AState B tax treaty or
State A internal law
USCo
PE
State B
U.S.-source
interest
12
Triangular PE Treaty Provision- Current Law
 Many U.S. treaties reduce treaty benefits w/r/t a



triangular PE arrangement.
Triggered if the combined residence-State and PE-State
ETR for an item of income is less than 50% (e.g. Ireland,
Luxembourg, South Africa) or 60% (e.g. France,
Germany, Switzerland and pending treaties with e.g.
Chile and Hungary) of the residence state's general tax
rate.
Some TEs indicate that the ETR should be calculated
under rules like the subpart F “high-tax kick-out” rules.
Some treaties except income from an active trade or
business (ATB) in the PE-State and royalty income from
IP developed by the PE.
13
Proposed Triangular PE Provision



The proposal includes a 60% combined ETR rate test,
w/o exceptions; per TE, the high-tax kick-out rules
should be used to test rates.
The Model does not require a true “triangular” case
– thus, US source payments to a US PE allowing a
reduced rate in the residence State would deny
treaty benefits for the payments.
Treaty benefits will also be denied if the PE is located
in a third state that does not have a comprehensive
income tax treaty with the source state, regardless of
effective tax rate in PE jurisdiction.
14
Triangular PE Provision--Comments
• No ATB exception as often currently
• Treaty benefits on the item totally denied, not
reduced as currently
• Rationale why PE rate is irrelevant if PE State has no
comprehensive treaty?
– Exch. of info? Concern that treaty country (tho LOB
met) is stepping stone to use nontreaty country?
• Provision is not limited to related party payments.
– Seems administrable: Even w/o a change to the W8BEN-E, the cert. of eligibility implicitly would cover
this issue, just as e.g. w/r/t conduit issues.
15
ANTI-INVERSION PROVISION
16
Proposed Anti-Inversion Provision
 Would deny treaty benefits for dividends,

interest, royalties and “other income” paid by an
“expatriated entity” w/I §7874(a)(2)(A).
Very generally, would apply where owners of the
pre-acq expatriated entity own at least 60%, but
less than 80%, of the post-acq foreign
corporation.
17
Anti-Inversion Comments
 Treaty denial not limited to payments to related parties
 But Treasury official has said under consideration.
 No stated grandfathering.
 Treasury hinted at this approach in Notice 2014-52:
“The Treasury Department is also reviewing its tax
treaty policy regarding inverted groups and the
extent to which taxpayers inappropriately obtain tax
treaty benefits that reduce U.S. withholding taxes
on U.S. source income.”
18
LIMITATION ON BENEFITS (LOB)
ARTICLE
19
LOB – Overview w/r/t Commercial Entities
• Public Trading Test
• Subsidiary of publicly traded parent company
• 50-50 Ownership-Base Erosion Test
• Active Trade or Business Test
• Derivative Benefits Test (New to the Model)
• Subjective Relief via Competent Authority
20
LOB – Publicly Traded Test – 2006 Model
• Publicly Traded Company Test
– Company’s principal class of shares (and any disproportionate class) is
regularly traded on one or more recognized stock exchanges, and either:
• (A) its principal class of shares is “primarily traded” on one or more
recognized stock exchanged located in the Contracting State in which
the company is a resident; or
• (B) the company’s primary place of management and control is in the
Contracting State of which it is a resident.
• Subsidiary of Publicly Traded Company Test
– At least 50% of the aggregate vote and value of the shares in the company
is owned by ≤ 5 publicly traded companies entitled to benefits under first
prong of the publicly traded company test.
– Note: in case of indirect ownership, each intermediate owner must be a
resident of one of the Contracting States. (Query; see also slides 37-8.)
21
LOB– Publicly Traded Test Currently (Cont’d)
Other
Public
FCX
“Principal class”; primarily traded on
LSE. (What if not primarily on LSE,
but primarily managed and
controlled in the UK?)
70%
FCX1
80%
If FCX1 were
resident in country Y
instead of X, problem
for FCX2.
FCX2
100%
US
22
LOB – Proposed Change to Public Company
Subsidiary Test
• Under the 2006 Model, no base erosion (BE) test applies to
public companies or their subsidiaries
• The proposed LOB would impose the BE test on a public
company subsidiary (other than re Article 10 (Dividends)).
• This BE test generally would require that deductible payments
(other than payments for goods and services in the ordinary
course) in an amount less than 50% of the gross income of
the subsidiary be made to persons:
– not qualifying under subparagraphs (a) (individuals), (b)
(governmental bodies), (c) publicly traded companies but not their
subsidiaries) or (e) (exempt organizations and pension funds) of
paragraph 2.
23
LOB – Proposed Change to Subsidiary Test
Other
Public
UK
“Principal class”; primarily traded
on LSE. (Or primarily managed
and controlled in the UK.)
70%
UK
Loan from non-EB:
Must test
80%
UK
100%
US
24
LOB – Proposed Change to Public Company Subsidiary Test Comments
• Not entirely new: Treaties with Luxembourg
(1997), Barbados (2004) and Malta have such
provisions, in each case applicable to Article 10 as
well.
• Nevertheless, useful to ask: examples of targeted
abuse and concern?
25
LOB – Changes to Base Erosion Tests
• Under all 3 BE tests (subsidiary of publicly traded company,
50-50 private company, and derivative benefits):
• Denominator would exclude exempt dividends (other
than for Article 10) and certain intercompany payments;
• Payments (that are not excluded as eg ordinary course)
would count against the 50% limitation if the recipient
benefits from an STR in its resident State.
– Note: unlike general STR rules, here regardless of
whether recipient is a “related” person.
• Testing by “tested group” would be required (next slide)
• Treasury seeks comments on bank payment exception
for all 3 BE tests
26
LOB – Changes to Base Erosion Tests – Tested Group
• All 3 BE tests would be computed on a “tested
group” basis.
• “Tested group” means the company seeking
qualified person status and any intermediate
owner which form part of a consolidated regime
with it.
– Payment by a resident subsidiary of a consolidated
group would be tested both (i) with sub’s gross
income alone and (ii) with gross income of both the
sub and intermediate owners in consolidated group.
– Since a parent has no intermediate owner, no tested
group for payments by it, so only it is tested.
• Q re BE generally: U.S. classification of entities
relevant or not? Cf. conduit regs.
27
LOB – 50-50 Test under 2006 Model
• 50% Ownership/BE Test.
– (1) At least 50% of each class of shares/interests representing
50% of the vote and value of the resident entity must be owned
directly or indirectly by “residents of that Contracting State
entitled to the benefits of [the treaty]” (i.e., not the source State)
who are (a) individuals, (b) the Contracting State or its political
subdivisions, (c) publicly traded companies, or (d) tax exempt
organizations or pension funds (i.e., 2(a), (b), (c), or (e)).
• On at least half the days of the taxable year.
• Any intermediate owner must be resident of the same State.
– AND (2) less than 50% of gross income is paid or accrued as
deductible payments to noneligible persons but excluding arm’slength payments in the ordinary course of business for service or
tangible property.
• Same test and changes as for sub of publicly traded co.
28
LOB – ATB Test under 2006 Model
• A resident who fails to meet the qualified person or derivative
benefits test can still qualify for treaty benefits with respect to
items of income from the source State that are “connected with”
or “incidental to” an ATB of the resident in its resident State.
– If the source State income arises from an associated entity,
then the resident State business must also be “substantial”
compared to the source State business
• The 2006 Model and many treaties provide an attribution rule for
the ATB, derived in connection with, and substantial
requirements:
– A resident can include activities conducted in the State by
“connected” entities
– “connected” = if one possesses at least 50% of the beneficial
interest (or vote and value) in the other (or is a partner in the
other) or another person possesses at least 50% of the
beneficial interest (or 50% vote and value) in each person.
29
LOB – Proposed Change to ATB Test
• The proposed changes would limit attribution to
connected entities that each are in the same or a
complementary line of business.
• Treasury reasons that the prior Model did not contain a
derivative benefits provision and such provision is the
appropriate place to test holding company or finance
entity qualification.
– But the proposed restrictions are not limited to
holding and finance entities,
30
LOB – Proposed Change to ATB Test
Public +
Private
FC A
“Principal class” traded but not
primarily traded on required
exchange; and not primarily managed
and controlled in Country A)
100%
FC1B
ATB in Country B
conducted here
100%
FC2B
100%
USco
Holding company (or ATB in B
but not connected to USco
business)
Connected to FC1B business
31
LOB – Proposed Change to ATB Test -- Comments
• Similar issues in many variations (side by side,
etc.)
• Rationale?
• Restructuring often can avoid issue, but why
require?
• Any implication for HQ test as appropriate LOB
test for holding companies?
– While not in Model, test is in a few treaties including
pending Jan 2013 Spain Protocol
32
LOB – Derivative Benefits – Typical Provision in
Current Treaties
• Ownership prong: (typically) At least 95% of voting
power and value of company’s shares (and at least
50% of any disproportionate class of shares) is
owned by 7 or fewer persons (“equivalent
beneficiaries” (EBs)).
– Tricky EB issues for Ownership and BE (see slides 34-36)
• BE prong: less than 50% of gross income is paid or
accrued as deductible payments to non-EBs (other
than arm’s-length payments in the ordinary course
of business for service or tangible property.
33
Limitation on Benefits – Deriv. Benefits (Cont.)
• EBs must be residents of a country in the EU, EEA or NAFTA
• Entitled to all benefits under a comprehensive treaty
between such country and the source State (or if such
treaty lacks a comprehensive LOB article, would be
entitled under the treaty if residency were met) as an
individual, a government or political subdivision, a publicly
traded company, an exempt organization or a pension
fund.
• Which, w/r/t dividends, interest, royalties and insurance
premiums, provides no less favorable benefits in respect of
the relevant item of income (or an EU directive so
provides).
• Note: Qualification of an owner under 50-50
ownership/BE test, ATB test or DB test under a treaty is
not sufficient to be an EB.
34
LOB – Derivative Benefits - Proposed Changes to
Typical EB Definition
• Potentially eligible persons no longer limited to residents
of EU and NAFTA countries (Major favorable change)
• Must be entitled to benefits analogous to the benefits of
the treaty as an individual, a government or political
subdivision, a publicly traded company, an exempt
organization or a pension fund (if comprehensive LBO
article).
• Resident of source State ineligible even for ownership
test (Major negative change; conforms to 50-50 test.)
• For an individual to qualify for EB status, he/she must be
liable to tax currently on FSI (addresses remittance
regimes)
35
LOB – Derivative Benefits – Proposed Changes to
EB Definition (Cont’d)
• Currently, EB must be entitled to “as low as” rate for
dividend, interest and royalty payments if treaty benefits
claimed for such and, for any such payments as are
deductible, to no not count towards base erosion.
• Proposed revisions would expand to include requirement
that an EB’s tax be “at least as favorable as” treaty claimant
w/r/t business profits, gains and “other income.”
– What does “at least as favorable” mean in this context?
– Examples where not met?
– Explanation of concern?
– Given cliff effect, reasonable clarity needed.
36
LOB – Derivative Benefits – Proposed
Intermediate Owner Requirements
• Most existing DB provisions do not impose intermediate owner
restrictions; the pending 2013 Spanish Protocol requires each
intermediate owner to be a resident of an EU or NAFTA State
(but not more).
• Proposed rules would require, for purposes of the ownership
test, that each intermediate owner must be a QIO, meaning
• A resident in a country whose U.S. treaty also has an STR
provision, and w/r/t Articles 10-12 and certain other benefits,
contains the “as low as” and the new “at least as favorable” EB
requirements
• Resident of the source State is excluded, which could affect
qualification ability of other owners to qualify.
• Resident of the recipient State literally is excluded (see
“analogous”); seems unintended.
37
LOB – Derivative Benefits – Proposed
Intermediate Owner Requirements
• QIO status denied if the QIO State treaty does not contain an
STR provision even if such regime is not applicable to a specific
payment received by the QIO.
– Contrast the different test for BE payments to an EB: If the EB
State treaty fails to contain an STR provision, that does not
disqualify EB status by itself, it only affects BE computation if
the EB State contains such regime and it is applicable to the EB.
• The QIO requirement appears designed to prevent “parking”
income in potentially ineligible or base eroding countries in the
chain of ownership.
– Is this requirement accomplishing anything? The earnings could
be dropped into a tax haven by any QIO in the chain.
– What if a CFC regime in the EB State applicable to the income?
38
LOB – Derivative Benefits – Base Erosion Test
.
• Potentially base eroding payments can avoid charge against
the 50% limit only if made to EBs.
• Thus, payments to QIOs that are not also EBs base erode.
– The key differences between the two is that EBs must
qualify as an individual, a government or political
subdivision, a publicly traded company, an exempt
organization or a pension fund
39
LOB – Derivative Benefits—
Rate Issue Currently and Proposed
CaymanCo
(No treaty)
DutchCo
(0% interest rate)
SpainCo
(10% interest rate)
German
FinCo
(0% interest rate)
German
FinCo
(0% interest rate)
German
FinCo
(0% interest rate)
USCo
USCo
USCo
Interest
W/O LOB
0%
LOB
30%
W/O LOB
0%
LOB
0%
W/O LOB
0%
LOB
30%
Assume German FinCos do not satisfy LOB tests other than derivative benefits
(but meet base erosion leg of deriv. ben.). Assume DutchCo and SpainCo each
satisfy LOB test of relevant treaty with U.S.
40
LOB – Derivative Benefits –
Rate Issue and Other Continuing Issues
• The “as low as” derivative benefits requirement used in
current treaties) continues its cliff effect
– Full disallowance even if the ultimate owners are residents in
jurisdictions eligible for higher but reduced treaty rates.
– Why not use the higher ultimate owner rate rather than
disallowing all benefits?
• Application of DB test for company with primary trading/place
of management tests treaty requirement but owner treaties
do not: “analogous” standard.
• How apply “equivalent beneficiary” requirement to dividends
where treaty with owner would allow 0% rate but treaty with
third country has only 5%?
41
LOB – Derivative Benefits –
Other Continuing Issues
• Is there a substantiality test for the branch profits
tax where the underlying revenues are from
unrelated parties?
• Query U.S. concept of LOB article vs. other OECD
countries
– E.g., “simplified” LOB draft coupled with
principal purpose test in BEPS Action 7 Revised
Discussion Draft)
42
Proposed LOB Changes – Competent Authority
Review
• Subjective relief provision: intended as safety valve
• Currently must show that neither the establishment,
acquisition or maintenance nor conduct of
operations have as one of its principal purposes the
obtaining of treaty benefits.
• Proposed change adds the requirement that the
resident must demonstrate a “substantial nontax
nexus” to the resident State.
43
Proposed LOB Changes – Competent Authority
Review (Cont’d)
• This may make it more difficult for a legacy resident
holding company whose shares are held by a third State
owner to claim benefits under the subjective relief
provision.
– E.g., non-public German company acquires Dutch holding
company (“Holdco”) from Dutch public or from a US seller.
Holdco owns several US subsidiaries.
– Proposed Model would require Holdco to establish a
substantial nontax nexus despite long history and despite
similar benefits available under German treaty.
– What would show substantial nexus in this case?
• Is this going in the wrong direction?
44
Competent Authority Review—Related Issues
• Rev. Proc. 2015-40
– Requests for assistance from U.S. competent authority
acting thought APMA and the Treaty Assistance and
Technical Interpretation Team of LB&I
• Pending litigation under the subjective relief
clause
45
OTHER ISSUES FOR MODEL
TECHNICAL EXPLANATION
46
Fiscally Transparent Entities - Model Art. 1(6)
• Art. 1(6): “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 laws of such Contracting State as the income, profit
or gain of a resident.”
• Compare §1.894-1(d) by which the US applied a similar rule
unilaterally, but only w/r/t FDAPI.
• Should treaty rule be reconsidered (e.g, is same character/current
inclusion w/o reference to a regime too strict to flatly disallow
benefits? And if recipient would have been exempt if received
directly?
• TE Clarification esp needed re business profits (BPT; filing; etc.)
47
Other Issues for Clarification in TE
• Will issues such as the following be addressed in
the new Technical Explanation?
– Ownership through disregarded entities
– Holding period following reorganizations
– Revisions to consistency rule discussion
– Arm’s length pricing and other considerations
arising from AOA for Article 7
– Double tax relief (in view of taxes like the diverted
profits tax)
48