Income derived through fiscally transparent entities: practical issues and unintended consequences.

• Author: Almeras, Jon

TaxClinic

PRACTICAL ADVICE ON CURRENT ISSUES

Foreign companies investing in the United States often rely on U.S. income tax treaties to reduce or eliminate the 30% U.S. withholding tax imposed on payments of U.S.-source fixed or determinable, annual or periodical (FDAP) income. When such investments are made through an entity that is "fiscally transparent" under the laws of the United States and/or any other jurisdiction, the regulations under Sec. 894(c)(2) deny income tax treaty benefits on items of U.S.-source FDAP income to the extent such income is not "derived by" a treaty resident.

An item of income is derived by an entity when the entity is not fiscally transparent under the laws of the entity's jurisdiction (i.e., it is fiscally opaque) and the income is derived by an entity's interest holder if the entity is fiscally transparent and its interest holder is fiscally opaque, in each case under the laws of the interest holder's jurisdiction. An entity or interest holder is fiscally transparent with respect to an item of income if, under the laws of its jurisdiction, its interest holder is required to separately take into account the item of income on a current basis with the same source and character as if the interest holder had realized the income directly from the originating source (Regs. Secs. 1.894-1(d)(3)(ii)and (iii)).

An item of income therefore is not derived In an entity if, under the laws of the entity's jurisdiction, the entity is fiscally transparent as defined by the regulations. In such cases, the analysis turns to the interest holders in the entity, applying the same analysis under the laws of their jurisdiction, although again through the lens of fiscal transparency as defined by the regulations, and so on up the chain. Conversely, sometimes the same item of income may be derived by an entity and one or more of its interest holders, for example, when the entity is fiscally opaque under the laws of its jurisdiction yet is fiscally transparent under the laws of a fiscally opaque interest holder.

In navigating these rules, it is also important to note that an entity or an interest holder may be organized or incorporated in one jurisdiction and treated as a resident of another jurisdiction. In that case, the analysis for such an entity or interest holder may turn on the application and intersection of three sets of laws (i.e., the U.S. tax law, the law of the jurisdiction of incorporation or organization, and the law of the jurisdiction of residency). Although the regulations' basic methodology may be logical in theory, given the multitude and confluence of applicable laws, their application raises many practical and technical issues and can lead to unexpected land likely unintended) results.

Through a series of examples, this discussion summarizes the general approach adopted by the regulations and then highlights some of the practical difficulties encountered when determining whether a foreign company is entitled to treaty benefits when investing in the United States through an entity that may be fiscally transparent under the laws of one or more jurisdictions.

The Derived-By Requirement: Illustrative Examples

For each of the following examples, unless otherwise indicated, assume that Treaty Co. is a company organized in. and a resident of. Country X and is treated as fiscally opaque under the laws of Country X. Country X has entered into an income tax treaty with the United States, and Treaty Co. satisfies the requirements of the Country X-U.S. income tax...