Significant interpretation of treaty LOB provision.

• Author: Smith, Annette B.
• Position: Limitation-on-benefits

In Letter Ruling 200201025, the IRS clarified the meaning of "ultimate beneficial ownership" in the context of the U.S.-Swiss Treaty's derivative-benefits test. (While the ruling does not disclose the country involved, references to Article 22 and a Memorandum of Understanding (MOU) lead to the conclusion that it involves U.S.-source interest payments to a Swiss company.) The ruling is important for several reasons:

* It adopts a lookthrough approach, requiring that ultimate beneficial ownership be traced to taxpayers that would qualify for Swiss-treaty benefits without reference to their owners.

* It provides support for requiring lookthrough treatment in the context of other treaties that require "direct or indirect," rather than ultimate, beneficial ownership by qualifying residents.

* It does not appear to impose any requirement that the intermediate entity be a resident of any particular country.

Background

Many U.S. tax treaties contain anti-treaty-shopping provisions, also known as the limitation-on-benefits (LOB) provision. "Treaty shopping," in its basic form, occurs when a resident of a country that typically does not have a tax treaty with the U.S. sets up a legal entity in a third country that has such a tax treaty, with a principal purpose of obtaining treaty benefits. For example, absent an LOB provision, a corporation resident in Bermuda could lend funds to its U.S. subsidiary through a company resident in a tax treaty jurisdiction. This would reduce or eliminate the 30% U.S. withholding tax on interest payments, which would apply ordinarily to interest payments paid directly to the Bermuda parent.

An LOB provision aims to curb treaty shopping by requiring a treaty resident receiving income from U.S. sources to qualify under one of several mechanical tests. Qualification indicates that the resident has the necessary economic connection to the treaty country to warrant benefits.

Generally, under typical LOB provisions, a company that is a resident of one contracting state might qualify for benefits under the tax treaty only if it meets one of the following tests:

* An ownership/base erosion test, under which the company must be majority owned by persons who qualify for benefits under the tax treaty, without regard to their owners;

* A publicly-traded-company test, under which the company's stock (or that of its parent under certain conditions) is traded on a recognized stock exchange;

* An active-business test;

* A...