The noose tightens: Netherlands-2 Treaty enters into force but with revisions.

• Author: Wacker, Raymond F.

Introduction

The Netherlands-2 Treaty(1)(*) was ratified by the U.S. Senate on November 20,

1993, and was signed by President Clinton on December 1, 1993. Since the Dutch ratification process was also completed by December 1, the new treaty-known for its extensive limitation on benefits article preventing treaty shopping or the utilization of a treaty by third-country nationals(2)--entered into force for tax years beginning after January 1, 1994. The new treaty, however, became effective subject to the provisions of an October 13, 1993, explanatory protocol [hereinafter referred to "Protocol"],(3) as well as diplomatic notes [hereinafter referred to as "Notes"] exchanged simultaneously by the two governments. The Notes are considered integral components of the Protocol.(4)

In its attempt to clarify certain ambiguities in the treaty and the accompanying understanding,(5) the Protocol and Notes modify certain aspects of the stock exchange, active-trade-or-business, and headquarters tests that operate to restrict treaty benefits. The Protocol also places a new U.S. withholding tax on any interest and royalties remitted to a Dutch company that are in turn allocated by the Dutch company to a branch operating as a permanent establishment in a low-tax third-country. This article explains the new restrictions and summarizes their effects on the ability of Dutch companies with investments in the United States to qualify for treaty benefits.

Stock Exchange Test

The Protocol modifies the residency test applicable to the subsidiaries of a qualifying publicly traded corporation. Under the Netherlands-2 Treaty, any such subsidiary (other than a conduit company)(6) is allowed treaty benefits if it resides within the Netherlands or the United States and more than 50 percent of the aggregate vote and value of all shares outstanding is directly or indirectly owned by five or fewer publicly traded companies residing in either treaty nation. In the case of Dutch corporations, only 30 percent must be owned by five or fewer Dutch corporations as long as 70 percent is owned by five or fewer corporations residing within the European Community.(7)

The treaty imposes one critical restriction: each corporation in the ownership chain used to satisfy the relevant ownership test must itself meet the residence requirement.(8) The Protocol relaxes this requirement to provide that each intermediate corporation in the chain need only be a resident of either treaty nation or any EC member.(9) Therefore, a Dutch corporation may make greater use of EC-based intermediate corporations that have substantial non-Dutch ownership.

Active-Trade-or-Business Test

The Notes address three separate issues relating to the active-trade-or-business test. Under the Netherlands-2 Treaty, a Dutch company carrying on an active trade or business in the Netherlands can claim treaty benefits for operations within the United States if--

(1) its U.S.-source income is derived in connection with its Dutch trade or business and is...