The U.S. Model Income Tax Treaty generally represents the United States' opening position in treaty negotiations. As a result, any changes to such treaty need to be carefully analyzed to determine whether they potentially can impact existing cross-border structures. On May 20, 2015, the Treasury Department released five proposed amendments (proposals) to the U.S. Model Treaty, which, if adopted in their current form, undoubtedly will have a major impact on many inbound structures. In general, the proposals are intended to ameliorate the problem of "stateless income" as well as influence the Organization of Economic Co-operation and Development's (OECD) work on the Base Erosion and Profit Shifting (BEPS) initiative.
Although the proposals clearly are BEPS related, the proposals do not address several important issues being considered by the OECD as part of the BEPS initiative, including 1) permanent establishments; 2) transfer pricing; or 3) the use of hybrid arrangements. Treasury has requested public comments on the proposals and has indicated that it plans to finalize the proposals by the end of 2015. (1)
Taxation of Foreign Persons
Foreign persons are subject to U.S. federal income tax on a limited basis. Unlike U.S. persons who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income: 1) certain types of passive U.S.-source income (e.g., interest, dividends, royalties, and other types of "fixed or determinable annual or periodical income," collectively known as FDAP), which are subject to a 30 percent gross basis withholding tax; and 2) income that is effectively connected to a U.S. trade or business (ECI), which is taxed at graduated tax rates applicable to U.S. persons. (2)
Although the statutory rate of withholding on U.S.-source payments of FDAP income to a foreign person is 30 percent, most, if not all, income tax treaties concluded by the U.S. reduce or even eliminate the U.S. withholding tax on payments of dividends, interest, royalties, and certain other types of income. In addition, unlike the taxation of foreign persons that are engaged in a U.S. trade or business, treaties provide for a higher threshold in that foreign persons are only subject to tax in the U.S. on business profits that are attributable to a permanent establishment in the U.S.
To be eligible for treaty benefits, the taxpayer must be considered a resident of a particular treaty jurisdiction and, in the case of most modern income tax treaties, must satisfy the treaty's limitation on benefits (LOB) provision.
Denial of Treaty Benefits for Income Attributable to Low-Tax Permanent Establishment
One of the proposals, which already is included in a number of existing LOB provisions of U.S. income tax treaties, would amend 17 of art. 1 of the U.S. Model Treaty to state that when 1) a resident derives income from the other state; and 2) the residence state's domestic law attributes that income to a permanent establishment (PE) located outside the company's country of residence, then the treaty benefits that would ordinarily apply are inapplicable if the PE's profits are subject to a combined aggregate effective tax rate of less than 60 percent of the generally applicable corporate tax rate in the residence state, or the state in which the PE is situated does not have a comprehensive income tax treaty with the state from which the treaty benefits are being claimed (unless the residence state includes the PE's income in its tax base).
An example of the use of such a structure for inbound financing purposes may involve a Hungarian company that establishes a Swiss finance branch. (Other commonly used structures include the use of a Spanish or Polish company with a Swiss finance branch or a Romanian company with a Luxembourg branch). The Hungarian entity would loan funds through the Swiss branch to a U.S. entity and, in return, receive interest on such loan. The interest presumably would be deductible in the U.S. and would be exempt from U.S. withholding tax under the U.S.-Hungary income tax treaty. The Hungary-Switzerland income tax treaty currently provides that any income allocated to a Swiss PE is exempt from tax in Hungary. As a result, little, if any, tax is actually paid in Hungary and the Swiss finance branch rules provide for extremely low rates of income tax.
Under the proposal, the interest payments would not be eligible for U.S. treaty benefits...