Qualifying for treaty benefits under the 'derivative benefits' article.

• Author: Rubinger, Jeffrey L.
• Position: Tax Law

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. (1)

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 United States reduce or even eliminate the U.S. withholding tax on payments of dividends, interest, royalties, and certain other types of income.

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. The purpose of the LOB provision is to prevent treaty shopping, defined by the Treasury as the "use, by residents of third states, of legal entities established in a [contracting [s]tate with a principal purpose to obtain the benefits of a tax treaty between the United States and the other [c]ontracting [s]tate." (2)

Each LOB article sets forth a number of objective tests, which, if satisfied, will entitle the resident to treaty benefits, even if the resident was formed or availed of for a tax-avoidance purpose. The most common of these tests include 1) a public company test; 2) an ownership and base erosion test; 3) an active trade or business test; and 4) in some cases, a derivative benefits test. (3)

Derivative Benefits Provision

The purpose of the derivative benefits provision is to ensure that an entity owned by nonresident shareholders (i.e., equivalent beneficiaries) may qualify for treaty benefits, even if the other LOB tests are not satisfied, when it is clear that such entity was not used for treaty-shopping purposes. To qualify for treaty benefits under the derivative benefits test, a specified percentage (typically 95 percent) of an entity's shares must be owned, directly or indirectly, by seven or fewer equivalent beneficiaries and a base erosion test must be satisfied.

An "equivalent beneficiary" generally means any person that:

1) In connection with certain European country treaties, is a resident of a member state of the EU, any state of the European Economic Area (EEA), a party to NAFTA, or in some cases Switzerland or Australia (a qualifying country);

2) Is entitled to the benefits of a comprehensive income tax treaty concluded between such qualifying country and the contracting state from which treaty benefits are claimed and satisfies certain LOB requirements (even if that treaty has no LOB article); and

3) In the case of dividends, interest, royalties, and possibly certain other items (such as insurance premiums), would be entitled under the treaty between the qualifying country and the contracting state in which the income arises, to a rate of tax with respect to the particular class or item of income for which benefits are claimed that is "at least as low as" the rate provided for under the treaty between the contracting states.

The following U.S. income tax treaties currently in effect contain a derivative benefits provision within the LOB article:

1) Belgium--applies to residents of the EU, EEA, NAFTA countries, and Switzerland.

2) Canada--applies to any jurisdiction that has an income tax treaty with the United States.

3) Denmark--applies to residents of the EU, EEA, and NAFTA countries.

4) Finland--applies to residents of the EU, EEA, NAFTA countries, and Switzerland.

5) France--applies to residents of the EU and NAFTA countries.

6) Germany--applies to residents of the EU, EEA, and NAFTA countries.

7) Iceland--applies to residents of the EU, EEA, and NAFTA countries.

8) Ireland--applies to residents of the EU and NAFTA countries.

9) Jamaica--applies to any jurisdiction that has an income tax treaty with the United States.

10) Luxembourg--applies to residents of the EU and NAFTA countries.

11) Malta--applies to residents of the EU, EEA, NAFTA countries, and Australia.

12) Mexico--applies to residents of NAFTA countries.

13) Netherlands--applies to residents of the EU, EEA, and NAFTA countries.

14) Sweden--applies to residents of the EU, EEA, NAFTA countries, and Switzerland.

15) Switzerland--applies to residents of the EU, EEA, and NAFTA countries.

16) United Kingdom--applies to residents of the EU, EEA, and NAFTA countries.

The "at least as low" requirement is designed to prevent residents of a third country from using an entity than is a resident of one of the contracting states to obtain a more favorable...