Repatriation of profits to Latin America: who needs treaties!(TAX LAW)

• Author: Rubinger, Jeffrey L.

Generally, a non-U.S. taxpayer that is not engaged in a U.S. trade or business is taxable in the United States only on U.S.-source "fixed determinable, annual or periodical" income (FDAP). (1) Unless an applicable income tax treaty applies to reduce the rate of tax, FDAP income typically will be subject to a 30 percent gross basis withholding tax. Included in the category of FDAP income that is subject to U.S. withholding tax is U.S. source dividends. (2)

While the substantial majority of income tax treaties concluded by the United States reduce or even eliminate the 30 percent withholding tax on U.S.-source dividends, (3) not all foreign jurisdictions have comprehensive income tax treaties with the United States. This is particularly true in the case of Latin American jurisdictions. Currently, the only income tax treaties that are in effect with Latin American jurisdictions are those with Mexico and Venezuela, both of which have comprehensive limitations on benefits (LOB) provisions. (4) Therefore, unless a non-U.S. taxpayer is able to satisfy the LOB provision in one of these treaties, any U.S.-source dividends repatriated from the United States to a nontreaty jurisdiction will generally be subject to a 30 percent withholding tax.

There are, however, a number of strategies that may allow U.S. corporate taxpayers to repatriate profits tax-free (or at substantially reduced rates) from the United States to taxpayers resident in Latin American jurisdictions, regardless of whether a treaty exists between the United States and that particular jurisdiction. This article will analyze several of these alternatives.

Background

Non-U.S. taxpayers are subject to U.S. federal income taxation on a limited basis. Unlike U.S. taxpayers--who are subject to U.S. federal income tax on their worldwide income--non-U.S. taxpayers generally are subject to U.S. taxation on two categories of income: 1) certain passive types of U.S.-source income, e.g., interest, dividends, rents, annuities, and other types of income known as FDAP; (5) and 2) income that is effectively connected to a U.S. trade or business (ECI). (6)

As noted above, FDAP income is subject to a 30 percent withholding tax that is imposed on a non-U.S. taxpayer's gross income (subject to reduction or elimination by an applicable income tax treaty). ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. taxpayers.

For a non-U.S. taxpayer to be eligible for reduced withholding tax rates on U.S.-source FDAP income under a U.S. income tax treaty, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any LOB provision in the treaty (a provision which all recently negotiated comprehensive U.S. income tax treaties will contain). Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is "liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature."

Similarly, under most "modern" income tax treaties, a corporate resident of a treaty country can satisfy the LOB provision if 1) on at least half the days of the tax year at least 50 percent of each class of shares in the corporation is owned, directly or indirectly, by residents of the jurisdiction in which the corporation is formed (the "ownership test"); and 2) not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are residents of the U.S. or residents of the jurisdiction where the corporation is formed (the "base erosion" test). (7)

Treaties with Mexico and Venezuela

As noted above, the only income tax treaties that are currently in effect with Latin American jurisdictions are those with Mexico and Venezuela. (8) Under the U.S.-Mexico income tax treaty, the 30 percent U.S. withholding tax rate on U.S.-source dividends paid to a Mexican resident taxpayer can be completely eliminated, but only if the taxpayer is a Mexican company that has owned at least 80 percent of the voting shares of the U.S. corporation for at least 12 months prior to the time the dividend has been declared, (9) and either 1) the shares have been owned prior to October 1, 1998; (10) 2) the principal class of shares of the Mexican company are regularly traded on a recognized securities exchange in either the United States or Mexico; (11) or 3) the derivative benefits article of the LOB provision can be satisfied. (12) Otherwise, the withholding tax rate on U.S.-source dividends is reduced to either five or 10 percent, depending on the type of shareholder and percentage of ownership in the U.S. corporations. (13)

Unlike the U.S.-Mexico income tax treaty, the U.S.-withholding tax rate on U.S.-source dividends cannot be completely eliminated under the U.S.-Venezuela income tax treaty. Rather, the U.S. withholding tax rate on dividends under the Venezuela treaty is reduced to either five or 15 percent, depending on the type of shareholder and percentage of ownership in the U.S. corporations. (14)

Tax-efficient Repatriation Opportunities to Latin America

While a dividend paid by a U.S. corporation to a non-U.S. taxpayer resident in a Latin American jurisdiction that does not qualify for U.S. income tax treaty benefits typically would be subject to a 30 percent with-holding, a number of opportunities exist that may be used to eliminate or substantially reduce this tax. One such strategy takes advantage of the so-called "boot within gain limitation" of I.R.C. [section] 356(a).

* Boot within Gain Rule--In general, shareholders that are parties to a nontaxable reorganization do not recognize gain or loss with respect to exchanges of stock and securities in such reorganization. Under [section] 356, however, a recipient of money or other property (boot) in a nontaxable reorganization recognizes gain (if any) on the transaction in an amount not in excess of the sum of such money and the fair market value of such other property...