Anti-treaty shopping restrictions in the new U.S.-Netherlands tax treaty.

• Author: Wacker, Raymond F.

Introduction

The recently negotiated income tax treaty between the United States and the Netherlands [hereinafter Netherlands-2 Treaty] (1*) and accompanying protocol [hereinafter Netherlands-2 Protocol](2) contain a series of detailed anti-treaty shopping rules that have hitherto been absent in U.S. bilateral tax treaties. Intended primarily to update the antiquated U.S.Netherlands Treaty of 1948 [hereinafter Netherlands-l Treaty],(3) the new treaty represents the U.S. Treasury Department's most successful effort at extending into actual treaty formation extant U.S. statutory and regulatory restrictions on the use of a treaty by residents of a third nation.

Long stymied in its attempts to effectively combat this pervasive treaty-related abuse, the Treasury has increasingly insisted on including stringent anti-treaty shopping articles in tax treaties, as well as limiting the application of existing treaties through restrictive statutes, regulations, and revenue rulings. Nevertheless, the myriad treaty limitations in the Netherlands-2 Treaty are so comprehensive and complex that this treaty can only be regarded as a radical reorganization of the anti-treaty shopping regime.

The Treasury has long realized the critical need to amend its treaty with the Netherlands. Owing to its liberal tax regime governing foreign-source income earned by holding companies, an investor's easy access to its extensive tax treaty network, and the absence of any anti-treaty shopping article in the Netherlands-1 Treaty, few nations offer a better location for treaty shopping than the Netherlands. The Netherlands has become such a favored center for holding investment in the United States that many multinational corporations resident in U.S. treaty partners (such as France and Germany) hold their U.S. subsidiaries through Dutch holding companies.

The United States, on the other hand, provides a poor conduit for third-country investment in the Netherlands since the U.S. tax rules on foreign-source income are far less advantageous, and the United States has far fewer tax treaties in force. Accordingly, the limitations mandated in the Netherlands-2 Treaty can properly be viewed solely as an effort to deny treaty benefits on investment in the United States by non-Dutch residents. Because only foreign investment in the United States will be affected, the restrictions in the new treaty effectively represent a one-way street. The Dutch negotiators were only able to secure specific rules extending the definition of Dutch residency to the entire European Community (EC).(4)

Although the Netherlands-2 Treaty will not enter into effect before the end of 1993, multinational corporations operating through Dutch corporations in the United States should begin to reorganize their investments to meet the new rules. Failure to recognize the implications imposed by the new restrictions may cause the loss of treaty coverage altogether. This article delineates the effect of the Netherlands2 Treaty upon investment in the United States by Dutch corporations. More specifically, it considers the tax benefits offered by the Netherlands-2 Treaty upon such investments and the extensive provisions limiting the treaty's application. Current U.S. policy concerning anti-treaty shopping maneuvers is also discussed.

Treaty-Related Benefits Specific to the Netherlands-2 Treaty

Standard treaty-imposed inducements to foreign investment are provided in the Netherlands-2 treaty. Business profits,(5) interest,(6) royalties,(7) and other income not specifically mentioned in the treaty(8) are not taxed by the source nation unless a permanent establishment or fixed based has been established in the source nation? Dividends may be taxed by both nations, though source nation withholding rates on dividends are set at 5 percent in the case of subsidiaries where the parent holds at least 10 percent of the voting power of the subsidiary and 10 percent otherwise.(10) In the absence of the treaty, U.S. with-holding rates of 30 percent would apply to each category of passive income.(11) The source nation is precluded from taxing shipping and air transport income altogether.(12) The Netherlands-1 Treaty contains similar inducements. Business profits,(13) interest,(14) royalties,(15) and transportation income(16) are also exempt from taxation in the source nation. Dividends are taxed at 5 percent in the case of a 25 percent subsidiary corporation and 15 percent otherwise.(17)

The Operation of Treaty Shopping

Treaty shopping is the utilization of a tax treaty by third-country nationals. The intent is to achieve treatyimposed exemptions and withholding rates upon the repatriation of income to non-treaty nations. This practice is ordinarily achieved when a national of neither treaty nation establishes a company in one of the treaty countries. For example, a resident of Malaysia holds several investments in the United States. Since the United States has no tax treaty with Malaysia, it would be impossible to achieve treaty benefits. The United States does have a treaty, however, with Indonesia, and the Malaysian investor can establish a company in Indonesia and repatriate profits to that company under highly favorable treaty terms. Since both Malaysia and Indonesia follow the territorial approach to taxation (whereby only income arising from within its borders is taxed), income arising from within the United States would be exempt from taxation upon subsequent repatriation to both nations.

Treaties may also be linked together. Since the Netherlands has a tax treaty with Malaysia, the investor may establish an intermediary company in the Netherlands and use its treaty with the United States to realize treaty benefits upon repatriation of profits to the Dutch company. Treaty-related benefits can then be achieved upon the repatriation of profits to Malaysia. In both cases, a resident of a nation with which the United States has no tax treaty is able to use a U.S. treaty, though the application of each treaty is intended solely for legitimate residents of the nations that negotiated the treaty.

U.S. Tax Policy Restricting Treaty Shopping

The Treasury Department has employed several techniques to curb treaty shopping. Treaties negotiated over the past two decades have contained specific anti-treaty shopping provisions, although the results actually achieved have been limited in scope especially when compared with the Netherlands-2 Treaty. The primary measure has been to limit the percentage of corporate ownership held by third-country nationals. The 1977 U.S. Model Tax Treaty, for instance, states that a corporation will not be considered a resident of either treaty nation unless at least 25 percent of its shares are owned by bona fide residents of either country and it is not a mere conduit to pass profits to a third nation.(18) The proposed 1981 U.S. Model Tax Treaty increased the level of ownership to 75 percent.(19)

Faced with its inability to negotiate effective anti-treaty shopping restrictions, the Treasury has increasingly relied upon unilateral anti-treaty shopping restrictions, which have in turn become the focal points of anti-treaty shopping language in treaty negotiation. The Tax Reform Act of 1986 provided for two independent scenarios allowing a foreign corporation to qualify as a resident of a treaty partner under the branch profits tax regime of section 884 of the Internal Revenue Code.

1. Publicly Traded Corporations

   Effective treaty shopping will normally be achieved only through a closely-held corporation. In light of this, a publicly traded foreign corporation automatically qualifies for treaty coverage if its stock is primarily and regularly traded on an established stock exchange in either the United States or the treaty partner.(20) In the case of a subsidiary corporation, this test is met if at least 90 percent of the subsidiary's stock is owned by another corporation that is incorporated in the treaty partner and whose stock is publicly traded there or in the United States.(21)

2. Shareholder and Base Erosion Tests

   A privately held foreign corporation must satisfy both a shareholder test and a base erosion test. The former test requires that more than half of the value of all stock be beneficially owned, as determined under U.S. look-through and attribution rules, by bona fide residents of the treaty partner or the United States.

   The base erosion test requires that no more than half of a corporation's total income be used to liquidate liabilities owed to persons who are not qualified residents of the treaty partner or the United States.(22) This measure is intended to operate in the following situation:

   Assume a Malaysian investor merely lends capital to a resident of Indonesia, who forms a corporation there. The Indonesian corporation operates a trade or business in the United States. Substantially all of the income earned from the U.S. operation is repatriated to the Indonesian corporation and then paid out...