Holding Companies, ETVEs, the Holding Companies, ETVEs, the United States’ LOB and United States’ LOB and

European Tax LawEuropean Tax Law

MadridMadrid May 30, 2012May 30, 2012

Yariv BraunerUniversity of Florida College of Law

IntroductionIntroduction Perception of tax treaties Treaty shopping

Anti treaty shopping measures vs. domestic anti abuse norms

Dissatisfaction with available mechanisms United States breaks with the OECD orthodoxy and

introduces LOB LOB catches on, albeit in a non universal format

United States Tax Treaty PolicyUnited States Tax Treaty Policy Bilateral, separately negotiable, specific agreements Leader in OECD, yet does not shy from unilateral action

– including treaty override Strong culture of specific anti abuse (tax) policy Variety of treaty provisions that limit benefits

Purpose clause Subject-to-tax, other residence restrictions, Transparent entities Beneficial ownership Anti-conduit, Anti dividend stripping Formal requirements

Aiken Industries v. Comm. (1971)Aiken Industries v. Comm. (1971)

Bahamas

Aiken (US) Ecuador

USCO Honduras

Loan

Aiken Industries (Cont.)Aiken Industries (Cont.)

Bahamas

Aiken (US) Ecuador

USCO Honduras

Back-to-back loans

Typical Netherlands Antilles SchemeTypical Netherlands Antilles SchemeUnited States

• A 30% withholding tax would have been imposed on interest paid by USCO to the Netherlands Antilles, since no tax treaty existed between the United States and the Netherlands Antilles.

• A treaty existed, however, between the United States and the Netherlands and between the Netherlands Antilles– The treaty provided for low, and eventually no

withholding tax on the payment of interest

• Dutch angle• Trigger for portfolio interest exception

Other casesOther cases Bass case – oil and gas leases

Intermediary was “managed as a viable concern and not as simply a lifeless facade”

SDI Netherlands Simple back-to-back royalties arrangement Complication of cascading royalties

Northern Indiana (1995)Northern Indiana (1995)

NIPSCO

Finance (N.A.)

Eurobonds Market

Del Commercial Properties (1999)Del Commercial Properties (1999)Delcom

(Ca.)

Cayman

N.A.

DutchDel

Commercial (U.S.)

Bank Debt

Securities

Chose not to reform the residence article Avoids interference/respect cries

Rhetoric: A tax treaty is bilateral and not a treaty with the

whole world Allowing treaty benefits to others reduces U.S.

bargaining power in negotiating treaties with new countries

United States Treaty Policy ShiftUnited States Treaty Policy Shift

Technical explanation to U.S. Model Technical explanation to U.S. Model Income Tax Convention ¶282Income Tax Convention ¶282

“A treaty that provides treaty benefits to any resident of a Contracting State permits “treaty shopping”: the use, by residents of third states, of legal entities established in a Contracting State with a principal purpose to obtain the benefits of a tax treaty between the United States and the other Contracting State. … [T]his definition of treaty shopping does not encompass every case in which a third state resident establishes an entity in a U.S. treaty partner, and that entity enjoys treaty benefits to which the third state resident would not itself be entitled. If the third country resident had substantial reasons for establishing the structure that were unrelated to obtaining treaty benefits, the structure would not fall within the definition of treaty shopping set forth above.”

Technical explanation to U.S. Model Technical explanation to U.S. Model Income Tax Convention ¶283Income Tax Convention ¶283

“[T]he fundamental problem presented by this approach is that it is based on the taxpayer’s intent, which a tax administration is normally ill-equipped to identify. In order to avoid the necessity of making this subjective determination, Article 22 sets forth a series of objective tests. The assumption underlying each of these tests is that a taxpayer that satisfies the requirements of any of the tests probably has a real business purpose for the structure it has adopted, or has a sufficiently strong nexus to the other Contracting State (e.g., a resident individual) to warrant benefits even in the absence of a business connection, and that this business purpose or connection outweighs any purpose to obtain the benefits of the Treaty”

Limitation on Benefits: Article 22 Limitation on Benefits: Article 22 Prevention of Treaty Shopping:

Article 22 is included in the US model to prevent situation where treaties were abused by non-residents through “conduits” in the other treaty country.

Before the 1980's most US treaties did not contain elaborate anti-treaty shopping mechanisms and residents of third countries (with no treaty with the US) were able to use these treaties and get reduced withholding taxation. Beneficial ownership not a solution

The first important example was the German treaty

Article 22 of U.S. ModelArticle 22 of U.S. Model As of 1996, article 22 of the Model stated the

U.S. ideal No actual treaty has a limitation on benefits article

identical to the Model U.S. ideas about the article have evolved over time Most countries are unwilling to accept the article

exactly as the United States proposes it

HistoryHistory 1977 model applied only to certain types of income (interest,

dividends, royalties) Only if favorable treatment in residence state 75% ownership test / no base erosion test

1981 added base erosion test, and removed the favorable treatment in residence state requirement

1986 enactment of branch profits tax, yield to treaty only for qualified residents, based on tests similar to ownership/base erosion test

1989 German Treaty adds the active business test and the competent authority relief provision. Further specification of public company and base erosion tests

HistoryHistory 1992 landmark Dutch treaty – significantly more detailed

Partly because language transferred from technical explanation to treaty

New: extension of benefits to subsidiaries of public companies, headquarters companies for MNEs included in some cases, derivative benefits (70% EU) and EU activities attribution rule, and triangular cases (in protocol) Ex.: U.S.s will impose a 15% WHT on interest and royalties

paid to a Dutch PE in a third country if that country's tax on the interest and royalties, combined with any Dutch tax due on the same income, is less than 60% of the applicable Dutch corporate tax rate.

1996 Model incorporated all of the above to the modern provisions we know

HistoryHistory 2006 model:

substantiality determined solely on facts and circumstances – no safe harbor

Removed treaty interpretation to "connected with” or “incidental to“ – left to domestic law

look-through added to Art. 22(3)(c) for "activities conducted by persons connected to a person". "Connection" determined by facts and circumstances control standard, with 50% usually enough

The Public Company TestThe Public Company Test A resident company will qualify for treaty benefits, if

there is substantial and regular trading of its principal class of stock on an approved stock exchange located in one of the two treaty countries More than 50% vote and value

Recognized stock exchanges include NASDAQ and any U.S. exchange established under the Securities Exchange Act of 1934, exchanges in the other Contracting State (vary), and other exchanges to be agreed on by the competent authorities.

Subsidiaries of public companies qualify as well if owned 50% or more (each class) directly by the public company, or indirectly if all intermediate owners are eligible to treaty benefits

The Public Company TestThe Public Company Test The assumption is that most of the SHs are residents, yet

even if not, regulation of public companies make them unlikely to be used for tax avoidance

Used to be “all of the shares” – but that was too limited an exception

“regularly traded” defined under the domestic law the class of shares must be traded in more than de minimis

quantities on at least 60 days of the taxable year. aggregate number of shares traded - at least 10% of the average

number of shares outstanding during the year. Trading may take place on more than one recognized exchange

The Ownership/Base Erosion TestThe Ownership/Base Erosion Test The 1996 Model LOB clause requires at least 50%

of equity holders to be qualified residents and more than 50% of deductible payments to be paid to qualified residents. – because not only shs can benefit from investment in corp but also creditors etc..

The Ownership TestThe Ownership Test Test met if more than a specified percentage (50/75%)

of the beneficial ownership of a person that is a resident of a Contracting State under the Residence article is owned by persons truly connected with a Contracting State.

First step: apply domestic anti-abuse norms to determine ownership or beneficial ownership Norms such as the business purpose doctrine, the step-

transaction and substance-over-form doctrines, and conduit principles

The Ownership TestThe Ownership Test Second step: apply the treaty rule - Paragraph 2(f)(i) of

Article 22 applies to entities (other than individuals) at least 50% of each class of its shares or other beneficial

interests is owned, directly or indirectly (so long as intermediate

owners qualify) for at least half the days of the taxable year by residents of either contracting state who are Individuals residents, including U.S. citizens; a Contracting

State and qualified government entities; publicly traded companies or their qualified subsidiaries; certain exempt organizations (including pension trusts) that primarily benefit residents of a Contracting State , including pension trusts.

The Base Erosion TestThe Base Erosion Test The purpose is to determine whether the income derived

from the source State is in fact subject to such state’s tax regime.

An entity meets the base-erosion test if it does not make payments that are deductible for income tax purposes in the entity's state of residence paid or accrued, directly or indirectly, to persons other than

residents of either contracting state unless the payment is attributable to a PE in either State

in the amount of 50% or more of the entity's gross income for the taxable year. Defined under U.S. principles. Mentioned: “gross receipts less cost of goods

sold.”

Active Trade or Business TestActive Trade or Business Test Different from other tests that heavily focus on residence substitute for the more subjective “principal purpose”

test of earlier treaties. It attempts to somewhat objectify/make more precise the query about the business purpose behind the tested income generation

This test is based on the nexus of the entity's business activities to a Contracting State usually only relevant in cases in which an entity claiming

treaty benefits is not entitled to benefits under the ownership/base reduction or public trading tests

Subjective test, yet self-executing and does not require a competent authority ruling or approval

Active Trade or Business TestActive Trade or Business Test Article 22(3) of the 1996 Model

entity must be engaged in the active conduct of a trade or business

the income must be “connected with” or “incidental to” that trade or business, and

the trade or business must be “substantial in relation to” the activity generating the income

A company meeting all three prongs of the test will enjoy treaty benefits, but only with respect to the item(s) of income in question

must be applied item by item

Active Trade or Business TestActive Trade or Business Test Active trade or business - specific unified group of

activities that constitute or could constitute an independent economic

enterprise carried on for profit only if the officers and employees of the corporation conduct

substantial managerial and operational activities Points to sec. 367 regs.’ definition Excludes headquarters companies - Not including business of

making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company

Active Trade or Business TestActive Trade or Business Test “In connection with”

Income-producing activity must be a line of business that “forms a part of” or is “complementary to” the source country business It forms a part of such business if the two activities involve

the design, manufacture or sale of the same products or types of products, or the provision of similar services

It is complementary if they are “part of the same overall industry and related in the sense that the success or failure of one activity will tend to result in success or failure for the other

Active Trade or Business TestActive Trade or Business Test Alternatively - “incidental to”

facilitates the conduct of the trade or business in the source state

Example: investment of the T/B’s working capital Source country operations must be “substantial in

relation to” the income-producing activity. Note: in some treaties apply only to the “In connection with” test. All facts and circumstances Safe Harbor: the size of the source country business must be

more than 7.5% of the size of the income-producing activity, testing: asset value; gross income; payroll expenses

Active Trade or Business TestActive Trade or Business Test and the average of the three calculations for the

source country business must exceed 10% of the size of the residence country.

“value” is determined under the method the taxpayer uses to keep its books for financial reporting in its country of residence Technical explanation cites Treas. Regs. §1.884-5(e)(3)(ii)

(A). Tested only with respect to residence country

operations and proportinately to tested taxpayer’s holding

Do Tax Treaties with LOB Provisions Do Tax Treaties with LOB Provisions Infringe on EU Tax Law? Infringe on EU Tax Law?

LOB clauses in tax treaties concluded by the United States with Member States essentially ignore the MFN elements in the freedoms Subject to derivative benefits clauses

Open Skies judgments Nationality clauses similar to LOB ruled

incompatible with freedoms But, Matteucci (Case C235/87) – Cultural

Agreements.

Cont.Cont. The question became whether Tax Treaties LOB

are also incompatible with freedoms Malta (until recently..) No - ACT Group Litigation: nonresidents are not, as

such, comparable to residents (without prejudicing their entitlement to become so by exercising the ECT fundamental freedoms and rights) – from a source country perspective.

Distinguishing residence from nationality clauses – residence is open to foreign nationals..

Cont.Cont. Even in case of incompatibility must check whether

justifiable obstacle to one of the freedoms D-case: a member state is not under the obligation to

extend the benefits of its DTCs to nationals of non-contracting States, unless they are in a comparable situation (residents..) So, the same rule applies to both source and resident countries

Finally, it comes down to distinction between nationals (non residents) and residents No MFN in EU tax law

ConclusionConclusion Increase use of alternative treaty shopping

mechanisms, including LOB, not only by the United States

LOB language in the OECD Commentary The United States currently have treaties with LOB

with all EU member states (old treaty with Greece an exception).

Derivative benefits clauses relieve some pressure Taste for EU wide treaties or treaty negotiation?

In many applications, the rules overlap the coverage of limitation on benefit articles

When the conduit rules apply, they purport to trump all treaty provisions, including limitation of benefits articles

The conduit rules generally apply in back-to-back situations A loans money to B, and B loans the same amount,

on similar terms, to C

Conduit RegulationsConduit Regulations

The conduit rules only apply to “financing transactions,” which are Loans Leases Licenses A few other types of transactions

Financing TransactionsFinancing Transactions

The rules apply to “financing arrangements” which are series of transactions in which: One person (the financing entity) advances money,

property, or a right to use property and Another person (the financed entity) receives the

property The transfer is effected thru one or more other

persons (intermediate entities)

Financing ArrangementsFinancing Arrangements

An intermediate entity will be disregarded and a financing arrangement deemed to be between the financing entity and the financed entity if the participation of the intermediate entity (if given effect) reduces U.S. withholding tax,

The intermediate entity’s participation is for a tax avoidance purpose, and

The intermediate entity either Is related to the financing or financed entity or Participated in the transaction with the financed entity

only because of the transaction with the financing entity

ApplicationApplication

QuestionsQuestions Are the conduit rules consistent with the limitation of

benefits article of the treaty? The regs. say that they are interpreting these rules,

but this is technically problematic Are the rules a case of treaty override? If so, are they subordinate to limitation on benefits

articles of subsequent treaties? The conduit rules are prescribed by administrative

regulations, not statutes Can the U.S. Treasury override treaties by

regulations?

U.S. hybrid entity regulationsU.S. hybrid entity regulationsReduced treaty withholding rate for U.S. source income available only if income is “derived by” a foreign recipient “resident” in the treaty partner

The entity is not fiscally transparent under the laws of the entity’s jurisdiction; the interest holder establishes that the interest holder is not fiscally transparent under the law of its residence;The treaty partners have an agreement with respect to the treatment that is specified in the treaty