The 2016 U.S. Model Income Tax Treaty in Action:U.S.-Luxembourg Protocol

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Edward Tanenbaum, Esq.

By Edward Tanenbaum, Esq. Alston & Bird LLP New York, New York

One of the stated purposes for U.S. Treasury's February 2016 release of the new 2016 U.S. Model Income Tax Treaty (“U.S. Model”) was to incorporate certain policy considerations of the Base Erosion and Profit Shifting (BEPS) initiative of the Organization for Economic Cooperation and Development. (The U.S. Model is Treasury's starting point for its negotiations with the treaty partners of the United States.)

Sure enough, on June 22, 2016, Treasury announced that the United States and Luxembourg were in the process of negotiating a protocol to the existing U.S.-Luxembourg Income Tax Treaty and that Luxembourg had introduced a bill in parliament with the text of an amendment to be included in the protocol relating to permanent establishments (PEs).

According to Treasury, the amendment reflects a critical component of its overall goal to prevent treaties from creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance. And in its own press release, Luxembourg indicated that, as a part of its commitment to take into account international tax developments, it chose to actively act against a possible situation of non-taxation that may result from the application of the bilateral tax treaty and from different interpretations of its provisions dealing with PEs.

In addition to containing provisions addressing “special tax regimes,” certain payments made by “expatriated entities,” subsequent changes in law, limitation on benefits, and Mutual Agreement Procedures, the U.S. Model in Article 1(8) addresses “exempt permanent establishments.”

Essentially, the provision denies treaty benefits for source State income paid to a PE (which is treated as such by an enterprise of the resident State) if: (1) the aggregate effective rate of tax in the PE State and the resident State is less than the lesser of 15% or 60% of the general applicable statutory company rate in the resident State; or (2) the PE is in a third jurisdiction that does not have a comprehensive tax treaty with the source State (unless the enterprise in the resident State includes the income attributable to the PE in its tax base). In such cases, the income may be taxed under the source State's domestic law. (As an exception, the Competent Authorities may grant benefits if they are justified.)

A number of our existing treaties already provide for a triangular PE rule of sorts. The classic fact pattern, for example, would be a foreign entity, resident of country X, a high-tax jurisdiction, which operates a branch in country Y, a low- or no-tax jurisdiction, and the foreign entity's branch receives U.S.-source income. Countries X and Y have a treaty pursuant to which the resident of country X is not taxed by country X on the receipt of the U.S.-source income to the extent it is attributable to a PE in country Y. (Alternatively, country X's domestic law does not tax income realized by the branch in country Y.) The result in this fact pattern is that little to no tax is paid in any foreign jurisdiction while at the same time the income is otherwise exempt from U.S. withholding tax under country X's treaty with the United States, a classic case of double non-tax.

Under these existing treaties, the inability to obtain U.S. tax benefits is lodged within the Limitation on Benefits (LOB) provisions. For example, Article 28(5) of the U.S.-Germany Income Tax Treaty provides that where an enterprise of a Contracting State (e.g., Germany) derives income from the other Contracting State (e.g., the United States), and the income is attributable to a PE the German enterprise has in a third jurisdiction, treaty benefits will not apply to that income if the combined tax actually paid in Germany and in the third jurisdiction is less than 60% of the tax that would have been payable in Germany if the income were earned in Germany and it were not attributable to the PE in the third jurisdiction. (The U.S.-Switzerland Income Tax Treaty has a similar provision.)

Under the provisions of those treaties, dividends, interest, and royalties will then be taxed at 15% and all other income would be subject to tax under the domestic laws of the source State notwithstanding any provision in the treaty to the contrary. Exceptions exist for royalties received with respect to intangibles produced or developed by the PE itself or, in the case of other income, if the income is derived from an active trade or business carried on by the PE in the third jurisdiction.

The U.S. Model, however, goes farther and does not limit the applicability of Article 1(8) to third-country jurisdictions. Thus, if the income is deemed by the resident Contracting State as attributable to a PE in the United States and is not taxed by that State — but the activities do not rise to the level of a PE under U.S. law, and the income is not otherwise subject to tax in the United States under the treaty — then the treaty provides that the income will be taxed under the domestic laws of the United States.

Unlike the existing treaties, there is no exception in Article 1(8) of the U.S. Model for an active trade or business and, further, treaty benefits are not simply reduced but, rather, are denied altogether. Moreover, if U.S.-source income is paid to a PE in a third jurisdiction and the third jurisdiction does not have a comprehensive treaty with the United States, then, even if the income is sufficiently taxed, treaty benefits will be denied (unless the enterprise in the resident State includes the income attributable to that PE in its tax base).

Clearly incentivized by BEPS, this protocol looks good for both Luxembourg and the United States (assuming it ever gets ratified) in terms of dealing with one particular high-profile issue of double non-taxation. Whether other (more complex) provisions of the new U.S. Model get a showing in upcoming treaty negotiations remains to be seen.

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