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By Kenneth J. Krupsky, Esq. Jones Day,Washington, DC
In recent years, Treasury has successfully renegotiated numerous U.S. income tax treaties to add or strengthen “Limitation on Benefits” (LOB) articles to curb avoidance of U.S. withholding taxes (and other evils) by means of “treaty shopping.” See Department of the Treasury Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties (Nov. 2007), at pp. 5-6. For example, modern LOB articles now discourage “conduit” financing transactions which seek to avoid U.S. withholding taxes and also “strip out” the tax base of the foreign treaty partner - where the lending party is resident - by means of deductible payments to related parties in non-treaty third countries. Not all U.S. treaties yet contain these articles, although the number of outliers is rapidly diminishing: the new Iceland treaty entered into force on December 15, 2008, and new treaties with Poland and Hungary are reportedly “in the works.”
In light of Treasury's success with LOB articles, whither the Regs. §1.881-3 anti-conduit regulations? Do we really need both of these anti-abuse regimes? As previously reported (see 38 TaxMgmt. Int'l J. 168 (3/13/09)), Treasury recently curbed certain conduit financing structures, involving foreign check-the-box entities, in a proposed clarification of the regulations (see REG-113462-08, 12/29/08). The Preamble says the government may issue additional guidance to address transactions where a foreign financing entity, typically resident in a non-treaty country, advances cash or other property to a foreign intermediate lender, resident in a treaty country, in exchange for a hybrid instrument that is treated as debt by the latter foreign country but as equity by the United States. The intermediate lender is not subject to the existing regulations, because it is funded with an instrument the United States regards as equity, although the same instrument erodes the tax base of the treaty partner because under local law it is treated as debt. And at least in some cases, the intermediate entity might “pass” the applicable LOB article (even a modern one). Query how many such cases there really are. But Treasury is concerned. How best to prevent such a hybrid instrument from facilitating treaty-shopping?
One suggested approach would likely be effective, but crude: treat each and every equity-funded foreign source of debt financing that claims a treaty-reduced rate of U.S. withholding as part of a “financing arrangement.” On first blush, this approach would appear to scrap Regs. §1.881-3(a)(2)(ii)(B), which treats only debt-like equity financing (and not true equity) as part of a financing arrangement, and might surprise treaty partners (especially those with modern LOB articles).
A second approach appears more elegant: adapt LOB ownership and base erosion concepts to test for regulatory conduit status. However, one might question whether imposing a second set of ownership and base erosion rules, by regulation, is a necessary or administrable solution to the perceived problem of hybrid instruments. As the Treasury describes this second approach, whether a foreign lender deserves a reduced treaty withholding rate might in the future depend on various factors indicating that “the financing entity has sufficient legal rights to, or other practical assurances regarding, the payment received by the intermediate entity to treat the stock as a financing transaction.” These factors could include the “intent of the parties to pay all or substantially all payments received by the intermediate” foreign lender to the financing entity - i.e., to the party the United States would view as the ultimate owner of the intermediate lender. Presumably, this rule - like LOB articles - would have application only where such payments reduce the taxable base of the jurisdiction in which the foreign intermediate entity is located. (The Canadian courts recently addressed quite similar issues in The Queen v. Prevost Car, Inc. (Fed. Ct. App., 2/26/09).)
If this importation of LOB concepts is to be adopted by regulation, resolution of some of the existing ambiguities and uncertainties of our LOB rules would surely be wise. Take, as just one thorny example, a non-publicly-traded, related-party lender resident in Luxembourg (Luxco) that is owned 2/3 by a private equity fund (Fund) resident in the Cayman Islands (and treated as a partnership for U.S. tax purposes) and 1/3 by a non-U.S., non-Luxembourgher individual (e.g., a Good Person of Szechwan). Fund itself is owned 1/2 each by a U.S. corporation (U.S. Corp) and a U.S. individual (U.S. Citizen). The Luxembourg treaty now contains a fairly typical LOB article. As relevant, the article provides that a company is a “qualified resident” if both ownership and base erosion conditions are satisfied. The ownership condition is satisfied if over 50% of the “principal class of shares” of Luxco are “ultimately owned” by other qualified residents or U.S. citizens. The base erosion provision is satisfied if less that 50% of the amounts paid to “qualified residents” or U.S. citizens for the taxable year “are deductible for income tax purposes in the company's state of residence (but not including arm's-length payments in the ordinary course of business for services or purchases or rentals of tangible property including immovable property).” Assume that at least 50% of the payments by Luxco to Fund and Good Person are treated by Luxembourg as deductible.
Applying the ownership condition, if the phrase “ultimately owned” is guided by U.S. principles - which it almost certainly should be, because the ultimate issue is a reduced rate of U.S. withholding - then the Fund would be treated as transparent and the ultimate owners of Luxco would be U.S. Corp, Good Person, and U.S. Citizen. Applying the base erosion condition is more difficult, because the treaty makes clear that Luxembourg law controls whether the payments by Luxco to Fund are “deductible.” Given that Luxembourg law controls deductibility, should Luxembourg law also control the question of “to whom” the deductible payments are made? For example, if under Luxembourg law the payments are treated as made to Fund, and Luxembourg law controls the application of the base erosion condition, then Luxco would fail that condition, because all of the payments that reduce the tax base in Luxembourg would be viewed as going to persons who are not qualified residents or U.S. citizens (i.e., Fund and Good Person). Alternatively, if U.S. law controls the question of “to whom” the base-eroding payments are made - or if Luxembourg law controls but treats Fund as transparent for this purpose - then Luxco would seem to satisfy the base erosion condition. Assuming that U.S. Corp is itself a “qualified resident,” then 2/3 of the payments go through Fund to either a qualified resident (U.S. Corp) or U.S. citizen.
But should one conclude that U.S. Corp is a qualified resident? Under the choice of law principle implicitly adopted above, because Luxembourg withholding is at stake with respect to payments by Luxco to Fund and Good Person, should not Luxembourg principles govern whether U.S. Corp satisfies the ownership or base erosion conditions? For instance, if Luxembourg and the United States have a different view of who “ultimately” owns U.S. Corp, as might be the case if U.S. Corp were financed through instruments that were treated as equity for U.S. purposes and debt for Luxembourg purposes, then Luxco might fail to be a qualified resident for purposes of a reduced rate of U.S. withholding, because U.S. Corp would fail to be a qualified resident for purposes of Luxembourg withholding. Similarly, if hybrid entities own U.S. Corp, Luxembourg might have a different vision of “to whom” the payment of deductible interest expenses are paid.
In sum, hybrid instruments raise conundrums under LOB articles quite frequently, because these articles are often ambiguous as to the proper choice of law with respect to the analytic steps required in applying the articles. Given these problems that hybrids pose for existing LOB articles, should the Treasury adopt similar rules to “solve” concerns raised by hybrid instruments under the conduit regulations? If the conduit regulations seek to tie the U.S. tax results to the foreign tax treatment, as is sometimes appropriate in the case of LOB articles, hybrid instruments that arguably create conduit results may continue to avoid the regulations.
This commentary also will appear in the July 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source Income to Foreign Persons,and Levine and Miller, 936 T.M., U.S. Income Tax Treaties -- The Limitation on Benefits Article, and in Tax Practice Series, see ¶7140, U.S. Income Tax Treaties, and ¶7150, Withholding and Compliance.
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