IRS Grants a Real Ruling on Hypothetical Treaty Benefits

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By James J. Tobin, Esq.  

Ernst & Young LLP, New York, NY


I've been thinking a lot about treaties lately.  Treaty
shopping/treaty abuse is the focus of Action 6 in the OECD Base
Erosion and Profit Shifting (BEPS) comprehensive action plan
(released July 19, 2013). And treaty benefit challenges, the
possible application of general anti-avoidance rule (GAAR)
principles to treaties, an increase in Limitation-on-Benefits
(LOB)-type rules, etc. are all happening, or at least are under
consideration, in many countries and are a big area of focus from a
risk agenda standpoint for many companies.

I actually have become a bit of a supporter of our U.S. Treasury
LOB approach to treaty eligibility, as I've indicated in prior
commentaries. U.S.-style LOB rules generally center on a pretty
clear set of criteria (ownership, business activities, and/or
derivative benefits) and are the outcome of bilateral negotiations
with prospective application. So what once seemed to me to be
complex and onerous now seems like the path forward when contrasted
with the potential application of after-the-fact, unilateral,
domestic-law GAAR rules that involve more subjective and undefined
intent factors and/or much more narrowly focused entity-based (as
opposed to broader affiliated-group level) business activity
requirements for treaty qualification. (Here I'm thinking, for
example, of the criteria set forth in China's Circular 601
regarding treaty qualification under the China GAAR rules.)

Having said that I'm starting to like the U.S. LOB approach
better, it still clearly is not perfect and it can be difficult to
apply with certainty as well. One wishes there were an effective
ruling procedure to rely on. As I've whined before, the complexity
of global business, the proliferation of multi-party ventures,
increasing global M&A activity, industry transformation, etc.
combine to make the traditional simple model of a parent company in
country X as the direct owner of a U.S. subsidiary and the direct
recipient of U.S. fixed or determinable annual or periodical income
(FDAP) less likely to be the fact pattern at issue today than in
the past. So the issue of treaty qualification for an income
recipient other than the parent or a home country affiliate is more
the norm and hence is a question that constantly needs

Given the need for greater certainty with respect to treaty
benefits, I was pleased to see the IRS release a recent CCA which
involves a potential treaty qualification issue - a rare event
indeed! CCA 201343019 involves qualification under the U.S.-Cyprus
Income Tax Treaty, although not specifically in the context of
applying the treaty to a U.S. payment but rather in the context of
qualification of dividends paid by a Cyprus corporation under
§1(h)(11), which provides for application of the reduced (now 20%)
capital gains tax rate to qualified dividends.

As an international tax guy with a limited investment profile, I
don't deal with the qualified dividend provisions much, if at all.
For other readers with a similarly limited focus, a dividend paid
by a qualified foreign corporation can qualify for the reduced tax
rate the same as a dividend from a U.S. corporation if, among other
criteria, such corporation is eligible for the benefits of a
comprehensive income tax treaty with the United States which the
Secretary determines is satisfactory and which includes an exchange
of information program. So the issue in the CCA was whether a
Cyprus corporation, a portion of the shares of which were owned by
a U.S. individual, would be eligible for the benefits of the
U.S.-Cyprus treaty so that the dividends it pays would qualify for
the reduced tax rate for the U.S. individual shareholder.

The interesting aspect of the CCA to me was the potential
application of the LOB provision in the U.S.-Cyprus treaty. Other
guidance issued by the IRS in connection with §1(h)(11)
(see Notice 2011-64) provides that the treaty
qualification test involves satisfying the specific treaty's LOB
requirements and for this purpose treating the foreign corporation
as though it were claiming treaty benefits even if it does not
actually derive income from the United States. In the situation in
the CCA, the Cyprus corporation in question had no U.S. assets or
U.S. income.

The LOB provision of the U.S.-Cyprus treaty is contained in
Article 26 - an older version of what is the modern multi-prong
U.S. LOB standard. The U.S.-Cyprus treaty provision requires that
the tested entity have more than 75% local ownership and that its
income not be subject to base erosion. However, there is a
principal purpose exception to this requirement under which treaty
benefits will be available "if it is determined that the
establishment, acquisition and maintenance of such person and the
conduct of its operations did not have as a principal purpose
obtaining benefits under the Convention."

The Cyprus corporation in the CCA had no local Cyprus ownership
so it did not qualify under the basic LOB provision.  The
facts stated in the CCA further provided that the Cyprus
corporation was established for reasons unrelated to the U.S.
treaty and that it had never earned U.S.-source income or claimed
benefits under the treaty.

The conclusion reached in the CCA was that the Cyprus
corporation qualified under the Cyprus treaty under the "no
principal purpose" provision and thus was considered a "qualified
foreign corporation" for purposes of §1(h)(11). A very interesting
result which seems correct to me. However, apparently this issue
had been in significant doubt.1 Concern has
existed under the language of Notice 2011-64 which requires the
foreign corporation in question to be treated as though it were
claiming treaty benefits.  Under this construct, the foreign
corporation could hypothetically be treated as having U.S.-source
income and then how could it prove a complete lack of motive for
accessing the U.S. treaty? Indeed, because it would only be the
hypothetical recipient of U.S.-source income, there would be no
guidance on how to weigh its relative hypothetical motives or
purpose in obtaining hypothetical U.S. treaty benefits on such
hypothetical income versus its actual business reasons for being
formed and maintained in the treaty country. Kind of a Catch 22
such that it seemed one might potentially never be able to rely on
a purpose test like the one in the Cyprus treaty to support
qualification under §1(h)(11). So all should be pleased with the
conclusion of the CCA which solves the Catch 22 dilemma in this
particular case.  Of course, a CCA is not formal precedent
(which more often than not I am happy about) and the language of
Notice 2011-64 still leaves the Catch 22 concern there for others.
Also the CCA does not elaborate on the non-U.S. commercial reasons
why the Cyprus corporation was formed or the size or location of
its business operations. I'm not sure those factors would or should
be relevant to the conclusion as the lack of U.S. assets would mean
the absence of a U.S. motivation regardless of the materiality of
the corporation's activities or the actual non-U.S. motive for
selecting the use of a Cyprus corporation.  Nonetheless, the
CCA is encouraging and provides a reasoned basis for a positive

An interesting question is whether the rationale for the
conclusion in the CCA could have broader application. As I
indicated, the U.S.-Cyprus treaty is an old one with a unique LOB
provision. However, several treaties have LOB provisions that allow
for discretionary relief in cases where the various objective tests
are not satisfied. Take, for example, the U.S.-Netherlands Income
Tax Treaty where Article 26(7) provides, "A person resident in one
of the States … may, nevertheless, be granted benefits of this
Convention if the competent authority of the State in which the
income arises so determines. In making such a determination, the
competent authority shall take into account as its guideline
whether the establishment, acquisition or maintenance of such
person or the conduct of its operations has or had as one of its
principal purposes the obtaining of benefits under this
Convention." A standard that sounds quite similar to the standard
in the U.S.-Cyprus treaty.  Note that it requires Competent
Authority determination, which is different than the provision in
the U.S.-Cyprus treaty, but the technical explanation makes clear
that such determination does not need to be obtained in advance.
Thus, I would think the CCA guidance and rationale should similarly
apply in an equivalent fact pattern. However, the Competent
Authority approval requirement could present another Catch 22
dilemma. If the Dutch company in question had no U.S. income or
treaty nexus, would the Competent Authority be willing to make a
determination at all?

Some of our other U.S. treaties, like the Barbados treaty,
provide for the possibility of discretionary relief but without
reference to a "no tainted purpose" fact pattern as an example of
when discretionary relief should be provided. So one would likely
be less encouraged in those cases and I would suggest those
treaties should be the focus of some guidance from the IRS.

Next one wonders whether the rationale of the CCA could be
extended from application of the qualified foreign corporation
requirement of §1(h)(11) to actual treaty qualification
itself.  For example, assume the Cyprus corporation in
question were a holding company with investments in multiple
countries in Europe and the Middle East, as is often the case. If
it also in the future acquires a U.S. investment, could one rely on
its long existence, its reasons for being, which were unrelated to
the U.S. treaty qualification, and its continued diversified
geographic investments, etc. to support the conclusion that it was
not established, acquired, or maintained for a principal purpose of
obtaining U.S. treaty benefits? In the right fact pattern this
would seem a reasonable conclusion to me.

I realize that my conclusion "in the right fact pattern" is a
subjective standard and I stated at the outset of this commentary
that I prefer more objective standards. However, this subjective
test would be an exception to disqualification that would be
available where the other objective treaty LOB tests were not
satisfied. So it gives the taxpayer another chance for
qualification where the facts are favorable. But it would be an
appropriately high standard to satisfy, which clearly was the case
for the Cyprus corporation at issue in the CCA. A subjective GAAR
that is applied as a government tool to disallow benefits based on
perceived bad motives, even when objective treaty or other tests
are satisfied, is the kind of subjective rule I take issue with.
And given the increasing prevalence referred to at the opening of
this commentary of cross-border M&A activity, multi-party joint
ventures, etc., another chance for qualification often would be
useful even if it requires application of a subjective test. So I
will repeat my plea for advance ruling procedures which would
benefit both taxpayers and tax authorities in providing certainty
regarding treaty qualification. And as this CCA has reminded me,
the taxpayers that would be benefited by such certainty are not
just corporations but also U.S. individuals, including the
proverbial widows and orphans, who have invested their hard-earned
savings in dividend-paying stock.

This commentary also will appear in the January 2014 issue
of the
 Tax Management International Journal. For
more information, in the Tax Management Portfolios, see Levine and
Miller, 936 T.M.
, U.S. Income Tax Treaties - The Limitation on
Benefits Article,  and in Tax Practice Series, see ¶7160,
U.S. Income Tax Treaties.



views expressed herein are those of the author and do not
necessarily reflect those of Ernst & Young LLP.

 See Rubinger and LePree, "When Is a Statutory
Benefit a `Treaty Benefit'? When IRS Says So!" 117 J. of
, No. 6 (Dec. 2012).

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