US weighing changes to draft model tax treaty provisions, negotiating new treaty with Luxembourg

by Julie Martin

The US is considering changes to draft US Model Income Tax Convention provisions released last May, including several changes to provisions that deny tax treaty benefits to related party payments that are subject to a special tax regime (STR), US Treasury Associate International Tax Counsel, Quyen Huynh, said at the 28th Annual Institute on Current Issues in International Taxation, held December 17–18 in Washington.

Huynh also provided an update of US tax treaty negotiations, announcing that the US and Luxembourg are negotiating a new tax treaty.

Huynh told the conference that an updated version of the US model treaty will likely be published in early 2016. The US’s work revising the model’s limitation on benefits provision will inform OECD/G20 base erosion profit shifting (BEPS) work under action 6 on the same topic, expected to be released in February 2016, she said. The OECD deferred finalizing its work on limitation on benefits, Huynh said, to make certain that there are no unintended deviations between its work and the US model. The OECD work will not necessarily follow the US work, though, she said.

Huynh said that Treasury is considering revising draft provisions on STRs to require a country to provide notice to the other country before a tax regime can be considered an STR. She said that taxpayers have expressed concern that they may not know that a jurisdiction is an STR. “We don’t want our treaties to be uncertain,” she said.

Huynh noted the US has some concern that it will be difficult determine if a private tax ruling regime is an STR. She said it is possible that the OECD work on exchange of information on tax rulings will address this concern.

Huynh also said that Treasury is contemplating some changes to the STR exception applicable to royalties, which applies when a regime requires substantial activities to be conducted in the state to obtain benefits. The draft technical explanation currently provides that the substantial activity requirement will apply the standards adopted by the OECD Forum on Harmful Tax Practices, including the nexus approach for royalties, she noted.

Huynh said that while the US expects to continue to follow the OECD work on harmful tax practices to define substantial activity, it is also considering broadening the STR rules with respect to royalties to give the countries more flexibility to determine whether a regime is or is not a STR.

“Part of this rule is really to start the conversation with the other treaty partner to understand what regimes they do have in place, and which regimes we may or may not find offensive from the perspective of a source state ceding their taxing rights when the other jurisdiction is not necessarily imposing taxation,” Huynh explained.

John E. Hinding, Deputy to the Associate Chief Counsel (International) at the IRS, added that the US used the term “special tax regime,” as opposed to the OECD term “harmful tax practices,” to emphasize that STRs are different from harmful tax practices, even though there is overlap between the concepts.

Responding to questioning by Daniel M. Berman of RSM US, LLP, Huynh acknowledged that, as written, the draft model treaty clause provides that if the definition of a STR is met and a taxpayer receives other income, the taxpayer will be hit with the STR rule regardless of the type of other income received. Similarly, under current rules, Huynh said, if a taxpayer is benefiting from a STR for royalties, and if a particular royalty is paid that does not receive the benefit, the STR rule still applies to the payment.

Huynh said that both rules are being reconsidered. The US is reviewing the role that other income will play in an STR, and is also trying to tailor the STR rule so it applies only to an item of income that is benefiting from a particular STR, she said.

“We are thinking about paring back and looking at the objective and the scope of the treaty, so in cases where that particular item of income is subject to double taxation and does not benefit from the STR, then treaty may have a role to play in reducing and mitigating the double taxation that occurs,” Huynh said.

She noted, though, that changing the royalties provision may create difficulties with administrability. Upon receiving a royalty from a source state, a taxpayer may have difficulty figuring out if the particular royalty payment received benefited from an STR.

Huynh also said that Treasury is still planning to add proposed new article 28 on subsequent changes in law to the updated model. The provision would allow Treasury or its treaty partner to turn off some benefits of a tax treaty if the other country drops its corporate or individual tax rate below 15 percent or exempts “substantially all” foreign-source income.

Huynh said the goal of the clause to allow treaties to endure tax law changes and to facilitate the purpose of treaties, which is to reduce double tax. She said that if a country lowers its tax rate after it signs a treaty, this provision would create an incentive for the country return to the bargaining table to address its treaty partner’s concerns about the change in law.

The US would not in all cases issue a notice triggering denial of treaty benefits, Huynh said. There would need to be an evaluation as to whether the US could live with the changes or not, she said.

Huynh explained that one reason why the model tax treaty provisions were released in draft form was because that Treasury realized it was “cutting new cloth” in some of the provisions, particularly the STR rules and the rules under article 28. Both changes attempt to address situations where US treaties unintentionally create double nontaxation, she said.

Turning to draft model treaty provisions that deny treaty benefits with respect to payments from inverted companies, Huynh said that Treasury is “giving serious thought to” commentator requests to limit that rule to payments to related entities.

Huynh also said that she believed US will likely add to the 2016 US Model Income Tax Convention a statement providing that the treaty’s intent is to eliminate double taxation without creating opportunities for double nontaxation, following the BEPS agreements under action 6 concerning minimum standards for tax treaties. She said such a statement is consistent with current US policy.

Turning to treaty negotiations, Huynh announced that the US is in negotiations with Luxembourg regarding a new tax treaty. The parties will enter their third round of negotiations early next year, she said.

She also said that a tax treaty with Vietnam was signed on July 7 before official translations were complete. Once the translations are finished, the treaty will be transmitted to the Senate, she said.

Julie Martin is a US tax attorney and a member of MNE Tax’s editorial staff.

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