by David W. Powell and Kevin Walsh
The OECD on February 29 proposed changes to its model tax treaty which, if adopted, would add some clarity regarding the determination of residence of pension funds.
The OECD draft, titled “Concerning the Treaty Residence of Pension Funds,” would update the OECD Model Tax Convention, which serves as a model for OECD countries to use when negotiating tax treaties and designing their own tax treaty models.
The draft builds upon the OECD/G20 base erosion profit shifting (BEPS) plan final report under action six, “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances.” The OECD BEPS report concludes that work needs to be done to ensure that pension funds are considered resident in the state in which they are constituted for tax treaty purposes, including in cases where the pension fund benefits from a limited or complete tax exemption in that state.
Tax residence in one of the tax treaty party states is generally important for purposes of claiming the benefits of the treaty, such as exemption from or lowered withholding tax on dividends, interest, or royalties paid from an entity in one state to a pension fund in the other.
Currently, the OECD model does not include a special rule for determining whether a pension fund is a resident of a state. Two changes to the OECD model are proposed in the new draft.
First, the draft adds a definition of “recognized pension fund” to paragraph 1 of Article 3, as follows:
[T]he term “recognized pension fund” of a State means an entity or arrangement established in that State that is treated as a separate person under the taxation laws of that State and: (i) that is constituted and operated exclusively to administer or provide retirement or similar benefits to individuals and that is regulated as such by that State or one of its political subdivisions or local authorities; or (ii) that is constituted and operated exclusively to invest funds for the benefit of entities or arrangements referred to in subdivision (i).
Second, the draft amends the definition of the term “resident of a Contracting State” in paragraph 1 of Article 4 to add “a recognized pension fund of that state.”
The goal of these changes is to ensure that pension funds are considered residents of the state in which they are established. In the updated commentary, the draft makes clear that a broad definition of pension fund is used to capture the broad range of arrangements that provide pension benefits around the world.
“It does not matter whether the regulatory framework to which the entity or arrangement is subjected is provided in tax laws or in other legal instruments; what matters is that the entity or arrangement be recognized by law as a vehicle constituted to finance retirement benefits for individuals and be subject to conditions intended to ensure that it is used solely for that purpose,” the draft states.
The OECD is accepting comments generally, but has specifically invited comments on four parts of the new proposal:
- Does the phrase “that is treated as a separate person under the taxation laws of that State” adequately describe pension funds established in your state?
- Is the phrase “that is constituted and operated exclusively to administer or provide retirement or similar benefits” too restrictive given the normal operations of a pension fund?
- Are there examples of “benefits” that are typically granted by pension funds that would not be “similar benefits” to retirement benefits?
- Is the phrase “that is constituted and operated exclusively to invest funds for the benefit of entities or arrangements” too restrictive given the normal operations of an intermediary that invests on behalf of pension funds?
Residence of US pension funds
Changes to the OECD Model Tax Convention will likely have limited impact on the tax treatment of United States pension plans because the US has its own model tax treaty which was updated on February 17.
Unlike the OECD Model Tax Convention, however, the updated US model and its predecessor generally include a rule in the “limitation on benefits” article of the treaty which provides that a resident of a contracting state will not be entitled to treaty benefits otherwise accorded to residents of a contracting state unless such resident is a “qualified person.”
A “qualified person” in the case of a pension fund, requires that “more than 50 percent of the person’s beneficiaries, members or participants are individuals resident in either Contracting State.”
Another potential residence concern for pensions under the updated US model is that the definition of the term “pension fund,” where the fund is a group trust in which other pension funds invest, requires that the fund be “operated exclusively or almost exclusively … to earn income for the benefit of one or more persons established in the same Contracting State that are generally exempt from income taxation in that Contracting State and that are operated exclusively or almost exclusively to administer or provide pension or retirement benefits….” [Emphasis added]
Such trusts are commonly known as Revenue Ruling 81-100 trusts. The “almost exclusively” language would appear to preserve the ability of a group trust that includes plans qualified only in Puerto Rico (under ERISA section 1022(I)(1)) to qualify for treaty benefits as long as they do not constitute a significant number of the plans participating in that trust.
Because it is expected that the OECD will issue additional commentary when it finalizes its OECD Model Tax Convention, the new OECD draft provides an opportunity for pension funds and pension fund service providers to seek beneficial changes to the OECD Model Tax Convention. The OECD is accepting comments on until April 1. Comments on the updated US model tax treaty are being accepted by the US Treasury until April 18.
– David W. Powell and Kevin Walsh are attorneys at the Groom Law Group, a Washington DC law firm specializing in employee benefits.
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