A US district court has ruled that the IRS, specifically the US competent authority, acted reasonably when it denied a taxpayer’s request for discretionary tax treaty benefits under the US-Switzerland tax treaty. Accordingly, the court declined to set aside the IRS’s determination that the taxpayer was not entitled to a reduced withholding tax rate under the treaty.
The decision, Starr International Co. Inc. v. US, issued August 14 by the US District Court for the District of Columbia, is significant for its potential implications for pending and future taxpayer requests for discretionary benefits.
Starr International Company
In 2007, Starr International Company, Inc. (Starr), was a significant shareholder of American International Group, Inc. (AIG).
Starr had recently relocated to Switzerland from Ireland and, before that, Bermuda. Although Starr qualified as a resident under the US-Switzerland tax treaty, it did not meet the objective limitation on benefits tests in article 22 and thus sought a discretionary determination under article 22(6) from the US competent authority.
Such a determination would have permitted Starr to obtain a reduced rate of withholding on the dividends that Starr received from AIG.
Discretionary tax treaty benefits
Article 22(6) of the treaty states that a person not otherwise entitled to benefits under the objective tests may be granted benefits “if the competent authority of the State in which the income arises so determines after consultation with the competent authority of the other Contracting State.”
The Swiss treaty itself provides no standard for this determination; however, the Department of Treasury Technical Explanation of the treaty describes the criteria as follows:
“[W]hether the establishment, acquisition, or maintenance of the person seeking benefits under the Convention, or the conduct of such person’s operations, has or had as one of its principal purposes the obtaining of benefits under the Convention. Thus, persons that establish operations in one of the States with a principal purpose of obtaining the benefits of the Convention ordinarily will not be granted relief under paragraph 6.”
Starr sought discretionary relief under article 22(6) largely on the ground that it relocated to Switzerland for charitable considerations, not tax concerns.
In 2010, the competent authority denied Starr’s request for tax treaty benefits, determining that it could not conclude that obtaining treaty benefits was not at least one of the principal purposes for moving Starr’s management, and therefore its residency, to Switzerland.
Following the IRS’s denial of a claim for refund seeking the application of the lower tax treaty withholding tax rate, Starr filed a tax refund suit in the US District Court for the District of Columbia, contending that the competent authority had abused its discretion.
In September 2015, the district court concluded that the determination was reviewable because the treaty, read in conjunction with the Department of Treasury Technical Explanation, provided a manageable standard for determining whether the IRS abused its discretion.
However, following the government’s motion to reconsider, the court subsequently determined that it would be unable to grant monetary relief to the taxpayer.
The court explained that doing so would constitute an interference with the executive branch’s prerogative to engage in diplomatic consultation through the treaty process where the treaty requires consultation between the two competent authorities before discretionary benefits are granted.
The court did permit Starr to amend its complaint to have the IRS’s decision not to grant benefits set aside under the Administrative Procedure Act (APA).
The district court also explained, however, that it could not “preordain the result of the consultation process between the United States and Switzerland, which functions as a prerequisite to the granting of treaty benefits.”
As a result, the court warned that, even if Starr managed to prevail in its APA claim, “all Starr will have shown is that it is entitled to a remand to the IRS to reconsider its decision in light of this Court’s ruling.”
Starr subsequently re-filed its complaint. Both Starr and the IRS ultimately moved for summary judgment with respect to the following issues: (i) the proper legal standard for awarding treaty benefits under article 22(6) and (ii) whether the US competent authority reasonably applied this standard.
Article 22(6) standard
Starr argued generally that the treaty’s limitation on benefits provision is designed to combat “treaty shopping,” and treaty shopping always involves a third-country resident.
Thus, according to Starr, for purposes of the article 22(6) standard, treaty shopping covers only those situations where a third-country resident uses a treaty resident entity to secure treaty benefits.
Because Starr was domiciled in Switzerland and the owners of its beneficial interests and voting interests were, for the most part, either Swiss or American, in Starr’s view, the company could not have been treaty shopping and is thus entitled to relief under the treaty.
While the district court agreed with Starr’s “uncontroversial premise” that article 22, including its discretionary provision, was developed to combat treaty shopping, it rejected Starr’s “legalistic” conception of treaty shopping.
The district court concluded that Starr’s third-country-resident argument “cannot be squared with the text of the US-Swiss treaty or its accompanying agency guidance.”
Instead, according to the district court, “those authorities understand ‘treaty shopping’ as encompassing situations where an entity establishes itself in a treaty jurisdiction with a ‘principal purpose’ of obtaining treaty benefits.”
The district court thus reaffirmed that the proper standard for determining benefits under article 22(6) is the “principal purpose” test described in the Technical Explanation.
Application of principal purpose test
Starr claimed that the competent authority’s determination was arbitrary and capricious with respect to even the “principal purpose” standard because the competent authority relied on irrelevant facts and ignored material ones in reaching its determination.
However, the district court concluded that there was nothing arbitrary or capricious in the competent authority’s finding that “at least of one of the principal purposes” of Starr’s relocation to Switzerland was to obtain tax benefits under the US-Swiss tax treaty.
The district court found that certain “key evidence” relied on by Starr – in particular, a “decision matrix” outlining the four key criteria that the company analyzed in deciding where to move – actually revealed that US tax considerations were a top priority in selecting Starr’s new home.
The district court emphasized that Article 22(6) bestows significant discretion on the competent authority to “sift treaty shoppers from non-treaty shoppers.”
The court did not delve into the meaning of “principal purpose,” such as whether it might mean “a first purpose among equals,” as Starr argued, or instead an “important” purpose, finding it “inconsequential” as applied to the facts of the case.
Accordingly, the court declined to set aside the IRS’s determination under the APA.
Revenue Procedure 2015-40
Following Starr’s filing of a tax refund suit, and in connection with a broader update of the process for requesting assistance from the competent authority, the IRS issued Revenue Procedure 2015-40.
Revenue Procedure 2015-40 specifically states that, with respect to discretionary treaty benefit determinations, an applicant must demonstrate to the satisfaction of the competent authority that it does not qualify under the treaty’s objective limitation on benefits tests, it has a substantial non-tax nexus to the treaty country, and that, if benefits are granted, neither the applicant nor its direct or indirect owners will use the treaty in a manner inconsistent with its purposes.
The revenue procedure also lists certain situations in which the US competent authority typically will not exercise its discretion to grant benefits.
Discretionary benefits standard
In its prior decision, addressing whether the competent authority’s discretionary determination was subject to judicial review at all, the Starr court viewed the “one of its principal purposes” test in the Swiss tax treaty technical explanation as “an analogue to legislative history for treaty ratification” and a “meaningful standard” to enable a court to determine whether the IRS abused its discretion.
If the denial of a discretionary request made under the new revenue procedure were litigated, one could imagine a taxpayer contending that factors listed in an IRS revenue procedure, especially those not based on a particular treaty’s text or explanations, should not inform a court’s review.
Treasury’s 2016 US Model Income Tax Convention provides a standard for discretionary benefits that is generally consistent with the revenue procedure (taking into account the object and purpose of the treaty, whether the resident has demonstrated a substantial nontax nexus to the residence country, and the principal purpose standard), but that standard has not yet been incorporated into any US tax treaties.
Discretionary limitation on benefits rulings have generally been subject to thorough review by the competent authority (and the Office of Associate Chief Counsel (International), which is consulted in the process).
The Starr court notes in its decision that the competent authority spent 34 months before issuing a final determination letter denying Starr’s request for treaty benefits, with a “tentatively adverse” notification being made after 18 months.
Although the IRS ultimately prevailed on the merits (at least in the district court; an appeal by the taxpayer is still possible), the court’s earlier conclusion that court review is available under the APA still stands, likely causing a heightened internal IRS scrutiny—and corresponding extended time frame—for both favorable and adverse decisions.