US and Ireland commence tax treaty renegotiation: what could change

by Amanda Varma, Steptoe & Johnson LLP

Ireland’s Department of Finance announced August 26 that Ireland and the United States have begun discussions regarding updating the US-Ireland tax treaty in light of the recently updated US Model Income Tax Convention (US Model) and the OECD’s base erosion and profit shifting (BEPS) project recommendations. Ireland has also opened a public consultation, requesting written comments on the US Model and aspects of the current US-Ireland tax treaty that may be of relevance to stakeholders.

This article identifies provisions the US is likely interested in updating by focusing on key differences between the current US-Ireland tax treaty, signed and ratified in 1997 and revised in 1999, and the 2016 US Model, which is the baseline text used by the US Department of Treasury when negotiating tax treaties.

Inversions

Given the number of US companies that have inverted to Ireland, Treasury is likely to seek to include in an updated US/Ireland tax treaty several 2016 US Model provisions that reduce the tax benefits of inversions.

The 2016 US Model denies treaty reductions of US withholding taxes on US source dividends, interest, royalties, and certain guarantee fees paid by US companies that are expatriated entities to certain related persons (generally, persons related by 50% ownership) for 10 years after the inversion.

Under US tax law, an expatriated entity includes a US corporation, or any related US corporation, that was a party to an inversion transaction after March 4, 2003, that resulted in the former US shareholders owning at least 60 percent but less than 80 percent in the new foreign parent. Thus, if the Model provision were incorporated in a new US-Ireland tax treaty, US source dividends, interest, royalties, and certain guarantee fees paid to Irish affiliates by US subsidiaries of inverted companies would generally be subject to 30% withholding tax.

Another 2016 US Model provision potentially impacting inverted companies requires a publicly-traded corporation to (a) have its principal class of shares primarily traded on a recognized stock exchange in its country of residence or (b) be primarily managed and controlled in its country of residence to qualify for treaty benefits. Inverted companies may remain traded on US stock exchanges and continue to conduct management activities from the United States.

The Model specifies that a company’s primary place of management and control is in the residence country only if the executive officers and senior management employees and their staff conduct more day-to-day strategic, financial, and operational policy decision-making and related activities in the residence state than in any other state.

Similar rules were included in the 2006 US Model, but the US-Ireland treaty, which pre-dates the 2006 Model, requires only that a publicly-traded company have its principal class of shares substantially and regularly traded on one or more recognized stock exchanges.

Special tax regimes

Treasury is also likely to seek to include in an updated treaty the 2016 US Model rules with respect to “special tax regimes” (STRs). The 2016 US Model would deny treaty benefits for interest, royalties, and certain guarantee fee payments between related parties if the beneficial owner of the payment benefits from an STR with respect to the payment.

Under the Model, the term STR includes any statute, regulation, or administrative practice that results in a preferential rate of taxation or permanent reduction in the tax base for interest, royalties, guarantee fees, as compared to income from sales of goods of services, that is generally expected to result in a rate of taxation that is less than the lesser of 15 percent or 60 percent of the general statutory corporate tax rate in the source country.

A practice will not be considered an STR until the other country issues a written public notification identifying the regime as satisfying the relevant requirements. In the case of royalties, a regime is not a STR if it conditions benefits on the extent of research and development activities that take place in the residence state, which would appear to exclude Ireland’s knowledge development box designed to meet the OECD modified nexus approach.

Withholding and changes in law

It is possible that, more generally, Treasury could be considering whether changes in Ireland’s tax law since 1997 call into question benefits extended in the current treaty, which generally reduces US withholding tax on US source payments from 30% to 0% in the case of interest, 5 or 15 percent in the case of dividends, and 0% in the case of royalties.

When the existing treaty was negotiated, Ireland’s corporate tax rate was generally comparable to the US corporate tax rate. Since then, Ireland’s corporate tax rate has been significantly reduced, which appears to be the type of situation motivating the 2016 US Model’s new “subsequent changes in law” provision.

That provision, as described in the preamble to the 2016 US Model, “obligates the treaty partners to consult with a view to amending the treaty as necessary when changes in the domestic law of a treaty partner draw into question the treaty’s original balance of negotiated benefits and the need for the treaty to reduce double taxation.”

LOB article

In addition to the publicly-traded test, mentioned above, the limitation on benefits article in the 2016 US Model differs in a number of respects from the current US-Ireland tax treaty. Two significant differences pertain to the intermediate owners and anti-base erosion tests.

Under the 2016 US Model, a subsidiary cannot qualify for benefits under certain tests (specifically, the subsidiary of a publicly-traded company, ownership/base erosion, and derivative benefits tests) unless, in the case of indirect ownership, each intermediate owner is a qualified intermediate owner (QIO).

To be a QIO, an intermediate owner generally must be a resident of the same state as the company seeking benefits or resident in a country with a treaty with the source state that includes provisions addressing STRs (and notional deductions, another new provision in the Model).

Given that no US tax treaties currently include such provisions, no entities with third-country intermediate owners could qualify for benefits as the Model is currently drafted. This would also have been the case under the subsidiary of a publicly-traded company and ownership/base erosion tests in the prior 2006 US Model, which required any intermediate owner to be resident in one of the contracting states (depending on the provision), but not under the current US-Ireland tax treaty (which contains no restrictions on intermediate owners) or most recent derivative benefits tests in US tax treaties.

If incorporated in a revised US-Ireland treaty, the base erosion tests in the 2016 US Model LOB article would narrow the class of payments not considered under the base erosion test. For example, the base erosion prong of the current US-Ireland treaty derivative benefits provision requires that deductible payments to persons other than residents of EU or NAFTA countries not exceed 50 percent of gross income, while the 2016 US Model derivative benefits test would require that less than 50 percent of a company’s gross income be used to make deductible payments to non-equivalent beneficiaries (or equivalent beneficiaries failing certain tests).

The current US-Ireland tax treaty ownership/base erosion test differs from the 2016 US Model in a similar fashion. The subsidiary of a publicly-traded company test of the 2016 US Model also contains a base erosion test (with respect to benefits other than dividends), while the analogous test in the current US-Ireland treaty contains no provision considering base erosion.

The 2016 US Model also contains various other provisions likely to be under discussion, including changes to the LOB article in addition to those discussed above, rules requiring mandatory binding arbitration in treaty disputes, and a new twelve-month ownership requirement for the five percent withholding rate on dividends.

Other US Treaty Developments

Ireland is the second country to announce publicly that it is discussions with the United States regarding updating the existing tax treaty. In July, Luxembourg and the United States released a joint statement that they are currently negotiating a protocol to amend a number of provisions in the current US-Luxembourg tax treaty, including the addition of a provision denying treaty benefits in so-called “triangular” cases where income is treated by the residence state as attributable to a permanent establishment outside the residence state and (a) is subject to little or no tax or (b) is excluded from the tax base of the residence country and attributable to a permanent establishment located in a third country that does not have a tax treaty with the source country.

As Treasury continues to work to update the US tax treaty network, the US Senate has not approved a tax treaty or protocol since 2010 even though several are pending before it, including agreements with Chile, Hungary, Japan, Luxembourg, Poland, Spain, and Switzerland.