by Julie Martin
US Treasury has published an updated US model tax treaty, making significant revisions to the text of draft treaty provisions released last May.
The 2016 US Model Income Tax Convention, published on Wednesday, will be used as baseline text by the Treasury Department when it negotiates tax treaties with other nations. It replaces a model tax treaty that has been in place since 2006.
Amanda Varma, a partner with Steptoe & Johnson, Washington, commended Treasury for first releasing the update in draft form for public comment and also for taking into account taxpayers’ concerns in the final model. She said that many of the changes provide more certainty to taxpayers and reduce the likelihood of disputes.
Varma said that modifications made to a draft provision on ‘subsequent changes in law’ are an example of how Treasury improved the draft in response to taxpayer concerns.
The draft version provided for termination of a treaty’s withholding tax rates if a country’s corporate tax rate falls below 15 percent and a treaty partner invokes the provision, Varma said. The revised provision, in article 28, now requires the treaty partners to first consult to determine whether amendments to the treaty are necessary to restore an appropriate allocation of taxing rights, she said.
Varma also said the revised provision better targets situations where the original balance of negotiated benefits has been significantly altered. “Now article 28 is triggered if a treaty country’s general rate of company tax falls below the lesser of 15 percent or 60 percent of the other country’s general rate of company tax,” she said.
Limitation on benefits
Varma said final text significantly changes the limitation on benefits (LOB) provisions of the May 2015 draft.
Included is a new ‘headquarters company’ test; revisions to the active trade or business test to consider whether income ’emanates from’ an active trade or business; relaxation of rules that consider intermediate ownership; and numerous changes to the derivative benefits provision, such as the elimination of a ‘cliff effect’ that might deny benefits entirely where third-country owners are eligible for treaty reductions but not as much as the treaty residents being tested, she said.
Michael J. Miller, a partner with Roberts & Holland, New York, said that changes made to the draft’s active trade or business test are particularly significant.
The May 2015 draft would have virtually eliminated the ability of a taxpayer to qualify as engaged in an active trade or business through the attribution of activities of a related person; the 2016 model no longer includes that restriction on attribution, said Miller.
Instead, the 2016 model requires a closer relationship between the active trade or business conducted in the country of residence and the item of income for which treaty benefits are sought, Miller explained.
Under the 2016 US model, the more lenient ‘derived in connection with’ standard is replaced by a stricter test that is met only if the item of income for which treaty benefits are sought ’emanates from’ the taxpayer’s active trade or business, he said.
Varma added that it would be helpful it Treasury clarifies the ’emanates from” test in the future Model Technical Explanation.
Miller said that the 2016 update made many changes to the 2006 model’s LOB article to restrict treaty access.
Treasury did add one very taxpayer-friendly change, though, namely, a ‘derivative benefits’ test which permits a company that otherwise fails the LOB tests to qualify for treaty benefits if, among other requirements, 95 percent of its shares are owned by seven or fewer ‘equivalent beneficiaries’ and the company meets a base erosion test.
Miller noted the provision has been included in US treaties in the past, but has never been part of the US model.
“It appears that derivative benefits provisions will now be ‘standard issue’ in the LOB article, which represents a substantial and favorable change in US treaty policy,” he said.
Moreover, Miller said, under the existing derivative benefits provisions in tax treaties, an equivalent beneficiary generally must be resident in a member country of the EU or a NAFTA country. The derivative benefits provision in the 2016 US model dispenses with these geographic restrictions, he said.
Low taxed income
Miller said the 2016 model includes a few new provisions that were not in the 2006 model and that are also not currently included in any US tax treaty. These provisions are premised on Treasury’s view that tax treaties should not allow non-taxed or low-taxed income, he said.
Under one of these provisions, tax treaty benefits are lost altogether for items of income attributable to a permanent establishment (PE) outside the taxpayer’s country of residence if the income is subject to a combined rate tax, in the taxpayer’s residence country and in the PE country, that is below a threshold.
“This rule for low-taxed income is a prime example of how Treasury intends to restrict treaty benefits from now on,” Miller said.
Special tax regimes, inversions, arbitration
Another new rule denies tax treaty benefits for certain payments, including interest, royalties, and guarantee fees, to a related person that benefits from a “special tax regime” with respect to the income, he said.
“Since the special tax regime results in a low rate of taxation in the taxpayer’s residence country, it is consistent with Treasury’s treaty policy to deny treaty benefits on the ground that there is an insufficient threat of double taxation,” Miller said.
The 2016 US model would also deny treaty benefits for certain payments, including dividends, interest, royalties, and guarantee fees, by an ‘expatriated entity’ to a related person for a 10-year period following the date of the corporate inversion transaction, he noted.
“This rule is not so much about Treasury’s current treaty policy as it is about punishing corporations that expatriate,” Miller said.
Varma also noted that the new model also includes a provision mandatory arbitration. This is a “very welcome addition,” she said. “Hopefully, over time, the inclusion of arbitration in treaties going forward will improve the treaty dispute resolution process, making it more likely that disputes will be resolved in a relatively timely manner,” she said.
– Julie Martin is a US tax attorney and a member of MNE Tax’s editorial staff.
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