[Federal Register Volume 62, Number 127 (Wednesday, July 2, 1997)]
[Rules and Regulations]
[Pages 35673-35680]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-17467]
[[Page 35673]]
=======================================================================
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8722]
RIN 1545-AV33
Guidance Regarding Claims for Certain Income Tax Convention
Benefits
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Temporary regulations.
-----------------------------------------------------------------------
SUMMARY: This document contains temporary regulations relating to
eligibility for benefits under income tax treaties for payments to
entities. The regulations set forth rules for determining whether U.S.
source payments made to entities, including entities that are fiscally
transparent in the United States and/or the applicable treaty
jurisdiction, are eligible for treaty-reduced tax rates. The
regulations affect the determination of tax treaty benefits with
respect to U.S. source income of foreign persons. The text of these
temporary regulations also serves as the text of the proposed
regulations set forth in the notice of proposed rulemaking on this
subject in the Proposed Rules section of this issue of the Federal
Register.
DATES: These regulations are effective July 2, 1997.
These regulations apply to amounts paid on or after January 1,
1998.
FOR FURTHER INFORMATION CONTACT: Elizabeth Karzon, (202) 622-3860 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document contains temporary regulations relating to the Income
Tax Regulations (CFR part 1) under section 894 of the Internal Revenue
Code (Code).
Explanation of Provisions
These regulations prescribe rules for determining whether U.S.
source income paid to an entity is eligible for a reduced rate of U.S.
tax under an income tax treaty. The regulations are designed
principally to clarify the availability of treaty-reduced tax rates for
a payment of U.S. source income to an entity that is treated as
fiscally transparent, including a hybrid entity (i.e., an entity that
is treated as fiscally transparent in either (but not both) the United
States or the jurisdiction of residence of the person that seeks to
claim treaty benefits).
The regulations address only the treatment of U.S. source income
that is not effectively connected with the conduct of a U.S. trade or
business. Treasury and the IRS may issue additional regulations
addressing the availability of other tax treaty benefits, such as the
application of business profits provisions, with respect to income of
fiscally transparent entities.
Under the regulations, payments of U.S. source income to an entity
that is treated as fiscally transparent for U.S. federal income tax
purposes are eligible for reduced tax rates under a tax treaty between
the United States and another jurisdiction (the applicable treaty
jurisdiction) if the entity itself is a resident of the applicable
treaty jurisdiction, or if, and only to the extent that, the interest
holders of the entity are residents of the applicable treaty
jurisdiction and the entity is treated as fiscally transparent for
purposes of the tax laws of such jurisdiction.
Accordingly, payments of U.S. source income to an entity that is
treated as fiscally transparent for U.S. federal income tax purposes
but as non-fiscally transparent for purposes of the tax laws of the
applicable treaty jurisdiction are not eligible for a treaty-reduced
tax rate under the relevant treaty unless the entity itself is a
resident of the applicable treaty jurisdiction. Conversely, under the
regulations, a payment of U.S. source income to an entity that is
treated as non-fiscally transparent for U.S. federal income tax
purposes (other than a domestic corporation) is eligible for a reduced
tax rate under the relevant treaty if the entity itself is a resident
of the applicable treaty jurisdiction or if, and only to the extent
that, interest holders of the entity are residents of the applicable
treaty jurisdiction and the entity is treated as fiscally transparent
for purposes of the tax laws of such jurisdiction.
Under these temporary regulations, an entity is treated as fiscally
transparent by a jurisdiction only if the jurisdiction requires
interest holders in the entity to take into account separately their
respective shares of the various items of income of the entity on a
current basis and to determine the character of such items as if such
items were realized directly from the source from which realized by the
entity (for purposes of the tax laws of the jurisdiction). Accordingly,
entities treated as fiscally transparent by a jurisdiction are entities
subject in that jurisdiction to rules analogous to the U.S. rules
applicable to entities that are treated as partnerships for U.S.
federal income tax purposes.
These regulations are consistent with U.S. tax treaty obligations
and basic tax treaty principles. The regulations as applied to hybrid
entities are based on the principles discussed below. Treasury and the
Service will continue to coordinate these issues with U.S. tax treaty
partners in order to resolve any difficulty arising from the
application of the principles set forth in these regulations.
Problems Arising From Dual Classification
The United States generally applies its tax rules to determine the
classification of both domestic and foreign entities. When U.S. and
foreign laws differ on classification principles, a hybrid entity may
result. If income is paid to a hybrid entity, the entity may be
considered as deriving the income under U.S. tax principles (e.g., as
an association taxable as a corporation under U.S. tax principles), but
its interest holders, rather than the entity, may be considered to
derive the income under foreign tax principles (e.g., as an entity
equivalent to a U.S. partnership). This dual classification may give
rise to inappropriate and unintended results under tax treaties, such
as double exemptions or double taxation, unless the tax treaties are
interpreted so as to take into account the conflict of laws.
To avoid inappropriate and unintended tax treaty results with
respect to payments to hybrid entities, these regulations rely on the
basic principle that income tax treaties are designed to relieve double
taxation or excessive taxation. This objective is generally achieved
with provisions in treaties that limit the tax that a country may
impose on income arising from sources within its borders to the extent
that the income is derived by a resident of a jurisdiction with which
the source country has an income tax treaty in effect (an applicable
treaty jurisdiction). However, the agreement by the source country to
cede part or all of its taxation rights to the treaty partner is
predicated on a mutual understanding that the treaty partner is
asserting tax jurisdiction over the income. Stated simply, tax treaties
contemplate that income relieved from taxation in the source country
will be subject to tax in the treaty country. This principle is central
to the interpretation of treaty provisions in determining the extent to
which payments received by a hybrid entity are eligible for benefits
under tax treaties. Some treaties have specific rules reflecting this
principle that are helpful in deciding how the treaties should be
applied in such cases. However, the lack of specific rules in a
[[Page 35674]]
treaty does not suggest that this principle does not apply under that
treaty.
In order to implement this principle, virtually all U.S. income tax
treaties limit the eligibility for treaty benefits on the condition
that the person deriving the income must be a resident of the
applicable treaty country. Typical of this condition, for example, is
Article 12 of the U.S.-German treaty, which provides that ``Royalties
derived and beneficially owned by a resident of a Contracting State
shall be taxable only in that State.'' Sometimes, the term paid to is
used instead of the term derived by. However, those terms are used
interchangeably and a different choice of words does not indicate that
a different result is intended. Generally, a resident is defined as a
person who is liable to tax in the treaty country as a resident of that
country. See, for example, Article 4.1 of the U.S.-German tax
convention, which provides that ``the term `resident of a Contracting
State' means any person who, under the laws of that State, is liable to
tax therein by reason of his domicile, residence, place of management,
place of incorporation, or any other criterion of a similar nature * *
*.''
Limiting eligibility for treaty benefits to residents provides
assurance to the source country that, when it limits its taxation
rights on income arising from within its borders, it does so with the
expectation that the income derived by a resident of the treaty country
is subject to tax in the residence country.
Application of Principle to Hybrid Entities Generally
Based on the typical residence provisions of U.S. tax treaties, if
income is paid to an entity that is treated as fiscally transparent in
the treaty country in which it is organized, the entity itself is not
eligible for benefits under the applicable treaty because it is not a
resident of the treaty country (i.e., by virtue of not being liable to
tax in that country). Whether the entity is a resident of the treaty
country is determined under the laws of that country and not under the
laws of the source country. This observation is important if the entity
is a hybrid (i.e., an entity that is treated as fiscally transparent in
one jurisdiction and treated as non-fiscally transparent in another
jurisdiction). If the entity, treated as fiscally transparent in the
treaty country, is treated as a taxable entity in the source country,
the entity is considered by the source country as being liable to tax.
However, this determination under the source country tax laws does not
render the entity a resident of the treaty country. In order for the
entity to be a resident of the treaty country, it must be liable to tax
in that country, as determined under the laws of that country.
Where the entity is not eligible for treaty benefits (for lack of
residence in the treaty country), there is a question as to whether the
owners of the entity may be eligible for benefits under an applicable
income tax treaty. As stated above, the guiding principle is that
income is eligible for a rate reduction or an exemption in the source
country if ``derived by'' or ``paid to'' a resident of that country.
Where the entity is treated as fiscally transparent, the question is
whether the income can be considered ``derived by'' or ``paid to'' the
owner of the entity.
If the entity is treated as fiscally transparent by all tax
jurisdictions involved (i.e., the source country, the country where the
entity is organized, and the country where the owners are resident), it
is well established under U.S. income tax treaties that the entity is
ignored and a look-through approach is intended, with the result that
the entity's owners are treated as the persons who derive the income.
This result is consistent with the general principle that eligibility
for treaty benefits is conditioned upon the income being subject to tax
in the treaty country as the income of a resident of that country. In
fact, some treaties clarify this point. For example, Article 4.1(b) of
the U.S.-German income tax convention provides, like several other U.S.
tax conventions, that ``in the case of income derived or paid by a
partnership, estate, or trust, this term [resident] applies only to the
extent that the income derived by such partnership, estate, or trust is
subject to tax in that State [the State other than the source State] as
the income of a resident, either in its hands or in the hands of its
partners or beneficiaries.'' Further, even where no provisions are
included, the Technical Explanation sometimes explains that the look-
through rule applies without the need for a specific provision. See the
U.S. Treasury Department's Technical Explanation of U.S.-Japan Income
Tax Convention signed March 8, 1971, Article 3 (Fiscal Domicile).
Application of Principle to Reverse Hybrid Entity
If an entity is a ``reverse'' hybrid entity, meaning that it is
treated as a taxable entity under the tax laws of the source country
but as a fiscally transparent entity in the applicable treaty country,
a conflict arises because, under the source country's tax laws, the
entity's owners are not treated as deriving the income. Yet, under the
tax laws of the jurisdiction where the entity's owners are resident,
the owners are treated as deriving the income paid to the entity. Thus,
the question is whether the source country's laws or the laws of each
owner's jurisdiction of residence should govern the determination of
who is the person deriving the income for tax treaty purposes. Making
that determination under the tax laws of the applicable treaty
jurisdiction where the owners are resident leads to results consistent
with the principle discussed earlier that the source country cedes its
tax jurisdiction to the treaty partner based on the understanding that
the treaty partner asserts tax jurisdiction over the income by insuring
that it is taxable in the hands of a resident. In this case, the
entity's owners are resident in a treaty country that treats them as
liable to tax on the items of income paid to the entity. On the other
hand, applying the tax laws of the source country would lead to results
inconsistent with that principle. In other words, tax benefits would be
denied under the applicable treaty (because, under the source country's
tax laws, the entity's owners are not treated as deriving the income
paid to the entity), even though the income arising in the source
country is subject to tax in the hands of persons who are resident in
the applicable treaty jurisdiction.
Application of Principle to Regular Hybrid Entity
The same principle applies to a ``regular'' hybrid entity, i.e., an
entity that is treated as fiscally transparent in the source country
and as a non-fiscally transparent entity in the applicable treaty
jurisdiction. If the entity is organized in a treaty jurisdiction, the
applicable treaty with that country generally would treat the entity as
a resident. Therefore, under that treaty, the entity should be eligible
for treaty benefits as an entity deriving the income as a resident of
the treaty jurisdiction. On the other hand, the entity's owners who are
resident in that jurisdiction (or in any other jurisdiction that treats
the entity as non-fiscally transparent) should not be eligible for
treaty benefits under that treaty (or a treaty with the country where
they are resident that treats the entity as non-fiscally transparent).
This result should occur irrespective of the fact that the source
country considers that the taxpayers with respect to the income are the
entity's owners and not the entity (by virtue of treating the entity as
fiscally transparent under its own tax laws). Again, applying the laws
of the
[[Page 35675]]
applicable treaty jurisdiction to determine whether the entity or its
owners are deriving the income as residents of that country leads to
results consistent with the basic principle that the source country
cedes its tax jurisdiction over income to the extent the income is
subject to tax in the hands of a resident of the applicable treaty
country.
Applying the tax laws of the source country to determine the person
deriving the income for treaty purposes would not only be inconsistent
with the basic principle that income should be treated as derived by
the person in the treaty country who is liable to tax on that income,
it also potentially leads to tax avoidance under tax conventions,
including an inappropriate double exemption. For example, if the entity
does not fall within the taxing jurisdiction of the applicable treaty
jurisdiction (e.g., because the entity is organized in a third country
or as a fiscally transparent entity in the source country), the income
could be eligible for a treaty-reduced tax rate in the source country
and yet not be subject to tax in the jurisdiction where the owners are
resident.
In such a case, the owners may eventually be taxed on the income
when the entity makes a distribution of the income derived from the
source country. The Treasury and IRS believe that the potential for
later taxation should not affect the results under the treaty for two
reasons: First, the interposition of a hybrid entity between the income
and the owner of the entity allows the taxation event in the treaty
jurisdiction to be deferred, perhaps indefinitely; second, the income,
when distributed or deemed distributed (for example, pursuant to anti-
deferral rules of the treaty jurisdiction), may be transformed. In
other words, the income derived by the partner will be treated in the
partner's residence country as a distribution (or deemed distribution)
of profits from the entity and not as the type of income derived by the
entity from the source country. This disparity in treatment may lead to
a double exemption if, for example, the dividend distribution is exempt
from tax in the country where the entity's owners reside due to double
tax relief or a corporate integration regime that grants preferential
tax treatment to corporate distributions. Interpreting conventions in a
way that allows such a double exemption would not be consistent with
the primary goal of treaties to relieve double or excessive taxation.
This is especially true where, as is the case here, an alternative
interpretation exists that would produce results consistent with basic
tax convention principles.
Certain taxpayers have expressed the view that this analysis of the
treatment of payments to hybrid entities under tax treaties is
inconsistent with the treatment of so-called hybrid securities that are
treated differently under the tax laws of the source country and the
relevant treaty jurisdiction (e.g., an instrument that is treated as a
debt instrument in the source country but as an equity interest in the
relevant treaty jurisdiction). In certain cases, the use of hybrid
securities can lead to double exemptions, analogous to the double
exemptions possible with respect to ``regular'' hybrid entities, based
on the availability of an exemption from tax in the relevant treaty
jurisdiction. Treasury and the IRS recognize that hybrid securities can
produce inappropriate and unintended results under income tax treaties.
Although the residence concept of tax treaties, which incorporates the
basic ``subject to tax'' principle, generally is satisfied with respect
to payments on a hybrid security for the reasons discussed above,
Treasury and the IRS are considering whether inappropriate and
unintended tax treaty consequences, including both double exemptions
and double taxation, can arise with respect to hybrid securities and,
if so, what alternative avenues exist for addressing them.
The hybrid entity analysis applies regardless of where the entity
is organized and where the owners are resident. One example involves an
entity organized in one country and owned by persons residing in a
third country. If the third country and the source country treat the
entity as fiscally transparent, both the source country and the third
country can ignore the entity for purposes of granting treaty benefits
under the third country's convention with the source country. In such a
case, the entity's owners resident in the third country are treated as
deriving the income received by the entity, under both the source
country tax laws and the tax laws of the third country. In a three-
country situation, there may also be simultaneous application of two
treaties to the same flow of income: the treaty with the country where
the entity is organized, and the treaty with the country where the
entity's owners are resident.
The analysis applicable to fiscally transparent entities does not
depend on whether the entity has multiple owners or a single owner.
Accordingly, the analysis applies to a wholly-owned entity that is
disregarded for federal tax purposes as an entity separate from its
owner.
Application of Principle to Entity Organized in Source Country
The same analysis generally applies to entities organized in the
source country. If both the source country and the treaty jurisdiction
where the entity's owners are resident treat the entity as fiscally
transparent, then the entity is ignored and the eligibility for treaty
benefits is tested at the owners' level. If the entity, however, is
treated as non-fiscally transparent in the treaty jurisdiction, then
the income is not treated by the treaty jurisdiction as being derived
by the owners. Therefore, the owners are not eligible for benefits
under the treaty since they are not deriving the income for purposes of
the applicable treaty.
Taxpayers may argue that treaty benefits should be allowed to the
owners residing in the treaty country because, viewed from the source
country's point of view, the owners are deriving the income from the
source country and are resident in the treaty country. While the
provisions in current treaties do not explicitly provide for this
situation, the situation raises exactly the same issues as in the cases
discussed above. For this purpose, it is immaterial that the entity is
organized in the country of the owner, in a third country, or in the
source country.
The analysis does not apply, however, if the entity is a reverse
hybrid organized in the United States because, in such a case, the
United States treats the entity as a corporate entity, liable to tax in
the United States at the entity level. The right of the United States
to tax a domestic corporation is established under the ``savings
clause'' of all U.S. tax treaties which preserves the right of the
United States to tax its residents and citizens under its domestic law.
Distributions from a domestic corporation that is a reverse hybrid are
also subject to U.S. tax in the hands of the foreign owners who are
treated as shareholders for U.S. tax purposes.
Beneficial Ownership
The principles relied upon in these temporary regulations are
consistent with the proposed withholding tax regulations issued under
Secs. 1.1441-1(c)(6)(ii)(B) and 1.1441-6(b)(4) regarding claims of
treaty-reduced withholding rates for U.S. source payments through
foreign entities. The temporary regulations, however, do not utilize
the same terminology as the proposed withholding tax regulations.
The proposed withholding tax regulations condition eligibility for
treaty-based withholding rates for payments to an entity on a
[[Page 35676]]
determination of ``beneficial owner'' status for the entity or the
interest holders of the entity pursuant to the laws of the applicable
treaty jurisdiction. Accordingly, under the proposed withholding tax
regulations, the term beneficial owner functions as a surrogate for the
principle that a person is eligible for tax treaty benefits with
respect to a payment received by an entity only if the person is a
resident with respect to such payment.
The term beneficial owner as used in the proposed withholding tax
regulations may be confusing because this term has other meaning in the
tax treaty context. Accordingly, the temporary regulations do not
utilize the term beneficial owner in the same manner as the proposed
withholding regulations. Rather, they condition eligibility for treaty-
reduced tax rates for income paid to an entity on a determination that
the income is ``treated as derived by a resident'' of the applicable
treaty jurisdiction. Like the determination of beneficial owner status
required in the proposed withholding tax regulations, the determination
of whether a payment to an entity is ``treated as derived by a
resident'' is determined under the principles in effect under the laws
of the applicable treaty jurisdiction. Treasury and the Service intend
to conform the final withholding tax regulations to the temporary
regulations.
The temporary regulations reflect the fact that the concept of
beneficial ownership is an important separate condition for claiming
tax treaty benefits. In order to address difficulties where the
recipient acts as a ``nominee'' or ``conduit'' for another person or in
other situations involving a disconnect between legal and economic
ownership, most income tax treaties require that the resident be a
beneficial owner of the income. This requirement is entirely separate
from the beneficial ownership requirement with respect to U.S. source
payments to foreign entities reflected in the proposed withholding tax
regulations and the residence requirement with respect to U.S. source
payments to all entities reflected in these temporary regulations. As
used in tax treaties, the term beneficial owner is meant to address
``conduit'', ``nominee'' and comparable situations in which the person
receives the payment in form (and may even be taxed on that income in
the jurisdiction in which it resides), but is nevertheless not treated
as beneficially owning the income for purposes of a particular treaty
because, under the beneficial owner rules of the source country, the
income is deemed to belong to another person who is determined to have
a stronger economic nexus to the income. See, for example, section
7701(l) and Secs. 1.7701(l)-1(b) and 1.881-3. Thus, the temporary
regulations utilize the term beneficial owner in a manner consistent
with the treaty approach.
Mutual Agreement
Treasury and IRS intend that the principles of the regulations
should be applied in a reciprocal manner by U.S. tax treaty partners.
For this reason, the regulations include a special rule that provides
that, irrespective of any contrary rules in the regulations, a reduced
rate under a tax treaty for a payment of U.S. source income will not be
available to the extent that the applicable treaty partner does not
grant a reduced rate under the tax treaty to a U.S. resident in similar
circumstances, as evidenced by a mutual agreement between the relevant
competent authorities or a public notice of the treaty partner. Denial
of benefits under this provision would be effective on a prospective
basis only.
Effective Date
The temporary regulations apply on a prospective basis only to
amounts paid on or after January 1, 1998. Withholding agents should
consider the effect of these regulations on their withholding
obligations, including the need to obtain a new withholding certificate
to confirm claims of treaty benefits for payments made on or after the
effective date. Treasury and the IRS recognize that the applicable
principles for determining eligibility of reduced treaty rates for
income paid to hybrid entities may have been uncertain in the past.
Accordingly, the IRS does not intend to challenge any claim of treaty
benefits for payments to hybrid entities made before the effective date
of these regulations on the basis that the claim was based on
principles inconsistent with those upon which these regulations are
based.
Special Analyses
It has been determined that these temporary regulations are not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations and, because these regulations do
not impose on small entities a collection of information requirement,
the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.
Therefore, a Regulatory Flexibility Analysis is not required. Because
of rapidly increasing use of hybrid entities for cross-border
transactions, immediate guidance is needed on rules for determining
whether U.S. source payments made to entities, including entities that
are fiscally transparent in the United States and/or the applicable
treaty jurisdiction, are eligible for treaty-reduced tax rates.
Therefore, good cause is found to dispense with the notice requirement
of section 553(b) of the Administrative Procedure Act. Pursuant to
section 7805(f) of the Internal Revenue Code, these regulations will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority for part 1 continues to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Sec. 1.894-1T is added to read as follows:
Sec. 1.894-1T Income affected by treaty (temporary).
(a) through (c) [Reserved]. For further guidance, see Sec. 1.894-
1(a) through (c).
(d) Determination of tax on income paid to entities--(1) In
general. The tax imposed by sections 871(a), 881(a), 1461, and 4948(a)
on a payment received by an entity organized in any country (including
the United States) shall be eligible for reduction under the terms of
an income tax treaty to which the United States is a party if such
payment is treated as derived by a resident of an applicable treaty
jurisdiction, such resident is a beneficial owner of the payment, and
all other applicable requirements for benefits under the treaty are
satisfied. A payment received by an entity is treated as derived by a
resident of an applicable treaty jurisdiction only to the extent the
payment is subject to tax in the hands of a resident of such
jurisdiction. For this purpose, a payment received by an entity that is
treated as fiscally transparent by the applicable treaty jurisdiction
shall be considered a payment subject to tax in the hands of a resident
of the jurisdiction only to the extent that the interest holders in the
entity are residents of the jurisdiction. For purposes of the preceding
sentence, interest holders shall not include any
[[Page 35677]]
direct or indirect interest holders that are themselves treated as
fiscally transparent entities by the applicable treaty jurisdiction. A
payment received by an entity that is not treated as fiscally
transparent by the applicable treaty jurisdiction shall be considered a
payment subject to tax in the hands of a resident of such jurisdiction
only if the entity is itself a resident of that jurisdiction.
(2) Application of beneficial ownership requirement in respect of
certain payments received by entities--(i) Entities treated as fiscally
transparent for U.S. tax purposes. An entity that is treated as
fiscally transparent under the laws of the United States and that is
resident in an applicable treaty jurisdiction shall be treated as the
beneficial owner of a payment if the entity would be treated as the
beneficial owner if it were treated as nonfiscally transparent by the
United States.
(ii) Entity's owners as beneficial owners--(A) A resident of an
applicable treaty jurisdiction that derives a payment received by an
entity that is fiscally transparent under the laws of the applicable
tax jurisdiction shall be treated as the beneficial owner of the
payment unless--
(1) Such resident would not have been treated as the beneficial
owner of the payment had such payment been received directly by the
resident; or
(2) The entity receiving the payment is not treated as a beneficial
owner of the payment.
(B) For example, persons residing in treaty Country X and treated
under the laws of Country X as interest holders in a fiscally
transparent entity created under the laws of Country Y are treated as
the beneficial owners of the payments received by the entity from
sources within the United States unless the interest holders would not
have been treated as beneficial owners had they received the payment
directly (e.g., the partners act as nominees or conduits for other
persons). However, if the entity itself is acting as a nominee or
conduit for another person and, therefore, is not itself a beneficial
owner, then none of the interest holders can be treated as beneficial
owners, even if the interest holders own their interests in the entity
as beneficial owners. For this purpose, the determination of whether a
person is a beneficial owner of a payment shall be made under U.S. tax
laws.
(3) Application to certain domestic entities. Notwithstanding
paragraph (d)(1) of this section, an income tax treaty may not apply to
reduce the amount of tax on income received by an entity that is
treated as a domestic corporation for U.S. tax purposes. Therefore,
neither the domestic corporation nor its shareholders are entitled to
the benefits of a reduction of U.S. income tax on income received from
U.S. sources by the corporation.
(4) Definitions--(i) Entity. For purposes of this paragraph (d),
the term entity shall mean any person that is treated by the United
States or the applicable treaty jurisdiction as other than an
individual.
(ii) Fiscally transparent. For purposes of this paragraph (d), an
entity is treated as fiscally transparent by a jurisdiction to the
extent the jurisdiction requires interest holders in the entity to take
into account separately on a current basis their respective shares of
the items of income paid to the entity and to determine the character
of such items as if such items were realized directly from the source
from which realized by the entity (for purposes of the tax laws of the
jurisdiction). Entities that are fiscally transparent for U.S. federal
income tax purposes include partnerships, common trust funds described
under section 584, simple trusts, grantor trusts, as well as certain
other entities (including entities that have a single interest holder)
that are treated as partnerships or as disregarded entities for U.S.
federal income tax purposes.
(iii) Applicable treaty jurisdiction. The term applicable treaty
jurisdiction means the jurisdiction whose income tax treaty with the
United States is invoked for purposes of reducing the rate of tax
imposed under section 871(a), 881(a), 1461, and 4948(a).
(iv) Resident. The term resident shall have the meaning assigned to
such term in the applicable income tax treaty.
(5) Application to all income tax treaties. Unless otherwise
explicitly agreed upon in the text of an income tax treaty, the rules
contained in this paragraph (d) shall apply in respect of all income
tax treaties to which the United States is a party. However, a reduced
rate under a tax treaty for a payment of U.S. source income will not be
available irrespective of the provisions in this paragraph (d) to the
extent that the applicable treaty partner would not grant a reduced
rate under the tax treaty to a U.S. resident in similar circumstances,
as evidenced by a mutual agreement between the relevant competent
authorities or by a public notice of the treaty partner. The Internal
Revenue Service shall announce the terms of any such mutual agreement
or treaty partner's position. Any denial of tax treaty benefits as a
consequence of such a mutual agreement or treaty partner's position
shall affect only U.S. source payments made after announcement of the
terms of the agreement or of the position.
(6) Examples. This paragraph (d) is illustrated by the following
examples. Unless stated otherwise, each example assumes that all
conditions for claiming a treaty-reduced tax rate under a U.S. income
tax treaty with respect to a payment of U.S. source income are
satisfied (other than the condition that the income is treated as
derived by a resident of the applicable treaty jurisdiction), including
the beneficial ownership requirement and all requirements relating to
applicable limitation on benefits provisions. The examples are as
follows:
Example 1. (i) Facts. Entity A is a business organization formed
under the laws of Country X that has an income tax treaty with the
United States. Under the laws of Country X, A is liable to tax at
the entity level. A is treated as a partnership for U.S. income tax
purposes and receives royalties from U.S. sources that are not
effectively connected with the conduct of a trade or business in the
United States. Some of A's partners are resident in Country X and
the other partners are resident in Country Y. Country Y has no
income tax treaty in effect with the United States. Article 12 of
the U.S.-X tax treaty provides that ``royalties derived from sources
within a Contracting State by a resident of the other Contracting
State shall not exceed 5 percent of the gross amount thereof * *
*''. Article 4.1 of the treaty provides that for purposes of the
treaty, ``a `resident' of a Contracting State means any person who,
under the laws of that State, is liable to tax therein by reason of
his domicile, residence, place of management, place of
incorporation, or any other criterion of a similar nature * * *''.
Article 4.2 of the treaty provides that in the case of income
``derived or paid by a partnership * * *'', the term resident
applies only to the extent that the income derived by such
partnership is subject to tax in that State as the income of a
resident, either in its hands or in the hands of its partners.
(ii) Analysis. Under the U.S.-X income tax treaty, A is a
resident of Country X within the meaning of Article 4.1 of the
treaty. Also, as a resident of Country X taxable on the U.S. source
royalty under the tax laws of Country X, A meets the condition under
Article 12 of the treaty that it derive the income from sources
within the United States. Accordingly, the U.S. source royalty
income is treated as derived by a resident of X. Further, A is a
beneficial owner of the royalty income, as determined under
paragraph (d)(2)(i) of this section. The fact that A's interest
holders are also beneficial owners of the royalty income under U.S.
tax principles (as partners of A) does not preclude A from
qualifying as a beneficial owner for purposes of the treaty. In
addition, A may claim benefits under the U.S.-X income tax treaty
even though some of its interest holders do not reside in X or
reside in a country that does not have an income tax treaty in
effect with the United States.
[[Page 35678]]
Example 2. (i) Facts. The facts are the same as under Example 1
except that Article 12 of the U.S.-X income tax treaty provides that
royalties ``paid'' to a resident of a treaty country from sources
within the other may be taxed in both countries but the tax is
limited to 10 percent of the gross amount of the royalties in the
source country. Further the U.S.-X income tax treaty includes no
provision relating to income paid or derived through a partnership.
(ii) Analysis. As in Example 1, A is entitled to claim the
benefit of the U.S.-X income tax treaty with respect to the U.S.
source royalty income paid to A. The term paid and the term derived
are used interchangeably in U.S. income tax treaties. Accordingly,
the U.S. source royalty income is treated as derived by a resident
of X. It is irrelevant that the U.S.-X treaty does not include a
provision relating to income paid or derived through a partnership.
Example 3. (i) Facts. The facts are the same as under Example 2,
except that Country Y has an income tax treaty in effect with the
United States. Article 12 of the U.S.-Y income tax treaty reduces
the rate on U.S. source royalty income to zero if the income is paid
to a resident of Country Y who beneficially owns the income. Article
4.1 of the U.S.-Y treaty provides that for purposes of the treaty,
``a `resident' of a Contracting State means any person who, under
the laws of that State, is liable to tax therein by reason of his
domicile, residence, place of management, place of incorporation, or
any other criterion of a similar nature * * *''. The U.S.-Y treaty
does not include a provision relating to income paid or derived
through a partnership. Under the laws of Country Y, A is treated as
fiscally transparent entity. Thus, A's partner, T, a corporation
organized in Country Y is required to include in income on a current
basis its allocable share of A's income. T is a beneficial owner of
the income paid to A, as determined under paragraph (d)(2)(ii) of
this section.
(ii) Analysis. As in Example 2, A is entitled to claim the
benefit of the U.S.-X income tax treaty with respect to the U.S.
source royalty income paid to A. However, T is also entitled to
claim the benefit of the exemption under the U.S.-Y treaty for its
allocable share of the U.S. source royalty income. T meets the
conditions of Article 12 because it is a resident of Country Y
within the meaning of Article 4.1 of the treaty. Also, as a resident
of Country Y taxable on the U.S. source royalty under the tax laws
of Country Y, it meets the condition under Article 12 of the treaty
that income from sources within the United States be paid to a
resident. Accordingly, T's allocable share of the U.S. source
royalty income is treated as derived by a resident of Y. It is
irrelevant that the U.S.-Y treaty does not include a provision
relating to income paid or derived through a partnership.
Example 4. (i) Facts. Entity A is a business organization
organized under the laws of Country V that has no income tax treaty
with the United States. A is treated as a partnership for U.S. tax
purposes and receives royalty income from U.S. sources that is not
effectively connected with the conduct of a trade or business in the
United States. G, one of A's interest holders, is a corporation
organized under the laws of Country X. X treats A as an entity
taxable at the entity level and not as a fiscally transparent
entity. Therefore, G is not required to include in income on a
current basis its share of A's income. Instead, G is taxed in X on
its share of A's profits when distributed by A and such distribution
is taxed to G as a dividend. H, A's other interest holder, is a
corporation organized in Country Y. Y treats A as a fiscally
transparent entity and requires H to include in income on a current
basis its allocable share of A's income. Both X and Y have an income
tax treaty in effect with the United States. Article 12 of the U.S.-
X income tax treaty provides that royalties paid to a resident of a
treaty country from sources within the other may be taxed in both
countries but the tax is limited to 5 percent of the gross amount of
the royalties in the source country. Article 4.1 of the U.S.-X
treaty provides that for purposes of the treaty, a `` `resident' of
a Contracting State means any person who, under the laws of that
State, is liable to tax therein by reason of his domicile,
residence, place of management, place of incorporation, or any other
criterion of a similar nature * * *''. The U.S.-X treaty does not
include a provision relating to income paid or derived through a
partnership. Article 12 of the U.S.-Y treaty provides that
``royalties derived and beneficially owned by a resident of a
Contracting State shall be taxable only in that State''. Article 4.1
of the U.S.-Y treaty provides that, for purposes of the treaty, ``
`resident' of a Contracting State means any person who, under the
laws of that State, is liable to tax therein by reason of his
domicile, residence, place of management, place of incorporation, or
any other criterion of a similar nature * * *''. Article 4.2 of the
U.S.-Y treaty provides that in the case of income ``derived or paid
by a partnership * * *'', the term resident applies only to the
extent that the income ``derived by such partnership is subject to
tax in that State as the income of a resident, either, in its hands
or in the hands of its partners.
(ii) Analysis. A may not claim the benefit of any income tax
treaty since it is not a resident of a country with which the United
States has such a treaty. This result occurs regardless of how A is
treated for U.S. tax purposes or for purposes of the tax laws of
Country V. G may not claim the benefits of Article 12 of the U.S.-X
treaty. Under the tax laws of X, G's share of the U.S. source
royalty income paid to A is not treated as derived by a resident of
X since, under X's tax laws, A, rather than G, is required to
account for income received by A. This result occurs even if A
distributes the royalty amount immediately after receiving it
because, in such a case, G would be taxable on an amount treated as
a profit distribution from A and not on royalty income received from
sources within the United States. The fact that, for U.S. tax
purposes, G is treated as the taxpayer for its allocable share of
A's income is not relevant for purposes of determining whether, for
purposes of Article 12 of the U.S.-X income tax treaty, G's share of
the income paid to A is treated as derived by a resident of X. For
this purpose, the laws of Country X govern the determination of
whether G meets this condition. On the other hand, H may claim an
exemption from U.S. tax on its share of the royalty income received
by A under Article 12 of the U.S.-Y treaty because, under the tax
laws of Y, H rather than A, is required to account for income
received by A. Accordingly, H's share of the U.S. source royalty
income paid to A is treated as derived by a resident of Y.
Example 5. The facts are the same as in Example 4, except that A
is a business organization formed under the laws of a U.S. State as
a limited liability company. The consequences are the same as
described in Example 4. G is not eligible for benefits under Article
12 of the U.S.-X income tax treaty since, under X's tax laws, A,
rather than G, is required to account for income received by A.
Under section 881(a), G is liable for U.S. income tax on its
allocable share of A's U.S. source royalty income at a 30 percent
rate and A must withhold 30 percent from G's allocable share under
section 1442. Similarly, H may claim an exemption from U.S. tax on
its share of the royalty income received by A under Article 12 of
the U.S.-Y treaty because, under the tax laws of Y, H rather than A,
is required to account for income received by A.
Example 6. The facts are the same as in Example 4, except that A
is a so-called dual organized entity. In addition to being organized
under the laws of Country V, A has also been organized under the
laws of the United States pursuant to the State Z domestication
statute. Accordingly, both Country V and the United States regard
entity A as a domestic entity existing only in that jurisdiction.
Further, Country X and Country Y regard A as a Country V entity. A
is treated as a partnership for U.S. tax purposes. The fact that A
is a dual organized entity that is regarded differently in Countries
X or Y and the United States does not impact the relevant tax treaty
analysis. As in Example 4, A may not claim the benefit of any income
tax treaty since it is not a resident of a country with which the
United States has such a treaty. Similarly, G is not eligible for
benefits under Article 12 of the U.S.-X income tax treaty since,
under X's tax laws, A, rather than G, is required to account for
income received by A. Under section 881(a), G is liable for U.S.
income tax on its allocable share of A's U.S. source royalty income
at a 30 percent rate. Because A is treated as a U.S. partnership for
U.S. tax purposes, A must withhold 30 percent from G's allocable
share under section 1442. H may claim an exemption from U.S. tax on
its share of the royalty income received by A under Article 12 of
the U.S.-Y income tax treaty because, under the tax laws of Y, H
rather than A, is required to account for the income received by A.
Example 7. The facts are the same as in Example 5, except that A
distributes all U.S. source royalty income to its interest holders
immediately following A's receipt of such income. The consequences
are the same as described in Example 5. G remains ineligible for
benefits under Article 12 of the U.S.-X income tax treaty since,
under X's tax laws, A, rather than G, is required to account for the
royalty income received by A. The fact
[[Page 35679]]
that A distributes income on a current basis to G is irrelevant even
if Country X taxes G on such distributions on a current basis.
Country X regards such distributions to G as a distribution of
profits from A to G rather than an item of U.S. source royalty
income of G. H remains eligible for benefits under Article 12 of the
U.S.-Y income tax treaty with respect to H's allocable share of the
U.S. source royalty treatment received by A.
Example 8. The facts are the same as in Example 5, except that
Country X pursuant to a Country X anti-deferral regime requires that
G account for on a current basis as a deemed distribution G's pro
rata share of A's net passive income. For purposes of the anti-
deferral regime, the U.S. source royalty income of G is regarded as
passive income. The consequences are the same as described in
Example 5. G remains ineligible for benefits under Article 12 of the
U.S.-X income tax treaty because, under X's tax laws, A, rather than
G, is required to account for the royalty income received by A. The
fact that G receives a current deemed distribution of net passive
income is irrelevant even if Country X taxes G on such deemed
distributions on a current basis. Country X regards such deemed
distributions to G as a distribution of profits from A to G rather
than an allocation to G of G's share of A's U.S. source royalty
income. H remains eligible for benefits under Article 12 of the
U.S.-Y income tax treaty with respect to H's allocable share of the
U.S. source royalty treatment received by A.
Example 9. (i) Facts. Entity A is a business organization formed
under the laws of Country X that has an income tax treaty with the
United States. A has made a valid election under Sec. 301.7701-3(c)
of this chapter to be treated as a corporation for U.S. tax purposes
and receives royalty income from sources within the United States
that is not effectively connected with the conduct of a trade or
business in the United States. G, A's sole shareholder, is a
corporation organized under the laws of Country X. Under the tax
laws of X, A is treated as a fiscally transparent entity and,
therefore, G is required to include in income on a current basis its
share of A's income. Article 12 of the U.S.-X tax treaty provides
that ``royalties derived from sources within a Contracting State by
a resident of the other Contracting State shall not exceed 5 percent
of the gross amount thereof . . .''. Article 4.1 of the treaty
provides that for purposes of the treaty, a `` ` resident' of a
Contracting State means any person who, under the laws of that
State, is liable to tax therein by reason of his domicile,
residence, place of management, place of incorporation, or any other
criterion of a similar nature * * * ''. Article 4.2 of the treaty
provides that in the case of income derived or paid by a partnership
* * *'' the term resident applies only to the extent that the income
derived by such partnership is subject to tax in that State as the
income of a resident, either, in its hands or in the hands of its
partners.
(ii) Analysis. A does not qualify for benefits under the U.S.-X
income tax treaty because A is treated as a fiscally transparent
entity under the tax laws of X and thus is not a resident of X for
purposes of the treaty. G, on the other hand, qualifies for benefits
under the U.S.-X treaty with respect to the U.S. source royalty
income received by A because, under the tax laws of X, G is required
to account for the income received by A on a current basis. This
result applies even though, for U.S. tax purposes, A is treated as a
corporate entity. Accordingly, the U.S. royalty income paid to A is
treated as derived by G, a resident of X, as determined under the
tax laws of X. Based on G's qualification for treaty benefits with
respect to the U.S. source royalty income, A, as the taxpayer under
U.S. tax laws, may claim that the income that it receives for U.S.
tax purposes is eligible for benefit under the U.S.-X treaty.
Example 10. The facts are the same as in Example 9, except that
A is a corporation organized under the laws of a U.S. State and is,
therefore, a domestic corporation. A may not claim under the U.S.-X
income tax treaty a reduction of the rate of U.S. tax otherwise
imposed on its income under section 11. A reduced rate of tax is
unavailable under the U.S.-X treaty based upon the savings clause in
Article 1 of the U.S.-X treaty. Thus, A remains fully taxable under
U.S. tax laws as a domestic corporation.
Example 11. (i) Facts. Entity A is a business organization
organized under the laws of Country V that has no income tax treaty
with the United States. A is treated as a partnership for U.S. tax
purposes and receives royalty income from U.S. sources that is not
effectively connected with the conduct of a trade or business in the
United States. A is directly owned by H and J. J is a corporation
organized in Country Z which treats A as fiscally transparent and J
as an entity taxable at the entity level. Accordingly, Country Z
requires J to include in income on a current basis J's share of A's
U.S. source royalty income. H, A's other direct interest holder, is
a corporation organized in Country Y. H, in turn is owned by E and
F, both of which are entities organized in Country X. E and F are
each wholly owned by C which is a corporation organized in Country
V. Y treats both A and H as fiscally transparent entities. X treats
A, H, and E as fiscally transparent entities. X treats F as an
entity taxable at the entity level. Accordingly, X requires F to
include in income on a current basis F's indirect share of A's U.S.
source royalty income. H and J are treated as corporations for U.S.
federal income tax purposes while E, F, and C are treated as
partnerships for U.S. federal tax purposes. X, Y and Z each have in
effect an income tax treaty with the United States. Article 12 of
the U.S.-X and the U.S.-Z income tax treaty provides that royalties
paid to a resident of a treaty country from sources within the other
may be taxed in both countries but the tax is limited to 5 percent
of the gross amount of the royalties in the source country. Article
4.1 of the U.S.-Z and the U.S.-Z treaty provides that for purposes
of the treaty, a `` `resident' of a Contracting state means any
person who, under the laws of that State, is liable to tax therein
by reason of his domicile, residence, place of management, place of
incorporation, or any other criterion of a similar nature . . .''.
Article 4.2 of the U.S.-X and the U.S.-Z treaty provides that in the
case of income ``derived or paid by a partnership . . .'', the term
resident applies only to the extent that the income derived by such
partnership is subject to tax in that State as the income of a
resident, either in its hands or in the hands of its partners.
Article 12 of the U.S.-Y treaty provides that ``royalties derived
and beneficially owned by a resident of a Contracting State shall be
taxable only in that State.'' Article 4.1 of the U.S.-Y treaty
provides that, for purposes of the treaty, a `` `resident' of a
Contracting State means any person who, under the laws of that
State, is liable to tax therein by reason of his domicile,
residence, place of management, place of incorporation, or any other
criterion of Asimilar nature . . .''. The U.S.-Y treaty does not
include a provision relating to income paid or derived through a
partnership.
(ii) Analysis. A may not claim, based on its own status, the
benefit of any income tax treaty since it is not a resident of a
country with which the United States has such a treaty. This result
occurs regardless of how A is treated for U.S. tax purposes or for
purposes of the tax laws of Country V. H may not claim the benefits
of any treaty, including the benefits of Article 12 of the U.S.-Y
treaty, because H does not qualify as a resident of Y or any other
treaty jurisdiction. Similarly, neither E nor C may claim the
benefits of any income tax treaty, since neither entity qualifies as
a resident of X or any other treaty jurisdiction. F, however, may
claim the benefit of Article 12 of the U.S.-X treaty with respect to
F's indirect share of the U.S. source royalty income received by A.
Such income is treated as derived by F, a resident of X, because X
qualifies as a resident of X and, under the tax laws of X, F is the
first entity in the A, H, F chain that is not itself treated as
fiscally transparent in X. J may claim the benefits of Article 12 of
the U.S.-Z treaty with respect to J's indirect share of the U.S.
source royalty income paid to A because, under the tax laws of Z, J
rather than A, is required to account for income received by A.
Accordingly, J's share of the U.S. source royalty income paid to A
is treated as derived by a resident of Z. As illustrated in this
example, the U.S. federal income tax treatment of A, J, H, E, F and
C is irrelevant for purposes of determining the extent to which U.S.
source royalty income paid to A is eligible for treaty-reduced tax
rates under the U.S. income tax treaty with X, Y or Z.
Example 12. (i) Facts. Entity A is a business organization
formed under the laws of Country X that has an income tax treaty in
effect with the United States. A owns all of the stock of a U.S.
corporation B. Under the tax laws of X, A is subject to tax at the
entity level. For U.S. tax purposes, A is treated as a branch of its
single owner, G. G is a corporation organized under the laws of X. A
receives dividends from B that are from U.S. sources and are not
effectively connected with the conduct of a trade or business in the
United States. Article 10 of the U.S.-X tax treaty provides that
``dividends derived from sources within a Contracting state by a
resident of the other Contracting State shall not exceed 5 percent
of the gross amount thereof . . .''. Article 4.1 of the treaty
provides that for purposes of the treaty, a `` `resident' of a
Contracting State
[[Page 35680]]
means any person who, under the laws of that State, is liable to tax
therein by reason of his domicile, residence, place of management,
place of incorporation, or any other criterion of a similar nature .
. .''. The U.S.-X treaty contains no provision regarding income paid
or derived through a partnership.
(ii) Analysis. For U.S. tax purposes, A is treated as a wholly-
owned business entity that is disregarded for federal income tax
purposes. However, because, under the laws of X and under X's
application of the treaty, A is treated as deriving the dividend
income as a resident of X, A qualifies for benefits under the treaty
with respect to the U.S. source dividend. Thus, G, as the taxable
person for U.S. tax purposes, may claim the benefit of a reduced
rate under Article 10 of the U.S.-X treaty based on A's eligibility
for tax treaty benefits.
(7) Effective date. This paragraph (d) applies to amounts paid on
or after January 1, 1998.
Michael P. Dolan,
Acting Commissioner of Internal Revenue.
Approved: June 26, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97-17467 Filed 6-30-97; 12:19 pm]
BILLING CODE 4830-01-U
