Editor: Jon Almeras, J.D., LL.M.
Foreign Income & Taxpayers
Foreign companies investing in the United States often rely on U.S. income tax treaties to reduce or eliminate the 30% U.S. withholding tax imposed on payments of U.S.-source fixed or determinable, annual or periodical (FDAP) income. When such investments are made through an entity that is “fiscally transparent” under the laws of the United States and/or any other jurisdiction, the regulations under Sec. 894(c)(2) deny income tax treaty benefits on items of U.S.-source FDAP income to the extent such income is not “derived by” a treaty resident.
An item of income is derived by an entity when the entity is not fiscally transparent under the laws of the entity’s jurisdiction (i.e., it is fiscally opaque) and the income is derived by an entity’s interest holder if the entity is fiscally transparent and its interest holder is fiscally opaque, in each case under the laws of the interest holder’s jurisdiction. An entity or interest holder is fiscally transparent with respect to an item of income if, under the laws of its jurisdiction, its interest holder is required to separately take into account the item of income on a current basis with the same source and character as if the interest holder had realized the income directly from the originating source (Regs. Secs. 1.894-1(d)(3)(ii) and (iii)).
An item of income therefore is not derived by an entity if, under the laws of the entity’s jurisdiction, the entity is fiscally transparent as defined by the regulations. In such cases, the analysis turns to the interest holders in the entity, applying the same analysis under the laws of their jurisdiction, although again through the lens of fiscal transparency as defined by the regulations, and so on up the chain. Conversely, sometimes the same item of income may be derived by an entity and one or more of its interest holders, for example, when the entity is fiscally opaque under the laws of its jurisdiction yet is fiscally transparent under the laws of a fiscally opaque interest holder.
In navigating these rules, it is also important to note that an entity or an interest holder may be organized or incorporated in one jurisdiction and treated as a resident of another jurisdiction. In that case, the analysis for such an entity or interest holder may turn on the application and intersection of three sets of laws (i.e., the U.S. tax law, the law of the jurisdiction of incorporation or organization, and the law of the jurisdiction of residency). Although the regulations’ basic methodology may be logical in theory, given the multitude and confluence of applicable laws, their application raises many practical and technical issues and can lead to unexpected (and likely unintended) results.
Through a series of examples, this discussion summarizes the general approach adopted by the regulations and then highlights some of the practical difficulties encountered when determining whether a foreign company is entitled to treaty benefits when investing in the United States through an entity that may be fiscally transparent under the laws of one or more jurisdictions.
The Derived-By Requirement: Illustrative Examples
For each of the following examples, unless otherwise indicated, assume that Treaty Co. is a company organized in, and a resident of, Country X and is treated as fiscally opaque under the laws of Country X. Country X has entered into an income tax treaty with the United States, and Treaty Co. satisfies the requirements of the Country X–U.S. income tax treaty, including the limitation-on-benefits article.
Treaty Co. owns some but not all of the shares of Non-Treaty Co., a company organized in Country Y. Country Y has entered into an income tax treaty with the United States, but Non-Treaty Co. does not qualify for treaty benefits (e.g., it does not satisfy the limitation-on-benefits article). Prior to making a payment of U.S.-source FDAP income to Non-Treaty Co., the withholding agent has received and may rely on one or more withholding certificates (i.e., Forms W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding, and W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) claiming that the beneficial owner is entitled to a reduced rate of U.S. withholding tax under the applicable U.S. income tax treaty.
Example 1: Assume that Non-Treaty Co. is fiscally transparent under the laws of Country Y and Country X. Here, the U.S.-source FDAP income is not derived by Non-Treaty Co. but is derived by Treaty Co. because, under the laws of Country X, Non-Treaty Co. is fiscally transparent and Treaty Co. is fiscally opaque. Treaty Co. is therefore entitled to a reduced rate of U.S. withholding tax under the treaty between Country X and the United States. This result would not change if Non-Treaty Co. were fiscally opaque or if Treaty Co. were fiscally transparent under the U.S. tax laws. However, Treaty Co. would not be eligible for a reduced rate of U.S. withholding tax if Non-Treaty Co. were fiscally opaque under the laws of Country X.
Example 2: Assume that Non-Treaty Co. is fiscally opaque under the laws of its jurisdiction (Country Y) but is treated as fiscally transparent under the laws of Treaty Co.’s jurisdiction (Country X). Notwithstanding the fact that the U.S.-source FDAP income is treated as having been derived by both Non-Treaty Co. and Treaty Co., Treaty Co. is entitled to a reduced rate of U.S. withholding tax under the treaty between Country X and the United States. To avoid having to claim a refund, however, Non-Treaty Co. should not claim that it is the beneficial owner of that portion of the payment that is (also) derived by Treaty Co. Rather, Non-Treaty Co. should provide a flowthrough withholding certificate with which the withholding certificate of Treaty Co. that supports its claim for a reduced rate of U.S. withholding tax is associated. The result in this example would not change if Non-Treaty Co. were fiscally opaque or if Treaty Co. were fiscally transparent under U.S. tax laws.
Example 3: Assume the same facts as in Example 2, except that Non-Treaty Co. is eligible for treaty benefits. The same item of U.S.-source FDAP income would be eligible for a reduced rate of U.S. withholding tax under both treaties, the Country Y–U.S. income tax treaty and the Country X–U.S. income tax treaty. Again, this result would not change if both beneficial owners, Non-Treaty Co. and Treaty Co., were fiscally transparent under U.S. tax laws.
In this scenario, a couple of options are available. Depending on the U.S. withholding tax rates involved and the approach adopted by the withholding agent, these options could result in different U.S. withholding tax obligations. If the withholding agent can reliably associate the same portion of a payment of U.S.-source FDAP income with both Non-Treaty Co.’s claim and Treaty Co.’s claim for a reduced rate of U.S. withholding tax, then the withholding agent may choose to apply only the claim made by Non-Treaty Co. (but not Treaty Co.). This option may be advisable if, as between the two claims, Non-Treaty Co. is eligible for a lower rate of U.S. withholding tax on the same portion of the payment that is also derived by Treaty Co.
Conversely, if the withholding agent can reliably associate the same portion of the payment with both claims for a reduced rate of U.S. withholding tax made by Treaty Co. and Non-Treaty Co., the withholding agent may reject both claims and request documentation that allocates the payment between the two parties. The withholding agent may then apply the reduced rates of U.S. withholding tax under both treaties with respect to each party’s respective share of the payment made to Non-Treaty Co. This option may be advisable if, as between the two claims, Treaty Co. is eligible for a lower rate of U.S. withholding tax on the same portion of the payment that is also derived by Non-Treaty Co.
As the above examples illustrate, whether a payment of U.S.-source FDAP income is derived by an entity, its interest holders, or both is determined by reference to the laws of the jurisdiction of the entity or interest holder that is claiming treaty benefits. The originating source state’s characterization of the entity or its interest holder is irrelevant. However, as the next example illustrates, in determining whether income is derived by a tax treaty resident, the regulations rely on a U.S.-centric view of “fiscal transparency,” which raises a host of issues.
The Fiscal Transparency Requirement: Open Issues and Unintended Consequences
Under the regulations, an entity is fiscally transparent with respect to an item of income if, under the laws of the entity’s jurisdiction, the entity’s interest holders must separately take into account the item of income on a current basis with the same source and character as if the interest holders had received the U.S.-source FDAP income directly from the originating source. Because this fiscal transparency requirement evaluates the foreign law through the lens of subchapter K of the Code, the regulations raise a number of unanswered questions and, in certain circumstances, produce questionable results from a policy perspective. The following example illustrates some of these issues.
Example 4: Cross-border investments are often structured using tax-transparent contractual funds, such as the Irish Common Contractual Fund (CCF), the Luxembourg Fond Commun de Placement, or the new U.K. Tax Transparent Fund. Assume that a treaty-eligible institutional investor and a treaty-eligible pension plan (collectively, the investors) pool their funds to invest in U.S. securities through a CCF. The CCF is fiscally transparent under Irish law yet is treated as an entity for U.S. federal income tax purposes. Further, assume that the investors are fiscally opaque in their countries of organization. If the investors had invested directly in the U.S. securities, the institutional investor would have been eligible for a 5% rate of U.S. withholding tax on dividends under its treaty with the United States, while the pension plan would have been exempt from U.S. withholding tax on dividends under its treaty with the United States.
The pension plan must, and the institutional investor may, adopt a mark-to-market regime with respect to the CCF’s income. The mark-to-market regime affects each investor differently. The pension plan is exempt from tax and does not file any tax returns. Hence, for the pension plan, the mark-to-market regime is only relevant—indeed, the concept of fiscal transparency is only relevant—for financial statement purposes. In contrast, if the institutional investor opts into the mark-to-market regime, the income paid to the CCF becomes subject to tax at the institutional investor level on a current basis, but such income may not carry the same source and character as if the institutional investor had owned the U.S. securities directly.
If the institutional investor does not elect into the mark-to-market regime, the institutional investor will earn dividends paid to the CCF upon their distribution from the CCF to the institutional investor. In that case, the CCF will not be fiscally transparent under the laws of the institutional investor’s jurisdiction and, as such, will not be eligible for a reduced rate of U.S. withholding tax.
Would the result be different if the institutional investor elects into the mark-to-market regime? In that case, the dividend income would be taken into account on a current basis; however, the source and character would not be the same as if the institutional investor had received the dividends directly from the U.S. securities. What if the organizational documents require the institutional investor to report for tax purposes the dividends as if they were received directly from the U.S. payer? Would this private contractual commitment constitute the “law” of the investor’s jurisdiction, or would the tax authority need to be a party to the agreement (via a tax ruling)? Further, by the institutional investor’s simply opting into the mark-to-market regime, does the current inclusion of the dividend income become the “law” of the institutional investor’s jurisdiction? What if there are no constraints on when the institutional investor may opt out of the mark-to-market regime?
Should the fiscal transparency requirements apply to the pension plan? After all, the pension plan is exempt from tax on the income regardless of when the income is taken into account and regardless of the source and character of the income. Moreover, the mark-to-market regime is relevant only for financial reporting purposes, for which source and character are irrelevant. This further complicates the analysis. In response to these difficulties and unintended consequences, limited relief has been provided for pension plans under the competent-authority provisions of at least one U.S. income tax treaty (the Netherlands–U.S. tax treaty). For all other situations, pension plans may be ineligible for a reduced rate of U.S. withholding tax unless the entity through which the pension plan invests is fiscally transparent under the regulations.
Perhaps acknowledging these issues, the regulations provide an exception to the definition of fiscal transparency that, while helpful, raises additional issues: The CCF will be treated as fiscally transparent with respect to the nonseparately stated dividend income as long as such dividend income, if it had been separately taken into account, would not have resulted in an income tax liability that is different from that which would have resulted had the dividend income been separately taken into account, provided all nonseparately stated items of income paid to the CCF are taken into account by the interest holder on a current basis (the income-tax-liability-comparison test).
Under this exception, is the source and character irrelevant as long as the income tax liability is not different from that of a direct investment, and all items of income paid to the CCF are taken into account on a current basis? Whether an entity is fiscally transparent is supposed to be determined on an item-by-item basis. Is this exception available only on an aggregate basis—that is, if less than all of the income is taken into account on a current basis, are the items that are taken into account on a current basis ineligible for treaty benefits, even if such items result in the same income tax liability?
Assuming the pension plan’s full share of the CCF’s income is taken into account on a current basis under the mark-to-market regime, the pension plan may qualify for treaty benefits under this exception because its income tax liability is the same as for a direct investment in the underlying U.S. securities (zero vs. zero). Yet, if the pension plan does not report any income for tax purposes, could it be said that its full share of the CCF’s income has been “taken into account” as contemplated by this exception to the general rule?
Is the income-tax-liability-comparison test limited to each investor’s foreign income tax liability? This would appear to be the case, given that the determination of fiscal transparency is based on the laws of the resident claiming treaty benefits. However, a U.S. withholding tax is a liability of the payee and, through a foreign tax credit provision, may reduce the payee’s foreign income tax liability. If the U.S. withholding tax liability is relevant to the analysis, should the underlying U.S. securities be treated as if they were held by the investor directly? Otherwise, for U.S. treaties that include a “direct” ownership requirement to obtain a specified reduced rate of U.S. withholding tax on dividends, that investor’s indirect income tax liability would be greater than the corresponding direct investment and thus would be ineligible for treaty benefits, at least based on a plain reading of the regulations.
Similarly, a foreign participation exemption may be unavailable if the requisite ownership interest in the payee is held indirectly through an entity. This would also result in a greater income tax liability than if the investor had owned the underlying U.S. securities directly. From a policy perspective, it is unclear whether the regulations should be construed in a way that denies U.S. tax treaty benefits when the interposition of the hybrid entity results in a greater income tax liability.
Foreign companies investing in the United States through fiscally transparent entities must navigate the regulations under Sec. 894(c)(2). The analysis is not straightforward, and many issues and unintended U.S. tax consequences may result. Careful analysis is therefore critical.
The authors thank Robert Rothenberg, from Deloitte Tax LLP’s Washington National Office, for his helpful comments on this item.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, D.C.
For additional information about these items, contact Mr. Almeras at 202-758-1437 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.