Significant Interpretation of Treaty LOB Provision

In Letter Ruling 200201025, the IRS clarified the meaning of "ultimate beneficial ownership" in the context of the U.S.-Swiss Treaty's derivative-benefits test. (While the ruling does not disclose the country involved, references to Article 22 and a Memorandum of Understanding (MOU) lead to the conclusion that it involves U.S.-source interest payments to a Swiss company.) The ruling is important for several reasons:

• It adopts a lookthrough approach, requiring that ultimate beneficial ownership be traced to taxpayers that would qualify for Swiss-treaty benefits without reference to their owners.
• It provides support for requiring lookthrough treatment in the context of other treaties that require "direct or indirect," rather than ultimate, beneficial ownership by qualifying residents.
• It does not appear to impose any requirement that the intermediate entity be a resident of any particular country.

Background

Many U.S. tax treaties contain anti-treaty-shopping provisions, also known as the limitation-on-benefits (LOB) provision. "Treaty shopping," in its basic form, occurs when a resident of a country that typically does not have a tax treaty with the U.S. sets up a legal entity in a third country that has such a tax treaty, with a principal purpose of obtaining treaty benefits. For example, absent an LOB provision, a corporation resident in Bermuda could lend funds to its U.S. subsidiary through a company resident in a tax treaty jurisdiction. This would reduce or eliminate the 30% U.S. withholding tax on interest payments, which would apply ordinarily to interest payments paid directly to the Bermuda parent.

An LOB provision aims to curb treaty shopping by requiring a treaty resident receiving income from U.S. sources to qualify under one of several mechanical tests. Qualification indicates that the resident has the necessary economic connection to the treaty country to warrant benefits.

Generally, under typical LOB provisions, a company that is a resident of one contracting state might qualify for benefits under the tax treaty only if it meets one of the following tests:

• An ownership/base erosion test, under which the company must be majority owned by persons who qualify for benefits under the tax treaty, without regard to their owners;
• A publicly-traded-company test, under which the company's stock (or that of its parent under certain conditions) is traded on a recognized stock exchange;
• An active-business test;
• A headquarters-company test; or
• A derivative-benefits test, which allows owners in countries other than the contracting states to be regarded as "qualified" under certain circumstances.

If a company meets one of these tests, its eligibility for benefits under the tax treaty depends on whether it also satisfies other conditions imposed under the treaty's operative provisions and under Sec. 894, Regs. Sec. 1.894-1(d) and Sec. 7852(d), dealing with the interaction of Code provisions with tax treaties.

Derivative-Benefits Provision

Generally, under paragraph 7 of the MOU under the U.S.-Swiss Treaty, a company resident in one contracting state will be granted treaty benefits if it satisfies the following conditions:

• The ultimate beneficial owners of 95% or more of the aggregate vote and value of all of the company's shares are seven or fewer persons;
• Each of these shareholders is a resident of a state that is either a member of the European Union (EU) or the European Economic Area (EEA), or a party to the North American Free Trade Agreement (NAFTA);
• The company meets a base-erosion test;
• The EU, EEA or NAFTA country in which one or more of the relevant shareholders resides is a country with which the U.S. has a "comprehensive income tax convention," and each shareholder taken into account for purposes of the derivative-benefits test is entitled to all the benefits under the treaty;
• Each of these relevant shareholders would qualify under the ownership/base erosion test in paragraph 1 of Article 22 of the U.S.-Swiss tax treaty, applying the provision as if the shareholder were a resident of one contracting state; and
• The rate of withholding under the treaty between the U.S. and each relevant shareholder's country of residence on the type of income in question is at least as low as the rate applicable under the U.S.-Swiss Treaty.

Letter Ruling 200201025 clarifies the meaning of the terms "ultimate beneficial owner" and "comprehensive income tax convention."

Letter Ruling 200201025

Two publicly traded companies, each incorporated in an EU member country, own a Swiss finance subsidiary through a chain of wholly owned intermediate entities. The parents also own a U.S. subsidiary. The U.S. subsidiary pays interest on funds it borrowed from the Swiss finance subsidiary. The ruling assumes that interest paid to the Swiss finance subsidiary would be exempt from U.S. withholding tax if the Swiss finance subsidiary qualified under the U.S.-Swiss Treaty's derivative-benefits test.

The principal issue is whether the parents are the ultimate beneficial owners of the Swiss finance company under the derivative-benefits provision's ownership test. In this case, the MOU derivative-benefits test would be met; fewer than seven ultimate beneficial owners—the two parents—own all the shares of the Swiss finance subsidiary.

The ruling did not address the ownership test's other requirements, as the taxpayer had represented that each parent satisfied all such other requirements: Each ultimate parent (1) is a resident of a country that is an EU member state, (2) would qualify under the publicly-traded-company test (described in paragraph 1(e)(i) of Article 22 of the U.S.-Swiss tax treaty) if it was a Swiss company and (3) is eligible for a zero rate on interest under the U.S. tax treaty with its country of residence.

The Service agreed with the taxpayer's conclusion that the parents should be considered the ultimate beneficial owners of the Swiss finance subsidiary. The ruling further concluded that it is necessary to look through nonqualifying intermediate owners of the Swiss finance subsidiary until reaching a person that qualifies; the benefits of the provision apply at that level of "ultimate ownership."

The IRS based this conclusion on Treasury's interpretation of the term "ultimate beneficial owner," used in the Luxembourg Treaty's LOB provision:

The [LOB provision] requires that any intermediate owners of the company be disregarded and that ownership be traced to a person that is a qualified resident without reference to its owner (such as a publicly traded company under [Article 24(2)(d) of the Luxembourg Treaty]).

In the instant case, the taxpayer represented that each parent would qualify for benefits under the U.S.-Swiss Treaty under the publicly traded test—a test satisfied without reference to the parent's owners. As a result, each parent was considered an ultimate beneficial owner of the Swiss finance subsidiary, and all of the requirements of the derivative-benefits test must be tested at the parent level.

Conclusion

Letter Ruling 200201025 suggests that the terms "ultimate beneficial ownership" and "direct or indirect ownership" are similar, interchangeable concepts. While the ruling does not provide any detailed analysis on this issue, this line of reasoning is consistent with other treaties (such as the U.S.-Netherlands treaty, which embraces a lookthrough approach in which ownership can be indirect).

Finally, the ruling does not require that the intermediate entities through which the parent companies owned the Swiss finance subsidiary have to be residents of the U.S. or Switzerland. The U.S.-Swiss Treaty does not specify this, and the IRS should be commended for not imposing requirements to qualify for treaty benefits that are not present in the treaty's text or its explanatory notes. This outcome is consistent with the equivalent-derivative-benefits test in LOB provisions in other U.S. tax treaties.

From Christine Halphen, J.D., and Bernard Moens, LL.M., Washington, DC