ALI-ABA Course of Study International Trust and Estate Planning July 31 - August 1, 2008 Santa Fe, New Mexico

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1 79 ALI-ABA Course of Study International Trust and Estate Planning July 31 - August 1, 2008 Santa Fe, New Mexico Effect of Tax Treaties on U.S. Activities of Nonresidents By Joseph S. Henderson Ernst & Young LLP Washington, D.C.

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3 81 Effect of Tax Treaties on U.S. Activities of Nonresidents Joseph S. Henderson Washington, DC I. INTRODUCTION The increasing globalization of the world economy in the past 100 years has resulted in a number of phenomena: international mobility of people on a previously unimaginable scale, instantaneous global communications, and the rise of the transnational family and multinational investor. Accompanying the exponential growth of international commerce of the past century has been the exposure of multinational investors and business operations to taxation in more than one country. In 1939, the United States signed its first income tax treaty, thereby beginning a process of resolving double taxation issues through a bilateral tax treaty network. A tax treaty is a bilateral agreement between two countries in which each country agrees to modify its internal tax laws, thereby resulting in a reciprocal benefit. As a result, a tax treaty is an independent source of tax law that must be consulted in advising the multinational investor (in addition to the internal tax rules of the investor s country of residence as well as those of the country in which the investment is located). The most prevalent U.S. tax treaties are those addressing taxes applicable to income and capital gains, and the United States has some 65 income tax treaties currently in force. In addition, U.S. tax treaties focus on estate, gift and generation skipping taxes, and the United States has entered into treaties with 16 countries focusing on these taxes. 1 A tax treaty, however, is not the sole international agreement entered into by the United States affecting taxation. Non-tax treaties and agreements such as those related to the North Atlantic Treaty Organization, as well as treaties of friendship, commerce, and navigation may affect U.S. tax matters. In addition, Caribbean Basin Initiative and exchange of information agreements may impact U.S. taxation. Finally, Social Security Totalization Agreements (which are executive agreements and not treaties) can affect employer and employee liability for social security and Medicare taxes. 2 An income tax treaty s basic purpose is to facilitate international trade and investment by removing or preventing the erection of tax barriers to the free international exchange of goods and services, and the free international movement of capital and persons. 3 This goal is achieved through the three functions a tax treaty serves: (i) preventing double taxation; (ii) preventing discriminatory tax treatment of a resident 1 In addition, Art. XXIX B of the U.S.-Canada Income Tax Treaty addresses estate taxation. 2 A discussion of these agreements is outside the scope of this paper. 3 American Law Institute, Federal Income Tax Project: International Aspects of United States Income Taxation II (Proposals on United States Income Tax Treaties), 1992 at 1. 1

4 82 of a country; and (iii) permitting reciprocal administration to prevent tax avoidance and evasion. 4 Treaties relating to estate, gift, and generation skipping taxes have purposes similar to those of income tax treaties. Generally, the estate and gift tax treaties are intended to mitigate multiple transfer taxation and establish procedures for exchanging information and assisting in the collection of these taxes. The U.S. Treasury Department negotiates U.S. tax treaties; however, as with all U.S. treaties, a tax treaty must be ratified by the U.S. Senate before it can enter into force. As part of the ratification process, a legislative history is developed for a treaty: (i) the Treasury Department issues a Technical Explanation describing the provisions of the treaty; (ii) the Senate Foreign Relations Committee holds public hearings to discuss whether a particular treaty should be ratified by the Senate and issues a companion Committee report; and (iii) the Joint Committee on Taxation may also issue a report. In many cases, Letters of Understanding will be signed by the United States and the treaty partner clarifying the interpretation and application of the treaty. All of these sources must be reviewed to determine the scope and impact of a particular treaty provision when advising a client. Finally, a treaty may be modified by a Protocol, which generally will have its own separate Treasury Technical Explanation, Senate Foreign Relations Committee Report and possible Letters of Understanding that must also be reviewed in determining the ultimate effect of a tax treaty. Each U.S. tax treaty addresses specific issues resulting from the interaction of the tax systems of the United States and its treaty negotiating partner. However, the starting point for U.S. tax treaty negotiations is the appropriate U.S. model tax treaty. Following its recent issuance, income tax treaty negotiations will now be based upon the U.S. Model Income Tax Convention of November 15, 2006 (the Model Treaty ). 5 Estate tax treaty negotiations are based on the U.S. Model Estate and Gift Tax Treaty of November 20, Each model treaty is accompanied by a Treasury Department Technical Explanation discussing the scope and application of the treaty s provisions. In interpreting treaties, it can be helpful to refer to the current model treaty and its technical explanation. 6 4 Rev. Proc , 2.01, C.B Although superseded with regard to taxpayer requests for assistance under a treaty s mutual agreement procedure, this remains a correct statement of a tax treaty s functions. 5 The U.S. Model Income Tax Convention of November 15, 2006 (hereafter U.S. Model Treaty ) replaced the U.S. Model Income Tax Convention of September 20, 1996 (the 1996 Model Treaty ). The 1996 Model Treaty, in turn, replaced the U.S. Model Income Tax Convention of June 16, See, United States Model Technical Explanation Accompanying the United States Model Income Tax Convention of November 15, 2006 (hereafter U.S. Model Treaty, Technical Explanation. ) The importance of a U.S. Model Treaty and its accompanying Technical Explanation is shown in I.R.S. Letter Ruling (November 10, 1997). In that ruling, the IRS applied the provisions of the 1996 Model Treaty and its Technical Explanation to interpret the pension article of the U.S.-Germany income tax treaty, which entered into force in In the ruling, the IRS concluded that a contributory individual retirement account, i.e., an individual retirement account that was not a rollover account from a qualified pension plan, could qualify as a pension for purposes of applying the U.S.-Germany income tax treaty. The IRS based its conclusion on the 1996 Model Treaty, which is a change in policy from that followed on this point when the U.S.-Germany income tax treaty entered into force. 2

5 83 In addition, the Organisation for Economic Cooperation and Development (OECD), an international organization whose members include the world s major industrialized countries, has published model income and estate tax treaties that have influenced tax treaty policies of the United States as well as the OECD s other member countries. 7 The provisions of the OECD model treaties are considered the international norms to which tax treaty policy should adhere. Consequently, the appropriate OECD model treaty and accompanying commentary should also be consulted when interpreting a U.S. tax treaty article based on an OECD model provision. 8 II. INCOME TAX TREATIES Income tax treaty benefits generally are available only to a resident of a country, and special rules frequently apply to determine residency of trusts, estates, flowthrough and hybrid entities. Treaty benefits will nevertheless be restricted or denied if a party claiming treaty residency, and entitlement to an income tax treaty s benefits, does not satisfy the treaty s limitation on benefits article. Relief from double taxation is afforded a treaty resident by specific provisions allocating taxing jurisdiction over items of income between the two countries that are parties to a treaty, and by a treaty s tax credit provisions. Finally, administrative provisions, usually providing for a mutual agreement procedure and for exchange of information and assistance in collection, are aimed at preventing tax avoidance and evasion. This paper will review these topics, with the greater emphasis on residency and the effect of a treaty s limitation on benefits article. A. Residence The United States extends income tax treaty benefits only to a resident of its treaty partner. 9 Income tax residency is determined under the laws of the treaty partner. However, an individual or an entity will not be considered resident of a treaty partner for purpose of claiming the benefits of an income tax treaty unless the individual or entity is subject to tax by the treaty partner. An individual or entity subject to tax by the treaty partner only on income arising within that county (i.e., taxable only on a source basis) is not resident for income tax treaty purposes. 10 The traditional subject to tax test applied by the United States to determine residency in a treaty partner has not required that a tax actually be paid to the claimed residence country. Although the international norm for determining residency, this standard presents problems for the United States in connection with claimants of treaty benefits who reside in a treaty partner but benefit from a tax-favored regime, e.g., Switzerland s forfait method of taxation whereby an individual negotiates a lump-sum tax based on that person s specific circumstances, or the United Kingdom s system for taxing non-domiciliaries only on income derived in, or remitted to, the residence country. 7 OECD Model Tax Convention on Income and on Capital (January 2003); OECD Model Double Taxation Convention on Estates and Inheritances and on Gifts (June 1982). 8 In addition, the United Nations has promulgated its Model Taxation Convention Between Developed and Developing Countries (January 2001) addressing income taxation. However, the international norm remains the OECD s model income tax treaty. 9 U.S. Model Treaty, Art. 4(1); OECD Model, Art. 4(1). 10 U.S. Model Treaty, Art. 4(1); OECD Model, Art. 4(1). 3