Significant changes in the 2016 US Model Income Tax Convention

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1 from India Tax & Regulatory Services Significant changes in the 2016 US Model Income Tax Convention February 22, 2016 In brief On 17 February, 2016, the US Treasury Department released a revised US Model Income Tax Convention (the 2016 Model) updating the 2006 US Model Income Tax Convention (the 2006 Model). Further, the US Treasury Department has stated that the Technical Explanation for the 2016 Model will be released this spring. Various Articles in the 2016 Model have been revised vis-à-vis the 2006 Model. Though most of the updates are expansions of existing Articles, a few recommendations by the OECD in the recently released BEPS Action Plans have also been incorporated. The 2016 Model is a finalised version of the draft provisions of May 2015 which were first put out by the US Treasury Department for public comments. In detail Updates Given the above, we have highlighted the significant changes in the 2016 Model: OECD recommendations in BEPS Action Plan reports adopted Preamble of the 2016 Model The 2016 Model has modified the preamble for tax treaties that clarifies the intention of the treaty partners, and is in line with the recommendations in the BEPS Action Plan 6. The revised preamble clarifies that the purpose of a tax treaty is the elimination of double taxation with respect to taxes on income, without creating opportunities for nontaxation or reduced taxation through tax evasion or avoidance (including treaty-shopping arrangements). Additional conditions for beneficial tax treatment for dividends in the Source State Under Article 10(2) of the 2006 Model, dividends paid by a resident of a Contracting State to a resident of another Contracting State were taxable in the Source State at a rate of 5%, provided the beneficial owner owns at least 10 percent of the voting stock of the company paying dividends. Under the 2016 Model, the following conditions need to be fulfilled for the twelve month period, ending on the date of entitlement of dividend, to avail the lower tax rate of 5%: o The beneficial owner has been a company resident of the other Contracting State or of a Qualifying Third State. A Qualifying Third State has been defined to mean a State having a comprehensive tax treaty with the Contracting State, in which the dividendpaying company is a resident and such a tax treaty allows the beneficial owner to benefit from a rate of tax lower than or equal to 5%; and o At least 10% of the aggregate voting power and value of shares of the payer company is directly owned by the beneficial owner or a Qualified Predecessor Owner. A Qualified Predecessor Owner

2 means a company from whom the beneficial owner acquired the shares and who: (i) is a connected person with respect to the beneficial owner; and (ii) is a resident of a State having a comprehensive tax treaty with the Contracting State, in which the dividend paying company is a resident and such tax treaty would have allowed the company to benefit from a rate of tax on the dividend which is lower than or equal to 5%. o Further, to determine the percentage of shares directly owned, any shares held by the company through an entity which is (i) considered fiscally transparent under the laws of the Contracting State, and (ii) not a resident of the Contracting State in which the payer company is a resident, will be considered as directly held by the company to the extent of the company s ownership in the entity. It should be noted that although BEPS Action Plan 6 recommended additional conditions for beneficial tax treatment of dividends in the Source State, the changes in the 2016 Model have gone beyond the recommendations of BEPS and have incorporated more stringent conditions. Splitting up of construction contracts in the context of Construction Permanent Establishment (PE) The 2016 Model contains a clause in Article 5 wherein, for determining whether the activities exceed the twelve-month threshold for Construction PE, (i) the activities carried on by the foreign enterprise during different periods that in total do not exceeding twelve months, and (ii) any connected activities carried on by the foreign enterprise or closely related enterprise, during different periods exceeding 30 days, shall be combined. Introduction of an arbitration clause in Mutual Agreement Procedure (MAP) In line with the recommendations of BEPS in Action Plan 14, the 2016 Model has incorporated an arbitration provision in the Article on MAP. Though the BEPS Action Plan 14 had not explicitly outlined the scope of this provision, the 2016 Model has incorporated detailed scope and the procedure to be followed in cases of arbitration. The key features of this provision are as follows: Any case pending before the Competent Authorities (CA) of both the Contracting States for resolution under MAP, inter alia, o for at least two years; o where the CAs are unable to reach an agreement; o where the case is suitable for resolution through arbitration, as per the CAs; or o where a case has not already been disposed of by any Court of either Contracting State; shall be resolved through arbitration. Detailed guidance has been provided for the constitution of the arbitration panel, including the procedure for resolution of the case through arbitration. The MAP, including the arbitration proceedings, shall automatically terminate if the case is disposed of by any Court of either Contracting State during the arbitration proceedings. The determination of the case post arbitration shall be binding on the Contracting States, if accepted by all the concerned persons (whose tax liability may be affected by mutual agreement) within 45 days of receipt of the determination; in the event of non-acceptance, the case shall not be eligible for any further consideration by the CAs under MAP. The time periods and procedures involved in the process of arbitration should be mutually preagreed to by the CAs before submission of the case for arbitration. Other significant changes Limitation on Benefits (LoB) clause Largely, the LoB clause recommended in BEPS Action Plan 6 was based on the LoB clause in the 2006 Model; however, the LoB clause of the 2016 Model has been substantially modified. Key changes made in the LoB clause in the 2016 Model are captured below: The conditions prescribed in the LoB clause are required to be fulfilled by the resident of a Home State ( tested entity ) at the time the benefit is accorded PwC Page 2

3 to such tested entity under the 2016 Model; this change is in line with the recommendation under BEPS Action Plan 6. The derivative benefit test that is, the test based on ownership and base erosion has been modified as follows: o Ownership test expanded to cases where the residents of the Home State eligible for benefits of the convention indirectly own more than 50 percent of the aggregate vote and value of shares or other beneficial interest in the tested entity through the residents of a Third State. However, such a Third State should have a comprehensive tax treaty with the Source State that has provisions similar to Special Tax Regimes (STR) and notional deductions of interest. The 2016 model has defined the term STR to mean any statute, regulation or administration in a state, with respect to taxes covered by the tax treaty that satisfies all of the prescribed conditions. o The base erosion test, further restricted to incorporate the principles of STR/ notional deductions in cases of interest payments, that is, the payments to connected persons that benefit from STR/ notional deductions with respect to payments which are tax deductible in the Home State, should be less than 50 percent of the tested company s and tested group s 1 gross income 1. o In case the tested entity is a subsidiary of a company listed on a recognised stock exchange 1, which would have otherwise qualified under the ownership test, it has to also satisfy the base erosion test. o The derivative benefit test has been extended to tested entities, being a company in which at least 95% of the aggregate vote and value of shares or other beneficial interest is held directly or indirectly by seven or less equivalent beneficiaries. Equivalent beneficiaries are defined to include the following persons, with certain exceptions (like individuals taxable at fixed rate of tax or involvement of fiscally transparent entities): (i) Third State residents who satisfy specific conditions of the LoB clause. (ii) With respect to interest, dividends or royalties income for which benefit is sought, the Third State residents would be chargeable for tax at a rate lower than or equal to the rate applicable to the tested entity under the 2016 Model. (iii) With respect to business profits, gains and other income for which benefit is sought, the Third State 1 Defined under the revised model residents would be entitled to benefits at least as favourable as those for the tested entity under the 2016 Model. (iv) Residents of the Home State who are entitled to benefits under the 2016 Model, based on the LoB clause. (v) Resident of the Source State who are entitled to benefits under the 2016 Model based on the LoB clause. However, such Source State residents should not, together, own more than 25 percent of the aggregate vote and value of shares or other beneficial interest in the tested entity. The active business test, that is, the test where income for which benefit is sought is tested against the active conduct of business or trade carried on by the tested entity in the Home State, is modified as follows: o Instead of income for which the benefit under the 2016 Model is sought, being derived in connection with or incidental to the active trade or business of the tested entity, the income has to emanate from or has to be incidental to active trade or business of the tested entity in the Home State. o In addition to investment companies, holding companies, companies engaged in administrative and supervisory functions PwC Page 3

4 for group companies and group financing companies, or a combination of these, are disqualified from the benefit of the active business test. A headquarter company test has been introduced under the 2016 Model. A company otherwise not qualified for the benefit of the 2016 Model would be qualified to take the benefit of the 2016 Model solely for interest and dividend income received from the members of its multinational corporate groups, if it qualifies as a headquarter company. A company which functions as a headquarter company for a multinational corporate group consisting of its direct and indirect subsidiaries and satisfies the following conditions is regarded as a headquarter company: o Company s primary place of management and control 1 is in the Home State. o The multinational corporate group should consist of companies resident in at least four states/ group of states and engaged in active conduct of a trade or business in such countries/ group of states. o Gross income 1 of the group should be at least 10% from each of such states/ group of states. o Gross income 1 from any one state (other than the Home State of the Headquarter State) should be less than 50 percent. o Gross income 1 of the Headquarter State from the Source State should not exceed 25 percent. o The Headquarter State is subject to the same taxation laws in the Home State which are applicable to companies that are actively conducting trade or business, that is, such a state does not have a special tax regime for such Headquarter States. o The Headquarter State has to satisfy the modified base erosion test discussed above. Under the revised principal purpose test, the tested entity, in addition to demonstrating the fact that the principal purpose for its existence is not to obtain benefits of the 2016 Model, has to also demonstrate a substantial non-tax nexus to its Home State. Further, the CAs have to consult each other before accepting or denying the grant of benefit under this clause. The tie breaker rule in the case of companies Under Article 4(4) of the 2006 Model, provided if a company is a resident of both Contracting States, it shall be deemed to be a resident of the Contracting State in which it was organised. In all other cases involving dual residency, the authorities shall mutually determine the Contracting State in which the company will be treated as a resident. However, if the authorities do not reach a conclusion, the company will not be treated as a resident of either Contracting States. Article 4(4) of the 2016 Model now provides that if a company is a resident of both the Contracting States, such company shall not be treated as a resident of either Contracting States for claiming treaty benefits. Adjustment to profit attributable to PE Article 7(3) of the 2016 Model provides that where a Contracting State adjusts the profits attributable to a PE of an enterprise of one of the Contracting States and accordingly taxes profits which have been taxed in the other Contracting State, the other Contracting State shall eliminate double taxation by making an appropriate adjustment, if it agrees with the adjustment made by first Contracting State. If the other Contracting State does not so agree, the Contracting States shall eliminate double taxation by mutual agreement. Changes in the Article on Dividend, Interest and Royalty Special provision for payments by expatriated entities o The 2016 Model states that dividend, interest or royalties paid by an expatriated entity in the US and beneficially owned by a company resident in other specified Contracting States, where the payer and payee are connected persons, will be taxed in accordance with the laws of the US for a period of 10 years from the date of acquisition of the domestic entity. o The definition of expatriated entity has to be considered as per the domestic laws of the US. o Certain exceptions to the above provision have been provided. Taxability of dividend, interest and royalty payments in case of nonfulfilment of LoB clause PwC Page 4

5 o In case a tested entity is not able to fulfil the condition(s) under the applicable LoB clause with respect to a dividend, interest or royalty because it does not fulfil the requirement of being held by equivalent beneficiaries, such tested entity will be taxed in the Source State and as per the laws of that State. o However, the tax rate shall not exceed the highest of the rates to which the persons who do not qualify as equivalent beneficiaries would have been entitled to if such persons had received the dividend/ interest/ royalty directly. Taxability of interest and royalty in case of STR In case the interest or royalty is received by a resident of a Contracting State who benefits from an STR with respect to such interest or royalty in its Residence State, the interest may be taxed in the State in which it arises, in case the payer is a connected person with the recipient. Taxability of interest in specific cases o In case the interest is received by a resident of a Contracting State who benefits at any time during the taxable year in which interest is paid from notional deductions with respect to amounts that the residence State treats as equity, the interest may be taxed in the Source State in case the payer is a connected person with the recipient. o In case the interest is received by a beneficial owner who is resident of a Contracting State and is entitled to the benefits of the Article on interest only by reason of the headquarter rule in paragraph 5 of Article 22, the interest may be taxed in the Source State but the tax shall not exceed 10% of the gross amount of interest. Impact of cessation of residence As per the domestic tax laws of some Contracting States, when an individual ceases to be a resident of that State, it is deemed that s/he has alienated her/ his property for its fair market value, and is taxed on such alienation. As per the 2016 Model, in such a case, for the purpose of taxation in other Contracting States, the individual can elect to be treated as having alienated the property and reacquired the same at fair market value. Exchange of information The 2016 Model incorporates a new provision whereby any information received by the CAs can be made available under the provisions of a mutual legal assistance treaty in force between the Contracting States, which allows for the exchange of tax information. Subsequent change in law The 2016 Model incorporates a new Article that pertains to subsequent changes in laws in the other Contracting States. This Article addresses a situation in which, after a tax treaty is signed between the US and the other Contracting States, one of the Contracting States either: o reduces overall corporate tax rate applicable to resident companies to lesser of 15 percent or 60 percent of the overall corporate tax rate applicable to resident companies in the other Contracting States; or o exempts all foreign sourced income of resident companies from taxation. In this situation, to ensure the elimination of double taxation without creating opportunities for double non-taxation, as well as to restore appropriate allocation of taxing rights between the two Contracting States, this Article requires tax treaty partners to consult and determine if any amendments to the relevant articles of their tax treaty are necessary. In case such consultation fails to progress, a tax treaty partner can issue a diplomatic note stating that it will cease to grant tax treaty benefits for certain foreign sourced income. The takeaways Although the 2016 Model has incorporated several changes to the 2006 Model, it has not considered the recommendations made by the OECD in its BEPS Action Plan 7 with respect to dependent and independent agents, and the exemption for preparatory and auxiliary activities. In this context, the preamble states that such recommendations shall be adopted in the tax treaties post negotiations and discussions between the countries. PwC Page 5

6 The 2016 Model has not addressed the issues raised by the OECD in BEPS Action Plan 1 with respect to taxation in the digital economy (e.g., issues such as characterisation, nexus and taxable presence). The insertion of the new Article 28 Subsequent Changes in Law, is a significant addition and it will be interesting to see, practically, how the countries consult and determine the need for amendments in their tax treaty, on account of beneficial tax treatment to residents under domestic laws. Although the LoB clause in the 2016 Model is very extensive, it will be interesting to see how the countries incorporate such a clause in their tax treaties. The test for primary place of management and control has been provided for listed and companies and headquarter companies to qualify under the LoB clause. The definition of primary place of management and control lays emphasis on exercise of day-to-day responsibility for more of the strategic, financial and operational policy decisionmaking for the company and its direct/ indirect subsidiaries. At this stage, it will be relevant to compare this to the term, Place of Effective Management, introduced under Indian tax regulations, which lays emphasis on key management and commercial decisions that are necessary for the conduct of business of an entity as a whole. It will be interesting to see whether Indian tax regulators would import this term in Indian tax regulations/ treaties. It should be noted that the LoB clause in the BEPS report on Action Plan 6 is yet to be finalised by the OECD, and it remains to be seen whether the OECD incorporates the changes in the 2016 Model LoB clause in Action Plan 6. Let s talk For a deeper discussion of how this issue might affect your business, please contact: Tax & Regulatory Services Direct Tax Gautam Mehra, Mumbai gautam.mehra@in.pwc.com Rahul Garg, Gurgaon rahul.garg@in.pwc.com PwC Page 6

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