On July 16 and 17, 2019, the U.S. Senate approved resolutions of ratification of protocols to amend existing income tax treaties between the United States and various countries, including Spain, Japan, and Switzerland. Before these agreements are considered to be entered into force, a few additional steps must be taken, including ratification by the president of the United States and each respective country’s ratification procedures.
This article summarizes certain provisions of each protocol, which are generally similar to rules of recent U.S. income tax treaties –, the U.S. Model Income Tax Convention (the U.S. Model Treaty) and the 2010 Model Tax Convention on Income and on Capital of the Organisation for Economic Co-operation and Development – with certain deviations, including new provisions related to:
- Dividends
- Interest
- Mandatory binding arbitration
- Exchange of information
- With respect to Spain, (i) fiscally transparent entities, (ii) capital gains and (iii) limitation on benefits
- With respect to Japan, the definition of real property
Spain
The existing U.S.-Spanish Treaty1 would be amended by the new protocol (the Spanish Protocol). The Spanish Protocol contains the most expansive changes of the various protocols discussed in this article and generally modernizes the U.S.-Spanish Treaty to track more closely the United States’ income tax treaties with other European Union member countries.
Fiscally Transparent Entities
Under Section 894(c) of the Internal Revenue Code of 1986, as amended (the Code), and the Treasury Regulations promulgated thereunder, payments of U.S. source income to a non-U.S. investor qualifying for tax treaty benefits through an entity are eligible for reduced tax rates under the applicable tax treaty only if the entity is treated as fiscally transparent for purposes of the tax laws of the investor’s jurisdiction.
The United States is working to include provisions similar to Section 894(c) of the Code on fiscal transparency in its tax treaties, to ensure that a non-resident cannot argue that the lack of treaty-specific language overrides Section 894(c) of the Code. In this regard, the Spanish Protocol adds rules for items of income derived through fiscally transparent entities. These rules are largely the same as those in the U.S. Model Treaty, with one exception. Under these rules, income derived through an entity that is fiscally transparent under the laws of either treaty country, and that is formed or organized in either treaty country or in a country that has in force with the treaty country from which the income is derived an agreement including a provision for the exchange of information on tax matters, is considered to be the income of a resident of one of the treaty countries only to the extent that the income is subject to tax in that country as the income of a resident. For example, if a Spanish company pays interest to an entity that is treated as fiscally transparent for U.S. tax purposes and is formed or organized either in the United States or in a country with which Spain has an agreement in force including a provision for the exchange of information on tax matters, the interest will be considered to be derived by a resident of the United States only to the extent that U.S. tax laws treat one or more U.S. residents (whose status as U.S. residents is determined under U.S. tax laws) as deriving the interest income for U.S. tax purposes.
The scope of the rules for income derived through fiscally transparent entities in the Spanish Protocol is narrower than the scope of those rules in the U.S. Model Treaty and the rules provided in a 2006 mutual agreement between the competent authorities of Spain and the United States (the 2006 Competent Authority Agreement) related to the treatment of limited liability companies, S corporations, and other business entities treated as fiscally transparent for U.S. tax purposes. As described above, the rules of the Spanish Protocol apply only if the fiscally transparent entity in question is formed or organized in one of the two treaty countries or in a country that has in force with the treaty country from which the income is derived an agreement that includes a provision for the exchange of information on tax matters. By contrast, the U.S. Model Treaty rules and the rules of the 2006 Competent Authority Agreement apply without regard to the country of residence of the fiscally transparent entity.
According to the Technical Explanation, the Spanish Protocol’s rules for income derived through fiscally transparent entities apply even if an entity organized in one treaty country is viewed differently under the tax laws of the other treaty country. For example, income from U.S. sources received by an entity organized under the laws of the United States, which is treated for Spanish tax purposes as a corporation and is owned by a Spanish shareholder who is a Spanish resident for Spanish tax purposes, is not considered derived by the shareholder of that corporation even if, under the tax laws of the United States, the entity is treated as fiscally transparent. Rather, for purposes of the treaty, the income is treated as derived by the U.S. entity.
Dividends
The Spanish Protocol would have several changes with regard to dividend taxation. When a company that is a resident of one treaty country receives and beneficially owns dividends paid by a company that is a resident of the other treaty country, the source-country withholding tax rate is reduced to zero if the company receiving the dividends has owned shares representing at least 80% of the voting power of the company paying the dividend for the 12-month period ending on the date on which entitlement to the dividend is determined. Under the U.S.-Spanish Treaty, these dividends may be taxed at a 10% rate. The determination of whether the 80% ownership requirement is satisfied is made by taking into account stock owned directly or indirectly through one or more residents of either treaty country.
Eligibility for the benefits of the 0% rate provision is subject to a more stringent set of limitation-on-benefits requirements (the LOB Requirements) than the requirements that normally apply under the Spanish Protocol. Specifically, to qualify for the 0% rate, the dividend-receiving company must (1) satisfy the public trading test of the LOB Requirements; (2) meet the ownership and base erosion test, and satisfy the active trade or business conditions of the LOB Requirements with respect to the dividend in question; (3) satisfy the derivative benefits test of LOB Requirements with respect to dividends; or (4) receive a favorable determination from the competent authority with respect to the 0% rate provision.
A 0% rate of withholding tax also applies for dividends paid by a resident of one treaty country and beneficially owned by a pension fund that is a resident of the other treaty country, and is generally exempt from tax or subject to a 0% rate of tax, provided that the dividends are not derived from the carrying on of a trade or business, directly or indirectly, by the fund.
In addition, dividends paid by a company that is a resident of a treaty country to a resident of the other country may be taxed in that other country. The dividends also may be taxed by the country in which the payor company is resident, but the rate of tax is limited. Under the Spanish Protocol, source-country taxation of dividends (that is, taxation by the country in which the dividend-paying company is resident) generally is limited to 15% of the gross amount of the dividends derived and beneficially owned by residents of the other treaty country. A lower rate of 5% applies if the beneficial owner of the dividends is a company that owns directly at least 10% of the voting stock of the dividend-paying company.
The rate of branch profits tax is generally limited to 5%, but a 0% rate applies where LOB Requirements parallel to those applicable to the 0% rate provision for dividends are satisfied.
Interest
The Spanish Protocol provides that interest arising in one treaty country (the source country) and beneficially owned by a resident of the other treaty country generally is exempt from tax in the source country. This exemption from source-country tax is similar to the rule of the U.S. Model Treaty.
The exemption from source-country taxation does not apply if the beneficial owner of the interest carries on business through a permanent establishment in the source country or performs in the source country independent personal services from a fixed base situated in that country, and the debt-claim in respect of which the interest is paid is effectively connected with that permanent establishment or fixed base. In that circumstance, assuming the beneficial owner of the interest is a resident of one of the treaty countries, the interest is taxed as business profits (Article 7) or income from independent personal services (Article 15). According to the Technical Explanation, interest on a debt claim that is effectively connected with a permanent establishment or fixed base, but that is received after the permanent establishment or fixed base, is no longer in existence is taxable in the country in which the permanent establishment existed.
The Spanish Protocol provides anti-abuse exceptions to the general source-country exemption from tax on interest arising in the United States, notably, related to contingent interest payments. The Spanish Protocol permits the United States to tax interest arising in the United States that is contingent interest and therefore does not qualify as portfolio interest under U.S. law. The rate of U.S. tax on contingent interest arising in the United States and beneficially owned by a Spanish resident may not exceed 10% of the gross amount of the interest. This 10% rate is lower than the U.S. Model Treaty’s maximum rate of 15% for contingent interest but is the same as the highest permitted source country rate of tax on interest.
Capital Gains
The Spanish Protocol adds a new provision to the U.S.-Spanish Treaty permitting, providing that gains from the disposition of shares or other rights which directly or indirectly entitle the owner of such shares or rights to the enjoyment of immovable property (real property) situated in a treaty country (the source country) may be taxed in the source country.
Limitation on Benefits
The limitation-on-benefits provision includes restrictions similar to the limitations article included in the U.S. Model Treaty, as well as rules developed and included in recent U.S. income tax treaties to address headquarters companies and derivative benefits. A resident of either treaty country, as determined under Article 4 (Residence), may satisfy the restrictions of this article in one of several ways, subject to anti-abuse provisions.
The Spanish Protocol extends full benefits to the same categories of persons identified in the U.S. Model Treaty as qualified persons:
- an individual other than one receiving income as a nominee for, or on behalf of, a beneficial owner resident in a third-country;
- one of the two treaty countries, or any political subdivision or instrumentality thereof;
- a public company or its subsidiary;
- certain pension funds and charitable or philanthropic organizations that are established in its country of residence exclusively for religious, charitable, scientific, artistic, cultural, or educational purposes, regardless of its tax-exempt status under the residence country’s domestic law; or
- an entity that satisfies both an ownership test and a base-erosion test.
In addition to these five categories, the Spanish Protocol extends full benefits to headquarters companies, that is, entities that perform headquarter functions for a multinational group of companies and are subject to the same income tax rules in its country of residence as would apply to a company engaged in the active conduct of a trade or business in that country with independent authority to carry out its supervisory and administrative functions.
Mandatory Arbitration
The Spanish Protocol adds rules for mandatory and binding arbitration for certain cases about which the competent authorities cannot reach a negotiated agreement. A mandatory and binding arbitration procedure is not included in the U.S. Model Treaty but has recently been included in the U.S. income tax treaties with various jurisdictions. In general, the new rules mandate resolution through arbitration of any case initiated under the mutual agreement procedure if the competent authorities have tried but are unable to reach a complete agreement within two years of the commencement date of the case.
Exchange of Information
The Spanish Protocol has updated the exchange of information provisions similar to the U.S. Model Treaty and OECD standards. Information may be exchanged to enable each treaty country to administer its own domestic law, to the extent that taxation under that law is not contrary to the Spanish Protocol. The competent authority of one treaty country may request information about a transaction from the competent authority of the other treaty country even if the transaction to which the information relates is a purely domestic transaction in the requested country and information exchange about the transaction would not be undertaken to carry out the Spanish Protocol.
Entry into Force
The Spanish Protocol is subject to ratification in accordance with the applicable procedures in the United States and Spain. The treaty countries shall notify each other in writing, through diplomatic channels, when their respective applicable procedures have been satisfied. The Spanish Protocol will enter into force three months following the date of the later of the notifications. The date the Spanish Protocol enters into force is not necessarily the date on which its provisions take effect.
With respect to withholding taxes (principally on dividends, interest, and royalties), the Spanish Protocol has effect for amounts paid or credited on or after the date on which the Spanish Protocol enters into force. With respect to taxes determined with reference to a taxable period, the Spanish Protocol has effect for taxable periods beginning on or after the date on which the Spanish Protocol enters into force. In all other cases, the Spanish Protocol has effect on or after the date on which the Spanish Protocol enters into force.
Japan
The existing U.S.-Japanese Treaty2 would be amended by the new protocol (the Japanese Protocol).
Dividends
The U.S.-Japanese Treaty provides that dividends paid by a company that is a resident of one of the treaty countries and beneficially owned by a company that is a resident of the other treaty country may not be taxed by the country of residence of the company paying the dividends if, among other requirements, the beneficial owner of the dividends has owned, directly or indirectly through one or more residents of either treaty country, more than 50% of the voting stock of the company paying the dividends for the 12-month period ending on the date on which entitlement to the dividends is determined.
The Japanese Protocol reduces the (i) ownership threshold for elimination of source-country tax to at least 50% of the voting stock of the company paying the dividends and (ii) the required holding period to the six-month period ending on the date on which entitlement to the dividends is determined.
By contrast with the U.S.-Japanese Treaty and Japanese Protocol, the U.S. Model Treaty does not provide a 0% rate of source-country withholding tax on parent-subsidiary dividends. Zero-rate provisions have, however, been included in 13 in-force and proposed U.S. bilateral income tax treaties and protocols3. The 50% ownership (existing treaty [more than 50%] and Japanese Protocol [at least 50%]) and six-month holding period (Japanese Protocol) requirements of the U.S.-Japanese Treaty are less strict than the 0% rate requirements of the other 12 treaties. Those other 12 treaties provide 80% ownership and 12-month holding period requirements.
Interest
While Article 11 of the U.S.-Japanese Treaty allows for source country taxation of interest beneficially owned by a resident of the other treaty country, Article IV of the Japanese Protocol brings the tax treatment of cross-border interest payments into closer alignment with the rules described in the U.S. Model Treaty and exempts such interest from source-country taxation. Contingent interest may be taxed in the source country in accordance with its internal laws. However, if the beneficial owner is a resident of the other treaty country, the gross amount of such interest may not be taxed at a rate exceeding 10%.
Definition of Real Property
The Japanese Protocol defines real property situated in the United States as including a United States real property interest, conforming with the definition with the U.S. Model Treaty, incorporating United States domestic law (e.g., FIRPTA).
Exchange of Information
Under the Japanese Protocol, the United States and Japan agree to exchange such information as is foreseeably relevant in carrying out the provisions of the Japanese Protocol or in carrying out the provisions of the domestic laws of the two treaty countries concerning all taxes of any kind imposed by a treaty country. The use of the word “relevant” indicates the breadth of the scope of the exchanges in establishing the standard for determining whether or not information may be exchanged under the Japanese Protocol. The Technical Explanation makes clear that the language of the Japanese Protocol is intended to provide for exchange of information in tax matters to the widest extent possible while clarifying that the United States and Japan are not at liberty to engage in “fishing expeditions” or otherwise to request information that is unlikely to be relevant to the tax affairs of a given taxpayer.
Mandatory Arbitration
The Japanese Protocol would add a binding arbitration provision similar to that in the Spanish Protocol.
Entry into Force
Article XV provides that the Japanese Protocol is subject to ratification in accordance with the applicable procedures of each country and that instruments of ratification will be exchanged as soon as possible. The Japanese Protocol will enter into force upon the exchange of instruments of ratification.
The Japanese Protocol is effective with respect to taxes withheld at source for amounts paid or credited on or after the first day of the third month next following the date on which the Japanese Protocol enters into force. With respect to other taxes, the Japanese Protocol is effective for taxable years beginning on or after January 1 of the year following the date on which the Japanese Protocol enters into force.
The mandatory binding arbitration rules will have effect with respect to cases that are under consideration by the competent authorities as of the date on which the Japanese Protocol enters into force.
The exchange of information provisions will have effect from the date of entry into force of the Japanese Protocol.
Switzerland
The existing U.S.-Swiss Treaty4 would be amended by the new protocol (the Swiss Protocol).
Dividends
The Swiss Protocol exempts from source-country taxation dividends paid to a pension plan or other retirement arrangement that is a resident in the other country, or an individual retirement savings plan that is set up in and owned by a resident of the other country. This exemption does not apply if such pension plan or other retirement arrangement or such individual retirement savings plan controls the company paying the dividend.
Mandatory Arbitration
The Swiss Protocol would add a binding arbitration provision similar to that in the Spanish Protocol and Japanese Protocol.
Exchange of Information
The Swiss Protocol would add a binding arbitration provision similar to that in the Spanish Protocol.
Entry into Force
The Swiss Protocol is subject to ratification in accordance with the applicable procedures of each treaty country, and instruments of ratification will be exchanged as soon as possible. The Swiss Protocol will enter into force upon the exchange of instruments of ratification.
With respect to withholding taxes, the provisions of the Swiss Protocol will have effect for amounts paid or credited on or after the first day of January in the first calendar following the year in which the Swiss Protocol enters into force.
The Swiss Protocol applies, with respect to Articles 3 and 4, to requests made on or after the date the Swiss Protocol enters into force. For information described in paragraph 5 of Article 25, the Swiss Protocol applies to information relating to any date beginning on or after September 23, 2009 (the date of signature of the Swiss Protocol). With respect to all other information, the Swiss Protocol applies to taxable periods beginning on or after January 1, 2010 (the year following the date of signature of the Swiss Protocol).
The binding arbitration provisions will apply with respect to cases that are under consideration by the competent authorities as of the date the Swiss Protocol enters into force and to cases that come under consideration after the Swiss Protocol enters into force.
1 Convention Between the United States of America and the Kingdom of Spain for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, as amended (the U.S.-Spanish Treaty).
2 Convention Between the Government of the United States of America and the Government of Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, as amended (the U.S.-Japanese Treaty).
3 Explanation of Proposed Income Tax Treaty Between the United States and Japan, Joint Committee on Taxation, October 28, 2015.
4 Convention Between the United States of America and the Swiss Confederation for the Avoidance of Double Taxation with Respect to Taxes on Income, as amended (the U.S.-Swiss Treaty).
