Triangular Tax Treaty Provision: IRS Overview for Foreign Investors

Triangular Tax Treaty Provision of Foreign Investors

Triangular Tax Treaty Provision of Foreign Investors

Triangular Tax Treaty Provision of Foreign Investors: In general, a Tax Treaty is designed facilitate an international tax “understanding” between two countries (contracting states). The United States has entered into bilateral tax treaties with more than 50 countries. There are also estate tax treaties, totalization agreements and FATCA agreements — but the focus on this article is the triangular tax treaty provision, in which three (3) countries are involved, and Taxpayers maneuvers through and around multiple tax treaties, in order to work to reduce or eliminate taxes and the IRS hassle that would otherwise not be available if the tax treaties were not in existent. Let’s review the basics of the Triangular Tax Treaty Provision:

Common Example of a Triangular Tax Treaty Provision

Here is a common example of a triangular tax treaty conundrum:

• • • Resident of Country “R”

    • Has a Permanent Establishment in “PE”

    • Which derives income from Country “S”

Stated another way: a Resident of Country R owns a Permanent Establishment in country PE. The Permanent Establishment receives passive income from Country S. Since there are multiple tax treaties — and PE is a big catalyst for income — the question becomes how to apply the tax treaty so which treaty should apply.

Austria Tax Treaty Triangular Cases

The Austria Tax Treaty refers to this issue as follows:

• • • Like other U.S. tax treaties and agreements, this Convention provides the standard anti-abuse rules for certain classes of investment income.

    • In addition, the proposed Convention provides for the elimination of another potential abuse relating to the granting of U.S. treaty benefits in the so-called “triangular cases,” to third-country permanent establishments of Austrian corporations that are exempt from tax in Austria by operation of Austrian law.

    • Under the proposed rule, full U.S. treaty benefits will be granted in these “triangular cases” only when the U.S.- source income is subject to a significant level of tax in Austria and in the country in which the permanent establishment is located. This anti-abuse rule does not apply in certain circumstances, including situations in which the United States taxes the profits of the Austrian enterprise under subpart F of the Internal Revenue Code.

Netherlands Tax Treaty Triangular Cases are a Problem

As provided in the Netherlands Tax Treaty:

• • • The Convention also provides for the elimination of another abuse relating to the granting of U.S. treaty benefits to third-country permanent establishments of Netherlands corporations that are exempt from tax in the Netherlands.

    • Under the new Convention, if the Netherlands has not dealt satisfactorily with this so-called “triangular case” problem through legislation prior to Senate consideration of the Convention, negotiations will be reopened to address this issue.

• • • Concerns that a Tax-Exempt business in the Netherlands forms a third-country permanent establishments of Netherlands corporations that are exempt from tax in the Netherlands

    • Article l of the Protocol added a new paragraph 8 to the Article to deal with the treatment of interest in the context of the so-called “triangular case”. The inclusion of such a rule was provided for in paragraph 4 of Article 24 of the Convention prior to the Protocol.

    • The term “the triangular case” refers to the use of the following structure by a resident of the Netherlands to earn, in this case, interest income from the United States.

    • The resident of the Netherlands, who is assumed to qualify for benefits under one or more of the provisions of Article 26 (Limitation on Benefits), sets up a permanent establishment in a third jurisdiction that imposes only a low rate of tax on the income of the permanent establishment.

    • The Netherlands resident lends funds into the United States through the permanent establishment. The permanent establishment, despite its third-jurisdiction location, is an integral part of a Dutch resident. Therefore the income that it earns on those loans, absent the provisions of paragraph 8, is entitled to exemption from U.S. withholding tax under the Convention. Under current Netherlands law, under a Netherlands income tax treaty with the host jurisdiction of the permanent establishment, or in the case of the Netherlands Antilles or Aruba, under Netherlands Kingdom law, the income of the permanent establishment is exempt from Netherlands tax. Thus, the interest income is exempt from U.S. tax, is subject to little tax in the host jurisdiction of the permanent establishment, and is exempt from Netherlands tax. A

    • Although the paragraph is drafted reciprocally, as a practical matter, it will apply only with respect to U.S. source interest that is attributable to a third-jurisdiction permanent establishment of a Dutch resident, because the United States does not exempt the profits of a third-jurisdiction permanent establishment of a U.S. resident from U.S. tax, either by statute or by treaty. The descriptions in this explanation, therefore, are in the context of a resident of the Netherlands deriving U.S. source income.

Paragraph 8 Article 12 Example

• • • It was mutually recognized by the two States that the multiple non-taxation resulting from this structure is an abuse that must be corrected. Proposed Netherlands legislation to correct the problem could not be enacted prior to ratification of the Convention, and, in any event, the proposed legislation would not deal with the issue with respect to Netherlands tax treaties or Kingdom legislation.

    • When the legislation is enacted, and Dutch treaties and Kingdom legislation are amended to remove the exemption in abuse cases, the provision of paragraph 8 will be applicable less frequently.

Breaking Down the Basics of a Triangular Tax Treaty Scenario

• • Resident of the Netherlands sets up a Tax Exempt Company in Netherlands: the structure established in in the Netherlands is Tax Exempt in that country.

  • PE in a low-taxed 3^rd party country: The Permanent Establishment is in a low-taxed J/x, so that when the PE is taxed, it is only taxed at a very low rate AND foreign tax credits are not necessary — since it is Tax Exempt in Netherlands.

  • The Netherlands Company uses the PE to lend to the United States: The PE (foreign company) lends money to the US and generates interest.

  • Interest generated from the US loan (Without new paragraph 8) would not have tax withholding in the US: Without prevention, the interest would go back to Netherlands (with no withholding) and would be exempt in in Netherlands

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