by Jeffrey L. Rubinger
Generally, a non-U.S. taxpayer that is not engaged in a U.S. trade or business is taxable in the United States only on U.S.-source “fixed determinable, annual or periodical” income (FDAP).1 Unless an applicable income tax treaty applies to reduce the rate of tax, FDAP income typically will be subject to a 30 percent gross basis withholding tax. Included in the category of FDAP income that is subject to U.S. withholding tax is U.S. source dividends.2
While the substantial majority of income tax treaties concluded by the United States reduce or even eliminate the 30 percent withholding tax on U.S.-source dividends,3 not all foreign jurisdictions have comprehensive income tax treaties with the United States. This is particularly true in the case of Latin American jurisdictions. Currently, the only income tax treaties that are in effect with Latin American jurisdictions are those with Mexico and Venezuela, both of which have comprehensive limitations on benefits (LOB) provisions.4 Therefore, unless a non-U.S. taxpayer is able to satisfy the LOB provision in one of these treaties, any U.S.-source dividends repatriated from the United States to a nontreaty jurisdiction will generally be subject to a 30 percent withholding tax.
There are, however, a number of strategies that may allow U.S. corporate taxpayers to repatriate profits tax-free (or at substantially reduced rates) from the United States to taxpayers resident in Latin American jurisdictions, regardless of whether a treaty exists between the United States and that particular jurisdiction. This article will analyze several of these alternatives.
Non-U.S. taxpayers are subject to U.S. federal income taxation on a limited basis. Unlike U.S. taxpayers — who are subject to U.S. federal income tax on their worldwide income — non-U.S. taxpayers generally are subject to U.S. taxation on two categories of income: 1) certain passive types of U.S.-source income, e.g., interest, dividends, rents, annuities, and other types of income known as FDAP;5 and 2) income that is effectively connected to a U.S. trade or business (ECI).6
As noted above, FDAP income is subject to a 30 percent withholding tax that is imposed on a non-U.S. taxpayer’s gross income (subject to reduction or elimination by an applicable income tax treaty). ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. taxpayers.
For a non-U.S. taxpayer to be eligible for reduced withholding tax rates on U.S.-source FDAP income under a U.S. income tax treaty, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any LOB provision in the treaty (a provision which all recently negotiated comprehensive U.S. income tax treaties will contain). Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.”
Similarly, under most “modern” income tax treaties, a corporate resident of a treaty country can satisfy the LOB provision if 1) on at least half the days of the tax year at least 50 percent of each class of shares in the corporation is owned, directly or indirectly, by residents of the jurisdiction in which the corporation is formed (the “ownership test”); and 2) not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are residents of the U.S. or residents of the jurisdiction where the corporation is formed (the “base erosion” test).7
Treaties with Mexico and Venezuela
As noted above, the only income tax treaties that are currently in effect with Latin American jurisdictions are those with Mexico and Venezuela.8 Under the U.S.-Mexico income tax treaty, the 30 percent U.S. withholding tax rate on U.S.-source dividends paid to a Mexican resident taxpayer can be completely eliminated, but only if the taxpayer is a Mexican company that has owned at least 80 percent of the voting shares of the U.S. corporation for at least 12 months prior to the time the dividend has been declared,9 and either 1) the shares have been owned prior to October 1, 1998;10 2) the principal class of shares of the Mexican company are regularly traded on a recognized securities exchange in either the United States or Mexico;11 or 3) the derivative benefits article of the LOB provision can be satisfied.12 Otherwise, the withholding tax rate on U.S.-source dividends is reduced to either five or 10 percent, depending on the type of shareholder and percentage of ownership in the U.S. corporations.13
Unlike the U.S.-Mexico income tax treaty, the U.S.-withholding tax rate on U.S.-source dividends cannot be completely eliminated under the U.S.-Venezuela income tax treaty. Rather, the U.S. withholding tax rate on dividends under the Venezuela treaty is reduced to either five or 15 percent, depending on the type of shareholder and percentage of ownership in the U.S. corporations.14
Tax-efficient Repatriation Opportunities to Latin America
While a dividend paid by a U.S. corporation to a non-U.S. taxpayer resident in a Latin American jurisdiction that does not qualify for U.S. income tax treaty benefits typically would be subject to a 30 percent withholding, a number of opportunities exist that may be used to eliminate or substantially reduce this tax. One such strategy takes advantage of the so-called “boot within gain limitation” of I.R.C. §356(a).
• Boot within Gain Rule — In general, shareholders that are parties to a nontaxable reorganization do not recognize gain or loss with respect to exchanges of stock and securities in such reorganization. Under §356, however, a recipient of money or other property (boot) in a nontaxable reorganization recognizes gain (if any) on the transaction in an amount not in excess of the sum of such money and the fair market value of such other property. Moreover, if the exchange has the effect of the distribution of a dividend, then all or part of the gain recognized by the exchanging shareholder is treated as a dividend to the extent of the shareholder’s ratable share of the corporation’s earnings and profits.15 The remainder of the gain (if any) is treated as gain from the exchange of property.16
Accordingly, if a shareholder receives boot in connection with a corporate reorganization, the amount that the shareholder is required to recognize as income is limited to the amount of gain realized in the exchange (i.e., the boot within gain limitation). This rule applies regardless of whether the property received would otherwise be considered to be a dividend for U.S. federal income tax purposes.
What is notable about this provision is that it applies not only in a purely domestic setting, but it also applies in the cross-border setting. For example, assume a Brazilian parent corporation wholly owns multiple U.S. operations companies. Also assume that the shares of the U.S. subsidiaries have substantially increased in value and that one or more of the companies has excess cash that it desires to repatriate to Brazil without incurring U.S. withholding tax. Because the United States does not currently have an income tax treaty with Brazil, a dividend paid by one of the U.S. subsidiaries to the Brazilian parent would be subject to a 30 percent U.S. withholding tax.17
In an attempt to minimize the U.S. withholding taxes in this situation, the Brazilian parent transfers the shares of the U.S. subsidiaries to a Spanish holding company (ETVE).18 Assume that the Spanish ETVE is owned 75 percent by the existing Brazilian parent and 25 percent by a newly formed Brazilian company (which in turn is wholly owned by the existing Brazilian parent).19 Subsequently, an IRS Form 8832 (i.e., a “check-the-box” election) is filed on behalf of the Spanish ETVE converting it from a corporation into a partnership for U.S. federal income tax purposes.20
As a result of this deemed conversion, the Spanish ETVE is treated as if it distributed all of its assets (i.e., the shares of the U.S. subsidiaries) and liabilities to its shareholders in liquidation of the corporation, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.21 These deemed transactions should have no adverse U.S. federal income tax consequences, but will result in the shares of the U.S. subsidiaries being stepped up to fair market value for U.S. federal income tax purposes.
Subsequently, in a transaction characterized as a “D” reorganization for U.S. federal income tax purposes, one of the U.S. subsidiaries merges into another one of the U.S. subsidiaries (or into a disregarded U.S. LLC wholly owned by one of the U.S. subsidiaries) and, in exchange, the Spanish ETVE receives solely cash as consideration in the merger.22As a result of the shares of the U.S. subsidiaries being recently stepped up to fair market value pursuant to the check-the-box election, there will be no “gain” in the reorganization. Therefore, the boot (i.e., the cash) received by the Spanish ETVE in the reorganization will be received tax free under the “boot within gain limitation” rule, even though it would normally be treated as a dividend subject to a 30 percent withholding tax. The cash can subsequently be distributed from Spain to Brazil without triggering any foreign withholding taxes.23
As a result, the combination of §356(a) and the check-the-box rules allows for the repatriation of cash by the U.S. subsidiary to the Brazilian parent without triggering a U.S. withholding tax.24 This strategy is extremely beneficial when it is not practical to liquidate a U.S. operating company, which may be a simple solution to avoiding U.S. withholding tax on the repatriation of profits in certain situations.25
• Using Treaties without LOB Provisions — As previously indicated, it is the policy of the United States to insist on the inclusion of an LOB provision when entering into a new treaty or protocol. Nevertheless, a handful of older treaties do not contain such a provision. These treaties include the U.S. income tax treaties with the following countries: 1) Egypt, 2) Greece, 3) Korea, 4) Morocco, 5) Norway, 6) Pakistan, 7) Philippines, 8) Poland, 9) Romania, and 10) Trinidad and Tobago. None of these treaties currently contain LOB provisions.26 The benefits afforded by these treaties relate primarily to the reduced rates of U.S. withholding tax on payments of dividends, interest, and royalties.
As indicated above, payments of U.S.-source dividends to a foreign person are generally subject to a 30 percent withholding tax. A simple strategy to significantly reduce this withholding tax is available by having the nontreaty resident invest in the United States through a company formed in a jurisdiction whose treaty with the United States has no LOB provision and provides for a reduction in the U.S. withholding tax. This planning opportunity is even more beneficial when the chosen foreign jurisdiction neither completely exempts from its local corporate income tax (by way of a participation exemption) dividends received from other jurisdictions or grants a foreign tax credit for taxes incurred at the U.S. corporate level. For example, instead of a Colombian resident investing directly in a U.S. corporation, the Colombian resident can invest in the United States through a Polish corporation. Using this approach, a dividend paid from the U.S. would be subject only to a five percent U.S. withholding tax under the U.S.-Poland income tax treaty. The dividend received in Poland (which currently has a corporate income tax rate of 19 percent) would essentially be received tax free as a result of its foreign tax credit system because the United States corporate tax rate is higher than the Polish corporate tax rate. Dividends can then be repatriated out of Poland tax-free to an EU jurisdiction, such as Cyprus, which itself has no withholding tax on outbound dividends.
Simply because a particular U.S. income tax treaty does not contain an LOB provision does not necessarily mean that the IRS would not have the ability to deny treaty benefits in certain situations. One possible argument to do so is that the foreign corporation should be disregarded as a “sham” because either it has no substance or no business purpose. Based on language from the U.S. Supreme Court, however, this argument may not be successful.27
In particular, the U.S. Supreme Court has stated that a corporation will not be disregarded as a “sham” if it has a business purpose or engages in any business activity. In Moline Properties, Inc. v. United States, 319 U.S. 436 (1943), the U.S. Supreme Court explained that if the purpose of incorporating is to gain an advantage under the law of the state of incorporation or to avoid or comply with the demands of creditors, or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity.
Following the principles of Moline Properties, the IRS has indicated on more than one occasion that the fact that a foreign holding company does not actively engage in business and has no assets other than stock of another corporation does not support disregarding the corporation’s existence. For example, in FSA 200122007, the IRS specifically ruled that a foreign holding company whose sole assets were shares of stock of another foreign corporation should not be treated as a “sham” corporation and should satisfy the Moline business activity requirement. The IRS stated that “the requirement of a business activity under Moline is minimal” and “all that is required under Moline is the holding of a minimal amount of assets by the corporate entity.” The IRS ruled that simply holding the shares of another corporation satisfies the “minimal amount of assets” requirement set forth in Moline. This authority seems to indicate that the use of a holding company in a jurisdiction whose treaty with the United States has no LOB provision, such as Poland, for the sole purpose of repatriating profits out of the United States at a reduced tax rate may not be successfully challenged if the corporate formalities with respect to such holding company are adhered to, such as holding annual director meetings, maintaining a separate set of corporate books, maintaining a separate bank account, etc. In this regard, obviously it would be beneficial if the taxpayer were able to articulate a nontax reason for the existence of such a holding company or were able to establish some substance in the country of formation.28
• Contingent Interest — The strategies discussed above allow for the repatriation of dividends to Latin American jurisdictions in a tax-efficient manner regardless of whether a treaty exists between the United States and the particular jurisdiction. An alternative that is essentially economically equivalent to paying dividends is to repatriate profits in the form of contingent interest.29 While it generally would not be possible to pay contingent interest tax-free under the so-called “portfolio interest” rules,30 a limited statutory exception does exist that would allow non-U.S. taxpayers to receive tax-free contingent interest under these rules.
Contingent interest is exempt from U.S. withholding tax under the portfolio interest rules so long as the interest is determined by reference to 1) changes in the value of “actively traded” property (including stock) within the meaning of §1092(d), other than property described in §897(c)(1) or (g) (i.e., U.S. real property interests (USRPIs) and interests in partnerships, trusts, or estates that are considered USRPIs); 2) the yield on such property; or 3) changes in any index of the value of such property.31Therefore, interest paid to a foreign person that is contingent on one of the above factors will be exempt from the 30 percent U.S. withholding tax, regardless of the existence of a treaty.
Not surprisingly, there is very little guidance on this exception. In PLR 200933002, a U.S. corporation issues equity-linked and credit-linked notes to foreign persons. The notes paid contingent interest, which was based on the performance of an unrelated investment fund during the term of the note. The corporation hedged its exposure to the contingent interest payment by holding shares of the fund while the notes were outstanding. The fund was registered in the E.U. under a regime comparable to registration in the U.S. under the Investment Company Act of 1940 and its daily net asset value was available on a quotation system. The IRS ruled that the contingent interest payments were exempt from U.S. withholding tax under the portfolio interest exception, holding that interests in the fund were traded in an “interdealer market” (and, therefore, were actively traded), since information on the fund’s daily net asset value was available to subscribers to a quotation system.
When attempting to take advantage of this provision, the issue is what will be considered “actively traded” property (within the meaning of §1092(d)). The legislative history to §1092 merely provides that “[i]n order to be treated as actively traded, property need not be traded on an exchange or in a recognized market.” The only other guidance is a statement from the preamble to the regulations under §1.446-3 (dealing with notional principal contracts), where the IRS stated that it “believes that the term ‘actively traded’ under §1092 was intended to cover financial instruments that are liquid or easily offset, even when those instruments are not traded in an exchange or in a recognized secondary market.”32 Accordingly, the guidance interpreting this provision is rather limited. What is clear is that contingent interest that is tied to changes in the value of U.S. real property will not be covered by this rule and, therefore, generally will be subject to a 30 percent U.S. withholding tax.33
Currently, the only income tax treaties in effect with Latin American jurisdictions are those with Mexico and Venezuela, both of which have comprehensive LOB provisions. Therefore, unless a taxpayer resident in Latin America is able to qualify for benefits pursuant to one of these treaties, the repatriation of profits from the United States generally will be subject to a 30 percent U.S. withholding tax. This is precisely why the structures discussed above should be carefully considered.
1 I.R.C. §§871(a) and 881(a). All references to “section” refer to sections of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
3 The U.S.-Trinidad and Tobago Income Tax Treaty is an example of a treaty that does not reduce the 30 percent withholding tax on U.S.-source dividends.
4 In February 2010, the United States signed an income tax treaty with Chile, but the treaty is awaiting Senate ratification.
5 I.R.C. §§871(a) and 881(a).
6 I.R.C. §§871(b) and 882(a).
7 Other common manners of satisfying a treaty’s LOB provision include 1) carrying on active trade or business in the particular treaty jurisdiction in which the U.S.-source income in question is derived in connection with or incidental to such trade or business; or 2) having a corporate taxpayer whose principal class of shares are regularly traded on a recognized securities exchange. See, e.g., U.S.-Mexico Income Tax Treaty, art. 17.
8 As noted earlier, the U.S. did recently sign an income tax treaty with Chile. That treaty, however, is not yet in effect as it is waiting Senate ratification. Under the proposed treaty, the U.S.-withholding tax rate on U.S.-source dividends will be reduced from 30 percent to either five or 15 percent, depending on the type of shareholder and percentage of ownership in the U.S. corporations.
9 U.S.-Mexico Income Tax Treaty, art. 10(3)(a).
10 U.S.-Mexico Income Tax Treaty, art. 10(3)(a)(i).
11 U.S.-Mexico Income Tax Treaty, arts. 10(3)(a)(ii) and 17(1)(d)(i).
12 U.S.-Mexico Income Tax Treaty, arts. 10(3)(a)(iii) and 17(1)(g). In general, to satisfy the derivative benefits article, 1) more than 30 percent of the shares of the Mexican company need to be owned by residents of the United States or Mexico; 2) more than 60 percent of the shares of the Mexican company need to be owned by residents of jurisdictions that are a party to NAFTA; and 3) less than 70 percent of the Mexican company’s gross income can be paid in the form of deductible payments to persons who qualify for treaty benefits, and less than 40 percent of the Mexican company’s gross income can be paid in the form of deductible payments to residents of NAFTA jurisdictions or persons who qualify for treaty benefits.
13 U.S.-Mexico Income Tax Treaty, art. 10(2).
14 U.S.-Venezuela Income Tax Treaty, art. 10(2). It should be noted that “contingent interest” is taxed in the same manner as a dividend under the U.S.-Venezuela Income Tax Treaty at the 15 percent rate. U.S.-Venezuela Income Tax Treaty, art. 11(4).
15 Whether the exchange has the effect of the distribution of a dividend, see United States v. Clark, 489 U.S. 726 (1989).
16 I.R.C. §356(a)(2).
17 In this example, reducing or eliminating U.S. withholding tax is extremely important. The Brazilian-controlled foreign corporation rules (CFC) will cause the income earned by the U.S. subsidiaries to be taxed in Brazil at a currently 34 percent rate, regardless of the character of the income. While Brazil will grant a foreign tax credit for the U.S. corporate taxes paid (currently subject to a maximum rate of 35 percent), any excess U.S. withholding taxes will not be currently creditable in Brazil.
18 This transfer should be nontaxable for U.S. federal income tax purposes (even if the U.S. operating companies are considered “U.S. real property holding companies” under the Foreign Investment in U.S. Real Property Tax Act (FIRPTA)). See Treas. Reg. §1.897-6T(b).
19 The Brazilian parent’s direct ownership of the Spanish ETVE needs to be less than 80 percent so that the deemed liquidation that results when the check-the-box election is filed is not treated as a nontaxable parent subsidiary liquidation under §332. See GraniteTrust Co. v. United States, 238 F.2d 670 (1st Cir. 1956), as support for the proposition that a taxpayer should be allowed to affirmatively plan into a taxable §331 liquidation.
20 Treas. Reg. §301.7701-3(g)(1).
22 This is known as an “all cash” D reorganization, which have been approved by the IRS and treasury in regulations issued a few years ago. See Treas. Reg. §1.368-2(l)(2). It should be noted that a transaction structured as an “F” reorganization under §368(a)(1)(F) (i.e., a mere change in identity, form, or place of organization of one corporation) would not produce the same results, despite such a transaction being easier to structure, as Treas. Reg. §1.301-1(l) would treat the distribution separate and apart from the reorganization and cause it to be taxable.
23 The dividend will not be taxable to the Spanish ETVE under its participation exemption regime. In addition, a dividend paid by the ETVE to Brazil will be exempt from withholding tax in Spain. It also should be noted that the Spain-Brazil Income Tax Treaty would seem to provide that the dividend paid by the Spanish ETVE should not be taxable in Brazil. See Spain-Brazil Income Tax Treaty, art. 23(4). The Brazilian tax authorities appear to take a different view, however, despite the clear language of the treaty. For a discussion of this issue, see Brazilian Taxation of Spanish Dividends Still Uncertain, 2007 WTD 44-3 (March 5, 2007). If attempting to repatriate funds to residents of Venezuela, a similar strategy could be used by having the cash being paid through a Dutch cooperative. This is because the Netherlands-Venezuela Income Tax Treaty also provides that dividends paid by a Dutch company should not be taxable in Venezuela. See Netherlands-Venezuela Income Tax Treaty, art. 23(5). This appears to be the case regardless of whether the dividend is taxable by the Dutch cooperative, which it should not be, if properly structured.
24 It should be noted that Congress had proposed to repeal the “boot within gain” rule in situations where the distribution would have the effect of a dividend. See H.R. 62, International Tax Competitiveness Act of 2011, Doc 2011-576, 2011 TNT 7-32. This legislation never passed, however. The IRS also recently issued guidance that would curtail the use of this provision in certain outbound asset reorganizations where intellectual property is being transferred as part of the reorganization. See Notice 2012-39, IRB 2012-31 (July 30, 2012).
25 Liquidating distributions by non-USRPHCs generally are not subject to U.S. withholding tax. But see §332(d).
26 The United States recently signed a new income tax treaty with Hungary that contains a comprehensive LOB provision. This treaty is not yet in force, however. Accordingly, the existing U.S.-Hungary Income Tax Treaty, which does not contain an LOB provision, may only be utilized for a brief period of time until the new treaty comes into effect.
27 See Moline Properties, Inc. v. United States, 319 U.S. 436 (1943).
28 Another exception from U.S. withholding tax on dividends exists for dividends paid out of “existing” 80/20 companies. Under I.R.C. §871(l), an existing 80/20 company is any corporation if 1) the corporation met the 80-percent foreign business requirements of §861(c)(1) (as in effect prior to the date of the enactment of new §861(l)) for such corporation’s last taxable year beginning before January 1, 2011; 2) such corporation meets the 80 percent foreign business requirements of §871(l)(1)(B) with respect to each taxable year after the taxable year referred to in one above; and 3) there has not been an addition of a substantial line of business with respect to such corporation after August 10, 2010.
29 For this purpose, contingent interest is defined as any interest if the amount of such interest is determined by reference to 1) any receipts, sales, or other cash flow of the debtor or a related person; 2) any income or profits of the debtor or a related person; 3) any change in value of any property of the debtor or a related person; 4) any dividend, partnership distributions, or similar payments made by the debtor or a related person; or 5) any other type of contingent interest that is identified by the secretary by regulation, where a denial of the portfolio interest exemption is necessary or appropriate to prevent avoidance of federal income tax. See I.R.C. §871(h)(4)(A).
30 See I.R.C. §§871(h) and 881(c).
31 I.R.C. §§871(h)(4)(v).
32 A strategy that would allow for the repatriation of future profits in the form of a repayment of principal is also possible. For example, a company in a nontreaty jurisdiction (e.g., Brazil) could distribute a note to its parent corporation. Subsequent to the distribution of the note, the Brazilian company could domesticate into a U.S. corporation (which would be a tax-free inbound “F” reorganization). The U.S. company could then use future profits to repay the note without incurring withholding tax as the payments would be treated as a repayment of principal (rather than a dividend). The advantage of distributing the note prior to becoming a U.S. corporation is that the distribution would not be treated as a dividend from a U.S. perspective because it would be paid from one foreign company to another foreign company.
33 It should be noted that certain treaties also exempt contingent interest from U.S. withholding tax, regardless of whether the interest is tied to changes in the value of U.S. real property, such as the U.S. income tax treaties with Poland, Norway, the Czech Republic, and Greece.
Jeffrey L. Rubinger is a tax partner at Bilzin Sumberg in Miami and heads its international tax practice. He received his J.D. from the University of Florida School of Law and an LL.M. in taxation from New York University School of Law. He is admitted to the Florida and New York bars.
This column is submitted on behalf of the Tax Section, Michael Allen Lampert, chair; and Michael D. Miller and Benjamin Jablow, editors.