Tax Treaties Hybrid Entities and Tax Planning International

Tax Treaties, Hybrid Entities and Tax Planning International Fiscal Association New York Region International Tax Seminar November 17, 2005 1

• Moderator – Peter J. Connors (Orrick, Herrington & Sutcliffe LLP, New York) • Panelists – – Rocco V. Femia (Miller & Chevalier Chartered, Washington DC) Jonathan Hare (Pricewaterhouse. Coopers LLP, New York) Klaas-Jan Visser (Stibbe, New York) Marco Q. Rossi (Marco Q. Rossi & Associates, New York) 2

Agenda • U. S. history and background • Italy, Netherlands and U. K. Entity Classification Rules • Specific examples involving hybrids and reverse hybrids • U. K. Finance Legislation 3

Terminology • Fiscally transparent entity: Entity whose income is treated for tax purposes as income of its owners as if the owners had earned the income directly (e. g. , a partnership) • Hybrid entity: Entity treated as fiscally transparent by one treaty country, but not the other • Source country: Treaty country from which the income arises and whose (withholding or net basis) tax typically is at issue • Residence country: Treaty country in which the recipient of the income with respect to which treaty benefits are claimed resides 4

General Principles • In general, the source country should allow treaty benefits for income earned through a hybrid entity to the extent the income is subject to tax by the residence country as the income of a resident • In general, the source country will not allow treaty benefits for income earned through a hybrid entity – To the extent the income is NOT subject to tax by the residence country as the income of a residence; or – If the hybrid entity is treated as a non-fiscally transparent entity, and taxed as a resident, by the source country (savings clause) 5

General Principles - Example R Parent R Sub P/S Debt • Interest from S Sub to P/S is entitled to treaty benefits if subject to tax by R country as the income of R Parent • Treatment of P/S by S country and country of organization irrelevant S Sub 6

General Principles • These general principles are articulated in: – The 1996 U. S. Model Income Tax Treaty – The Commentaries to the OECD Model Treaty – Regulations under I. R. C. sec. 894 – Recent U. S. income tax treaties 7

1996 U. S. Model Tax Treaty • “An item of income, profit or gain derived through an entity that is fiscally transparent under the laws of either Contracting State shall be considered to be derived by a resident of a State to the extent that the item is treated for purposes of the taxation law of such Contracting State as the income, profit or gain of a resident. ” (Art. 4(1)(d)). • “[T]he terms ‘enterprise of a Contracting State’ and ‘enterprise of the other Contracting State’. . . also include an enterprise carried on by a resident of a Contracting State through an entity that is treated as fiscally transparent in that Contracting State. . . ” (Art. 3(1)(c)). 8

1996 U. S. Model Tax Treaty Technical Explanation • Provides explanatory guidance with respect to a number of issues, including – U. S. entities that are treated as fiscally transparent – Application of “subject to tax” test in cases where income is not actually taxed by the residence country 9

Sec. 894 Regulations • Generally apply general principles to all treaties to which the U. S. is a party • Provides rules concerning payments received by, and made by, domestic reverse hybrid entities 10

Commentaries to OECD Model Tax Treaty • “[P]artners should be entitled, with respect to their share of the income of the partnership, to. . . benefits. . . to the extent that the partnership's income is allocated to them for the purposes of taxation in their State of residence. ” Paragraph 5 of Commentary to Article 1. • “Where a State considers that. . . the partners are liable to tax in their State of residence on their share of the partnership's income, it is expected that State will apply the. . . Convention as if the partners had earned the income directly so that the classification of the income for purposes of the allocative rules of Articles 6 to 21 will not be modified by the fact that the income flows-through the partnership. ” Para. 6. 6 of Commentary to Article 1. • Observations by the Netherlands, France, and Portugal. 11

2001 U. S. -U. K. Treaty • “An item, of income, profit or gain derived through a person that is fiscally transparent under the laws of either Contracting State shall be considered to be derived by a resident of a Contracting State to the extent that the item is treated for the purposes of the taxation laws of such Contracting State as the income, profit or gain of a resident. ” Art. 1(8). • Technical Explanation provides significant commentary on the application of the provision and its interaction with the savings clause • Diplomatic Notes, which provide guidance regarding the mitigation of double taxation where both countries tax the same income as earned by a resident, has been interpreted by some to allow the countries considerable latitude in 12 denying treaty benefits with respect to hybrid entities

2001 U. S. -U. K. Treaty • With reference to Article 24 (Relief from Double Taxation): it is understood that, under paragraph 4 or 8 of Article 1 (General Scope), the provisions of the Convention may permit the Contracting State of which a person is a resident (or, in the case of the United States, a citizen), to tax an item of income, profit or gain derived through another person (the entity) which is fiscally transparent under the laws of either Contracting State, and may permit the other Contracting State to tax (a) the same person; (b) the entity; or (c) a third person with respect to that item. Under such circumstances, the tax paid or accrued by the entity shall be treated as if it were paid or accrued by the first-mentioned person for the purposes of determining the relief from double taxation to be allowed by the State of which that first-mentioned person is a resident (or, in the case of the United States, a citizen), 13

2004 U. S. -Netherlands Protocol • Provision, and commentary in Technical Explanation, virtually identical to 2001 U. S. -U. K. Treaty (Art. 24 (4)) • Diplomatic Notes state that the competent authority may grant treaty benefits to a resident of the other country even if that resident is not treated as the recipient of the income IF the resident would not have been taxed on the income had it been so treated (Example: exempt pension) • July 6, 2005 Dutch decree provides that the hybrid entity provision in the protocol will not apply to a dividend paid to a FTE under Dutch law that is treated as a corporation under U. S. law provided the Dutch company that pays the dividend is engaged in “real” activities in the Netherlands. 14

July 2005 Dutch Decree -- Example US Parent CV Dividend BV • BV makes dividend payment through CV to US P • CV is treated as an FTE by Netherlands, but as a corporation by US • Decree allows treaty benefits for dividends under certain circumstances 15

2003 U. S. -Japan Treaty • Provides most detailed rules of any U. S. treaty to date • Provide five fact patterns and results for each (Art. 4 (6)) • Protocol provides specific rule regarding TKs, generally allowing both countries to apply domestic law • Technical Explanation provides additional guidance: – Income should be eligible for treaty benefits available if income had been earned directly by owner of FTE – Stock held through an FTE is treated as held directly if FTE treated as fiscally transparent by BOTH countries 16

2005 Comp. Authority Agreement under 1992 U. S. -Mexico Tax Treaty • 1992 Protocol provides that “a partnership, estate, or trust is a resident of a Contracting State only to the extent that the income it derives is subject to tax in that State as the income of a resident, either in the hands of the partnership, estate or trust, or in the hands of its partners or beneficiaries. . ” Para. 2(b) • 2005 Comp. Authority agreement provides that “it is understood that income from sources within one of the Contracting States received by an entity that is treated as fiscally transparent under the laws of either Contracting State, will be treated as income derived by a resident of the other Contracting State to the extent that such income is subject to tax as the income of a resident of the other Contracting State. ” 17

Entity Classification Rules • Italy –Recent legislation • Netherlands - Decrees December 18, 2004 - New corporate partnership legislation: domestic qualification rules for tax purposes will not change • U. K. 18

Italy • Domestic resident entities organized in a legal form that provides for limited liability, centralized management and unlimited life (typically, joint stock company - SPA - limited liability company - SRL - and limited partnership with stock divided by shares - SAPA) are classified as separate entities and are subject to corporate income tax (i. e. , they are corporations in the U. S. tax sense). • Domestic resident entities organized in a legal form that provides for unlimited liability, non-centralized management and limited life (e. g. , general partnership SNC - limited partnership - SAS -) are treated as fiscally transparent entities not subject to tax (i. e. , they are partnerships in the U. S. tax sense). • Nonresident entities are treated as separate entities (i. e. , like corporations in the U. S. tax sense) in any event, regardless or their legal form, characteristic and tax treatment under foreign law. • Resident corporations are taxed on their worldwide income. Nonresident entities are subject to tax in Italy on their Italian source income. 19

U. S. LLCs – Example 1 F Parent US LLC • If US LLC treated as a corp for US purposes, no treaty benefits (savings clause) • If US LLC treated as a FTE for US purposes, treaty benefits if F treats income as subject to tax in the hands of F Parent – Contrast Section 894 Regulations and U. K. and Japan Treaties. Dividend US Sub 20

U. S. LLCs – Example 2 US Parent US LLC Dividend • If US LLC treated as a corp for US purposes, treaty benefits under general rules • If US LLC treated as a FTE for US purposes, what is the result if F Sub is UK? Dutch? Italian? • What if F Sub is checked for US purposes? – Is item of income derived by U. S. parent? F Sub 21

Reverse Hybrids – Example 1 R Parent R Sub UK P/S Debt • US Sub makes interest payment to UK P/S that is treated as a corporation for US tax purposes • Interest payment not eligible for treaty benefits under U. S. -UK treaty • Interest payment may be eligible for treaty benefits under U. S. -R treaty US Sub 22

Reverse Hybrids – Example 2 US Parent US Sub UK P/S Debt • UK Sub makes interest payment to UK P/S that is treated as a corporation for US tax purposes • Interest payment not eligible for treaty benefits under U. S. UK treaty UK Sub 23

Reverse Hybrids – Example 3 US Parent • Neth BV makes dividend to Neth CV that is treated as a corporation for Dutch tax purposes, but a partnership in the U. S. • Compare to 2005 Dutch Decree Example US Sub Dividend Neth CV Dividend Neth BV 24

Reverse Hybrids – Example 4 UK Parent • US LLC elects to be a corporation. UK Sub • US Sub pays dividend to US LLC which is then paid to UK Sub. • Dividend withholding at US LLC level? Interest US LP Dividend US Sub 25

Reverse Hybrids – Example 5 US Parent • UK Sub pays dividend to US UK ULC which is then paid to US sub. • Dividend withholding at UK ULC level? US Sub Interest – What if UK Sub/ UK ULC Cos are Dutch or Italian equivalents? UK ULC Dividend UK Sub 26

U. S. Branch Interest Tax Interest UKAA UK UKBB UK US LLC US business • US LLC conducts a US business • US is a partnership for US purposes, but a corporation for UK tax purposes • Does the US branch level interest tax apply? If so, at what rate? 27

U. S. Branch Profits Tax UK A UK B UK P/S US business • UK P/S conducts a US business • UK P/S is a corporation for US purposes • UK A and UK B are individuals • Does the US branch profits tax apply? If so, at what rate? 28

Ownership Through Hybrid Entities Example 1 Netherlands 2 50% >10% P/S 25% US Sub 50% • US S makes a dividend payment • Dividends paid on Netherlands 1 direct stock are eligible for direct dividend rate. What about dividends paid through P/S? • What about dividends paid through P/S to Netherlands 2? • Does it matter whether P/S is a corporation for U. S. purposes? 29

Ownership Through Hybrid Entities Example 2 UK or Dutch Co. 100% Hybrid Dividend 100% • US S makes a dividend payment • Are dividends eligible for treaty benefits? Yes. • Are dividends eligible for the zero rate? – See PLR 200522006 • Does it matter whether Hybrid is a corporation for U. S. purposes? US Sub 30

Ownership Through Hybrid Entities Example 3 U. S 100% Hybrid Dividend 100% Dutch or Italy Co • Dutch or Italy Co makes a dividend payment • Are dividends eligible for treaty benefits? Yes. • Are dividends eligible for the lowest rate? • Does it matter whether Hybrid is a corporation for Dutch or Italian purposes? 31

Deferred Subscription Arrangement Step 1 NPV shares ($80) US Parent Nominal cash plus commitment to pay balance Shares UK Investor $100 value in shares UK Issuer Step 2 US Parent $100 repayment/ def. subscription UK Investor UK Issuer • Intended US result: Loan from UK Investor to US Parent; difference b/n $80 and $100 is deductible interest • Intended UK result: Sale of stock subject to subscription payment obligation; deferred subscription payments are nontaxable amounts received in consideration for issuance of stock • What is impact of UK legislation? • Are “interest” payments entitled to treaty benefits even though they arguably are not “subject to tax” in the UK? 32

UK anti-arbitrage rules • The UK anti-arbitrage rules contain provisions that can act to disallow deductions in computing UK tax payable (s 24 F(No. 2)A 2005). • They deny a UK deduction where four conditions are met…. 33

Deduction cases: conditions • Conditions A to D: – Condition A is that the transaction to which the company is party forms part of a scheme that is a ‘qualifying scheme’. A ‘qualifying scheme’ includes one that involves a hybrid entity. The term ‘scheme’ is broadly defined. – Condition B is that for the purposes of UK corporation tax an amount is allowed as a deduction (or is potentially available as a deduction) in respect of the transaction or an amount relating to the transaction is set off (or could be set off) against profits in an accounting period. This can be any deduction it is not limited to interest. – Condition C is that the main purpose, or one of the main purposes, of the scheme is to achieve a UK tax advantage for the company. – Condition D is that the amount of the UK tax advantage so achieved is more than a minimal amount. 34

Definition of hybrid entity • An entity is a “hybrid entity” if – a. under the tax law of any territory, the entity is regarded as being a person, and b. the entity’s profits or gains are, for the purposes of a relevant tax imposed under the law of any territory, treated as the profits or gains of a person or persons other than the entity. ” (para 3 Sch 3 F(No 2)2005) • • The above requirement will not apply by virtue solely of the entity’s profits or gains being subject to another territories Controlled Foreign Company regime. The following are relevant taxes – income tax; – corporation tax; and – any tax of a similar character to income tax or corporation tax that is imposed by the law of a territory other than the UK. 35

Rule A and Rule B – Where conditions A to D are met the re-computation provisions referred to as “Rule A” and “Rule B” set out in s 25 F(No 2)A 2005 must then be considered. Rule A – Applies where a deduction is claimed for an expense in the UK and the same expense is deductible for the purposes of computing income for the purposes of any other tax. – Impact: The deduction is disallowed in the UK tax computation equal to the expense that meets the criteria above. 36

Rule A and Rule B (cont) Rule B – Applies where a deduction is claimed in the UK for a payment and the recipient of the payment (“the Payee”) is not subject to tax on the receipt. – Payee deemed to be not subject to tax where an amount is deducted against the receipt as a result of transactions which form part of the qualifying scheme. – Payee deemed not to be not subject to tax on the receipt if either • • The Payee is not liable to tax on any income or gains under the law of any territory; or The Payee is not subject to tax on the particular payment as a result of an “exemption”, where the exemption in question is Ø provided under the law of a territory; and Ø does not involve the allocation of the income to another person – Impact: A deduction is disallowed in the UK tax computation equal to the income that has not been subject to tax 37

Examples Base case US Co Debt UK DE – Qualifying scheme using hybrid entity – UK tax deduction for interest – Main purpose? – Rule B applicable to deny relief for deductions? 38

Examples Foreign Source Income Generator US Co 1 US Co 2 US Co 3 UK Co 1 Debt – Qualifying scheme using hybrid entity – UK tax deduction for interest – Main purpose? – Rule A applies UK Co 2 39