Limitation of Benefit: US Tax Treaties

The basic rate for withholding on US source income such as dividends, interest, and royalties is 30%. However, under US tax treaties this withholding rate is often greatly reduced sometimes to 0 and often to 15%, 10% or 5%.

The most frequent problem we encounter in trying to take advantage of these favorable treaties is that there are provisions in most treaties which prevent “treaty shopping”. These provisions generally provide that in order to take advantage of a particular treaty, the ultimate beneficial owner of the income has to be a “qualified person” in the country which has the treaty with the US. So, for example, a favorable treaty which the US has with country X will not avail a company organized in country X, but beneficially owned by a tax resident of country Y (the ultimate beneficial owner or “UBO”) which does not have a similar treaty with the US. This example is an illustration of what is referred to as limitation of benefits (“LOB”) and it appears in virtually every US income tax treaty.

There are, however, several exceptions to the “qualified person” principle, a major one of which is the use of a “slot-in” company having an active trade or business in the country which has the favorable treaty with the US similar to one carried on in the US and of a magnitude which is sufficiently large compared to the US business. While this may or may not be difficult to accomplish with a traditional bricks and mortar business, it may be somewhat easier with high tech IP type businesses.

In this regard many IP businesses have looked to Ireland which has favorable treaty rates with the US and relatively low local tax rates. The “slot in” provisions of the US/Ireland tax treaty provide:

“(a) A resident of a Contracting State [Ireland] that is not a qualified person shall be entitled to the benefits of this Convention with respect to an item of income derived from the other State [US], if:

(i) such resident is engaged in the active conduct of a trade or business in the first-mentioned State [Ireland] (other than the business of making or managing investments, unless such business is carried out by a bank or insurance company acting in the ordinary course of its business), and

(ii) the item of income is connected with or incidental to the trade or business in the first-mentioned State [Ireland], provided that, where such item is connected with a trade or business in the first-mentioned State [Ireland] and such resident has an ownership interest in the activity in the other State [US] that generated the income, the trade or business is substantial in relation to that activity.

(b) For the purposes of subparagraph (a)(ii)

(i) an item of income shall, in any case, be connected with a trade or business if the activity in the other State [US] that generated the item of income is a line of business that forms a part of or is complementary to the trade or business conducted in the first-mentioned State [Ireland] by the income recipient;

(ii) whether the trade or business of the resident in the first- mentioned State [Ireland] is substantial in relation to the activity in the other State [US] shall be determined based on all the relevant facts and circumstances. In any case, however, the trade or business will be deemed substantial if, for the preceding fiscal year, or for the average of the three preceding fiscal years, the asset value, the gross income and the payroll expense that are related to the trade or business in the first-mentioned State [Ireland] equals at least 7.5 per cent of the asset value, the gross income and the payroll expense, respectively, that are related to the activity that generated the income in the other State [US], and the average of the three ratios exceeds 10 per cent, provided that for the purposes of calculating the above ratios, there shall be taken into account only the resident's proportionate ownership interest in such trade, business or activities, whether held directly or indirectly.”

The above ratio is not very high. So, in the right situation, Ireland may be a suitable place to set up a company where the “ultimate beneficial owner” has US source income but may not meet the “qualified person” test under the limitation of benefit provisions of otherwise potentially applicable favorable treaties.

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Caveat: this article is not intended as tax advice. Competent tax counsel should be consulted.

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