There are two basic methods of taxation for foreign taxpayers with income from U.S. sources: net income tax at graduated rates where the foreign person is engaged in a U.S. trade or business, or a 30% tax on gross payments of other fixed or determinable annual or periodic (FDAP) income. Tax treaties reduce the flat 30% rate on gross payments where the FDAP income recipient is a qualified resident of a treaty country. However, treaties may also offer special elections that recharacterize certain types of FDAP income that would otherwise be subject to withholding tax as effectively connected and thus taxable on a net basis at U.S. graduated rates.
Generally, the elections operate by recharacterizing the relevant income as business profits derived from a “deemed” permanent establishment. As business profits, the relevant income is no longer treated as income subject to withholding, but rather as effectively connected business income subject to taxation at U.S. graduated rates and eligible for related expense deductions.
The benefits of making such an election are typically dependent on the applicable withholding rate and the extent to which the taxpayer can offset the relevant income with deductible expenses. Where a high withholding tax rate applies or where significant deductions are available, an election to be taxed at a net basis may reduce or eliminate the taxpayer’s effective U.S. tax liability.
The most common election is for income derived from real property (e.g., rental income), but some treaties contain more unusual elections, such as the net basis elections for interest under the U.S.-Israel treaty and royalties under the U.S.-Kazakhstan treaty.
Income from Real Property
An election for income derived from real property to be taxed on a net basis is available in most U.S. tax treaties. The term “real property” is broad and generally encompasses, but is not limited to, any real estate, options, rights, covenants, accessories, agricultural livestock, and forestry equipment situated in the relevant treaty country.
The 2006 U.S. Model Income Tax Convention provides in Article 6(5) that “a resident of a Contracting State who is liable to tax in the other Contracting State on income from real property situated in the other Contracting State” may “elect for any taxable year” to “compute the tax [for any tax year] on such income on a net basis as if such income were business profits attributable to a permanent establishment in such other State.”
The benefit in making this election is that it allows taxpayers to obtain the allimportant deductions for interest and depreciation expenses. However, the election is not particularly relevant in the context of U.S. inbound investment because a similar election is already available under U.S. domestic rules for both individuals and companies under Secs. 871(d) and 882(d).
Most U.S. tax treaties do not reduce the 30% U.S. statutory withholding rate imposed on rental income. Consequently, the election to be taxed on a net basis for items such as rental income or the sale of real estate rights is usually beneficial to the extent that the tax on the net income from real property does not exceed the flat tax of 30% on the gross income from real property.
Examples of treaties containing an election to be taxed on a net basis for items other than interest are the U.S.- Israel treaty and the U.S.-Kazakhstan treaty.
Interest Under the U.S.-Israel Treaty
Treaty The U.S.-Israel treaty contains a unique net basis election for interest. The election applies only to interest paid between residents of either the United States or Israel and may be found under Article 13(2)(b) of the U.S.-Israel treaty.
Article 13(2)(b) provides that
[a] resident of a Contracting State may elect, in lieu of the tax that would be imposed under subparagraph (a), to be taxed on its interest income as if that income were industrial and commercial profits and were taxable under Article 8 (Business Profits).
The Treasury Technical Explanation of the 1993 protocol to the treaty explains that
[t]he gross-basis withholding tax of subparagraph (a) will not apply if, under subparagraph (b), the interest recipient elects to be taxed by the source State on its net interest income, under the rules of Article 8 (Business Profits), as though the interest income were industrial and commercial profits, attributable to a permanent establishment in the source State.
Article 13(2)(a) of the treaty offers qualified residents a reduced withholding tax rate of 17.5% on interest paid between residents of the United States and Israel. Compared with other U.S. tax treaties (which routinely reduce the interest withholding tax to 0%), this withholding rate is often considered a high burden for lenders. Thus, this circumstance may provide an incentive to make a net basis election where the Israeli recipient either is in a low U.S. tax bracket or can attribute significant expenses to the lending activity.
Royalties Under the U.S.- Kazakhstan Treaty
Similar to the Israeli net basis election, the U.S.-Kazakhstan treaty provides a net basis election for royalties paid for rights in either the United States or Kazakhstan. Specifically, Article 12(2) provides that “the beneficial owner [of the royalties] may elect to compute the tax on such income on a net basis as if such income were attributable to a permanent establishment or fixed base in the Contracting State in which the royalties arise.”
The U.S.-Kazakhstan treaty offers a 10% reduced treaty rate of withholding on royalties. The reduced treaty rate is lower than the lowest graduated rate that would be imposed if the election to be taxed on a net basis were made; therefore, the election will be beneficial only if the taxpayer can claim sufficient deductions to offset the royalty income.
Scope of Net Basis Elections
In general, these elections merely provide a method to determine the tax payable on a particular type of income. The “deemed” permanent establishment created by the election should not constitute a permanent establishment for any purpose other than describing the method by which the relevant income should be computed under the net basis election. Under a narrow interpretation, the election would have no impact on any other tax treaty provision or Code section.
However, the net basis election can raise a variety of unresolved issues, including:
- Sec. 163(j): Is the U.S. payer of interest to a related Israeli lender subject to the limitation on interest deduction? Arguably, Sec. 163(j) may not apply because the election causes the lender to be subject to U.S. tax like a domestic recipient. Still, a conservative interpretation of the U.S.-Israeli treaty should prevent it from affecting the tax position of another (here, U.S.) person.
- Sec. 267(a)(3): For the same reasons, one might argue that the U.S. payer should not be subject to the matching principle, which essentially denies the interest deduction until an actual payment is made (cash method of accounting). However, this argument appears weak because Sec. 267(a)(3) refers to the payer’s foreign status, which does not change as a result of the election.
- Limitation on benefits: The net interest election appears particularly attractive for back-to-back financing arrangements. An Israeli lender who borrows from another group entity to finance a U.S. subsidiary could risk losing all treaty benefits under the “base-erosion” test (Article 25(1)(b) of the U.S.- Israel treaty).
Based on the above, it may be appropriate for an Israeli taxpayer who wishes to invoke the net basis election to resolve those questions through a private letter ruling.
Filing Requirements
Generally, U.S. tax treaties provide that Treasury, in its capacity as the U.S. competent authority, may adopt procedures to govern the net basis elections. However, Treasury has not adopted specific procedures for elections in each treaty. Instead, a general procedure for disclosing treaty-based positions is provided under Sec. 6114.
First, upon making an election, the taxpayer should present the U.S. payer of rental income, interest income, or royalty income (appropriate to the election) with a completed Form W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected with the Conduct of a Trade or Business in the United States, declaring that the relevant income is effectively connected with a U.S. trade or business and thus not subject to withholding tax. Once submitted, the Form W-8ECI is effective for three years unless there is a change in circumstances (e.g., revocation of the election or change in address).
Next, the foreign taxpayer should file the appropriate annual tax return accompanied by a Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b). The Form 8833 should disclose and explain that the taxpayer has made a net basis election with respect to certain types of income and cite the appropriate treaty provisions. In the course of such explanation, the taxpayer should clarify that the income to which such election is made should not be subject to the 30% withholding tax because it has been recharacterized as U.S. effectively connected income attributable to a deemed permanent establishment. Timely filing of both the annual return and the Form 8833 is critical to avoid penalties and begins the three-year statute of limitation against IRS audit. The foreign taxpayer will require a taxpayer identification number in order to comply with these filing obligations.
Regarding the U.S. payer, receipt of the taxpayer’s Form W-8ECI does not absolve it of its filing obligations with respect to Forms 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, and 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. These forms should continue to be issued and filed, reflecting zero withholding. The taxpayer’s W-8ECI should remain in the U.S. payer’s records.
EditorNotes
Lorin Luchs is a partner in National Tax Services of BDO Seidman, LLP in Bethesda, MD.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.
For additional information about these items, contact Mr. Luchs at (301) 634-0250 or lluchs@bdo.com.
