U.S. taxpayers are subject to U.S. federal income tax on their worldwide income regardless of whether the income is from the conduct of a trade or business or passive. Foreign taxpayers are subject to U.S. tax under two regimes: income that is effectively connected to a U.S. trade or business, or certain types of passive U.S.-source income considered fixed or determinable, annual or periodical (FDAP). Typically, this includes income from an activity in which the taxpayer does not materially participate, e.g., dividends, interest, rents, annuities, royalties, compensation for personal services, etc.
The Code and regulations impose a 30% gross-basis withholding tax on U.S.-source FDAP income paid to a foreign taxpayer. However, most U.S. income tax treaties reduce or eliminate this withholding tax. Many treaties also contain articles that limit benefits and further define and limit who qualifies for treaty benefits, preventing foreign income recipients from passing income through a country only for the purpose of gaining access to the treaty. Therefore, it is extremely important to analyze the applicable treaty prior to making a payment of U.S.-source FDAP income to a foreign person in a treaty jurisdiction to ensure the recipient qualifies for reduced or lower rates provided by the treaty.
This analysis is even more complicated when U.S.-source FDAP income is paid to a foreign hybrid entity. The purpose of this discussion is (1) to explain the treaty benefit limitations imposed by Sec. 894(c) on U.S.-source FDAP income with respect to hybrid entities, and (2) to provide an overview of procedural requirements of obtaining those treaty benefits.
Background
The check-the-box regulations allow certain entities to elect to be taxed either as a corporation or as a partnership for U.S. tax purposes. Shortly after the check-the-box regulations were enacted, taxpayers began using hybrid entities—entities that are treated as fiscally transparent under U.S. laws and as fiscally nontransparent under the laws of an applicable treaty jurisdiction (or vice versa)—as a means of taking advantage of income tax treaty benefits. For example, if a payment of FDAP income was made to a Cayman Islands corporation, withholding tax would generally apply at a rate of 30% in the United States, since the United States does not have an income tax treaty with the Cayman Islands.
However, if the Cayman Islands corporation was owned by a French corporation, a check-the-box election could be filed in the United States to treat the Cayman Islands company as a fiscally transparent entity for U.S. purposes. As a result, the United States would look through to the French corporation as the beneficial owner of the income and would apply a lower withholding rate under the U.S.-France treaty. Due to the increase in the use of hybrid entities as a means of taking advantage of treaty benefits, the Taxpayer Relief Act of 1997, P.L. 105-34, enacted Sec. 894(c) to limit the applicability of treaty benefits to hybrid entities.
The regulations under Sec. 894(c) provide that income tax treaty benefits are allowed on items of U.S.-source FDAP income to the extent that income is derived by a resident of a treaty jurisdiction. Accordingly, to determine the availability of treaty benefits, the first step is to ascertain whether the entity, the interest holder, or both are deriving the U.S.-source FDAP income (the "derived-by" requirement); the second step is to determine whether the entity or the interest holder deriving the U.S.-source FDAP income is a resident of an applicable treaty jurisdiction (the residency requirement).
The derived-by requirement
Regs. Sec. 1.894-1(d)(1) provides two scenarios to determine whether FDAP income is considered to be derived by an entity or by an interest holder: (1) The entity is not fiscally transparent in the jurisdiction where the entity is a resident; and (2) the entity is fiscally transparent in the jurisdiction in which the interest holder is a resident, and the interest holder is not fiscally transparent in the jurisdiction where the interest holder is a resident. Generally, an entity is considered to be fiscally transparent under the laws of the entity's jurisdiction to the extent the entity's interest holder is required to include in its current taxable income its share of the entity's items of income or loss, regardless of whether the entity made any distributions to the interest holder.
In the first scenario provided by Regs. Sec. 1.894-1(d)(1), an entity will be considered to have derived the U.S.-source FDAP income only if the entity is treated as fiscally nontransparent under the laws of the entity's jurisdiction. For example, when a French entity that is classified as a partnership for U.S. income tax purposes but as a corporation for French purposes receives U.S.-source FDAP income, the French entity is considered to have derived the FDAP income, since it is treated as fiscally nontransparent by France. As such, the entity would qualify for reduced withholding rates provided by the U.S.-France income tax treaty, provided all the other treaty requirements are satisfied, including residence, which is discussed below.
In the second scenario provided by Regs. Sec. 1.894-1(d)(1), an interest holder will be considered to have derived the FDAP income only if the entity is considered to be fiscally transparent under the laws of its interest holder's jurisdiction and the interest holder itself is not fiscally transparent under the laws of its jurisdiction. This treatment applies regardless of whether the entity is fiscally transparent under the laws of the entity's jurisdiction. The following examples illustrate this scenario.
Example 1: A German entity is a partial shareholder of a French entity. The United States is a party to income tax treaties with Germany and France. Both Germany and France treat the German entity as fiscally nontransparent and treat the French entity as fiscally transparent. The French entity receives U.S.-source FDAP income.
In Example 1, the German entity is considered to have derived the FDAP income because under the laws of Germany, the French entity is treated as fiscally transparent, while the German entity is treated as fiscally nontransparent. As a result, the German entity is entitled to treaty benefits under the U.S.-Germany treaty. However, if Germany treats the French entity as fiscally nontransparent, the German entity would not be eligible for treaty benefits. In this case, no treaty benefit would be available because neither the entity nor the interest holder is deemed to have derived the income.
Example 2: Assume the same facts as Example 1, except the French entity is treated as fiscally nontransparent under the laws of France but treated as fiscally transparent under the laws of Germany.
In Example 2, both the German entity and the French entity are treated as having derived the U.S.-source FDAP income. The French entity is considered to have derived the U.S.-source FDAP income because it is fiscally nontransparent under the laws of France. The German entity is also considered to have derived the U.S.-source FDAP income because Germany treats the French entity as fiscally transparent and the German entity itself is not fiscally transparent under the laws of Germany. In this scenario, a claim could be made under either the U.S.-Germany treaty or the U.S.-France treaty, assuming all other requirements are met under both treaties.
Conversely, Regs. Sec. 1.894-1(d)(2)(i) denies treaty benefits to a U.S. entity that is treated as fiscally nontransparent for U.S. income tax purposes but that is fiscally transparent under the laws of the interest holder's jurisdiction. Such an entity typically is referred to as a domestic reverse hybrid entity. For example, assume a U.S. entity with a French interest holder is treated as a partnership for French tax purposes but as a corporation for U.S. purposes. If the U.S. entity receives U.S.-source FDAP income, treaty benefits are not available. The rationale for this rule is that the United States retains taxing jurisdiction over items of U.S.-source income paid to its residents consistent with U.S. income tax treaty principles.
The residency requirement
The final step in establishing the availability of treaty benefits is to determine whether the entity or the interest holder deriving the U.S.-source FDAP income is a resident of an applicable treaty jurisdiction. If the entity itself is considered to have derived the FDAP income, the residency of the entity is considered in determining treaty application. However, if the entity is considered to be fiscally transparent under the laws of its jurisdiction, the residency of the entity's interest holders is considered in determining treaty application.
Complexities may arise where an entity's interest holders are residents of multiple jurisdictions, since the treaty analysis would need to be performed separately with respect to each interest holder. Consider the following:
Example 3: A French partnership has the following partners: a German corporation, a Brazilian corporation, and a U.S. corporation, and all three entities are treated as fiscally nontransparent and residents of their respective jurisdictions. All jurisdictions treat the French entity as fiscally transparent. Consequently, all three entities are treated as deriving their respective share of U.S.-source FDAP income.
In Example 3, only the German corporation is eligible for treaty benefits because only the German corporation is a resident of a treaty jurisdiction. The United States does not have a treaty with Brazil and, as such, the Brazilian corporation is subject to the full 30% withholding tax. The U.S. corporation is subject to current U.S. income tax on its share of the income, and withholding would not apply.
Overview of the procedures for obtaining treaty benefits
The 30% gross-basis withholding tax is withheld by the payer of U.S.-source FDAP income. Prior to receiving U.S.-source FDAP income, a foreign payee eligible for a reduced rate of withholding pursuant to the terms of an applicable income tax treaty must provide a valid Form W-8 (e.g., Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals); Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities); 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; Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding and Reporting; or Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding and Reporting) to the payer substantiating its residency and its basis for a reduced rate of withholding.
Form W-8BEN-E contains information necessary to ascertain the entity or the interest holder deriving the FDAP income and determining whether that entity or interest holder is a resident of an applicable treaty jurisdiction. Form W-8IMY must be filed when U.S.-source FDAP income is received by an entity or an interest holder on behalf of another person or as a flowthrough entity. When dealing with hybrid entities, determining the appropriate form to provide and how it should be completed can be especially complex. This is true for the foreign entity that must provide the form but often has very limited knowledge of U.S. tax rules, as well as for the U.S. payer, who has a due-diligence responsibility to determine whether the form is reliable and accurate but may have limited knowledge about the payee.
Example 4: A payment of U.S.-source FDAP income is made to a U.K. entity that has two owners, a U.K. corporation and a French corporation. For U.K. purposes, the U.K. entity and both the U.K. and French owners are treated as fiscally nontransparent. For French tax purposes, the U.K. entity is treated as fiscally transparent.
In Example 4, both the U.K. entity and the French owner are considered to have derived the income. Assuming the U.K. entity meets the requirements of the U.S.-U.K. treaty, it could provide a Form W-8BEN-E to the payer of the income to claim a reduced rate of withholding. However, for the portion of the income derived by the French interest holder, the French entity could make a claim for reduced rates under the U.S.-France income tax treaty, assuming it meets all of the other treaty requirements. In this case, the U.K. entity would provide a Form W-8IMY to the payer to indicate that it is an intermediary and would attach a Form W-8BEN-E from the French entity claiming reduced rates on the portion of income allocable to the French entity. Such a claim may be beneficial in a situation where the French treaty provides a lower rate of withholding than the U.K. treaty.
The payer of the income would use the Form W-8BEN-E provided by the U.K. to determine the withholding on the U.K. portion of the income and would use the Form W-8IMY with the attached Form W-8BEN-E to determine the withholding on the French interest holder's portion of the income. Thus, an entity could provide both a Form W-8BEN-E and a Form W-8IMY with respect to the same payment and claim reduced rates under two different treaties.
Carefully scrutinize treaty benefits
Although check-the-box regulations have simplified the tax classification rules, Sec. 894 has added an extra level of complexity with respect to hybrid entities, i.e., entities that are treated inconsistently by two taxing authorities. The general rationale behind the requirements imposed by Sec. 894 is to ensure that an item of U.S.-source income is taxed currently either by the United States or by a foreign jurisdiction that is a party to an income tax treaty with the United States. As such, it is extremely important to analyze the applicable treaty prior to making a payment of U.S.-source income to a foreign person to ensure the recipient of the income qualifies for reduced withholding rates under the applicable treaty.
EditorNotes
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowehorwath.com.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.
