By Anthony Diosdi
Recently the U.S. Senate Foreign Relations Committee has proposed to review the U.S.- Russia Income Tax Treaty. This has sparked speculation that the United States may unilaterally revoke the treaty. This would not be the first time that tax policy has been weaponized for foreign policy objectives. However, it is very rare that the U.S. would withdraw from a tax treaty. The few cases are significant. For example, Democrats and Republicans came together in Congress to end the U.S.- South Africa Income Tax Treaty in 1987 as part of raising international pressure on the South African government over aparteid. The U.S. and South Africa did not enter into another bilateral tax treaty until 1997. See ITR, This week in tax: Russian tax treaties in doubt? (March 11, 2022) by Leanna Reeves. The U.S.- South African Tax Treaty was not the only tax treaty terminated by the United States. On June 29, 1987, the United States Treasury Department terminated the U.S- Netherlands Antilles Tax Treaty. The United States and the Netherlands Antilles had attempted to preserve the treaty for eight years. However, negotiations ended because of a loggerhead over the extent to which the Netherlands Antilles would maintain its tax haven status.
A Brief Overview of the U.S.- Russia Income Tax Treaty and U.S.- Cyprus Income Tax Treaty
The U.S.- Russia Tax Treaty addresses numerous areas of taxation, including patents and copyright royalties, exemptions of wages, salaries, and pensions. The U.S.- Russia Income Tax Treaty provides for a reduced tax rate on dividends as low as 5 percent.
However, the treaty’s most significant provisions are Articles 11 entitled “Interest.” Generally, the United States imposes a 30 percent withholding tax on foreign corporations which issue and pay interest on bonds (the “30 percent withholding tax” or “withholding tax”). Moreover, in certain cases, the U.S.- Russia Income Tax Treaty may permit a reduction of taxation of dividend payments made to Russian investors to only 5 percent. Revoking the U.S.- Russia Income Tax Treaty would certainly deal an economic blow to Russian investors attempting to use this particular treaty. Terminating the U.S.- Russia Income Tax Treaty does not mean that Russian investors cannot utilize another tax treaty to reduce cross-border tax on U.S. investments. For example, Russian investors can establish a Cypriot holding company and potentially qualify for benefits of the U.S.- Cyprus Income Tax Treaty.
The country of Cyprus has been nicknamed the “Moscow on the Med.” As tensions between the Kremlin and America (and the E.U) have been on the rise, the tiny island of Cyprus has attacked Russian investment. Cypriot holding corporations wholly owned by Russians are often used to avoid both Cyprus domestic tax and foreign taxes. Cyprus has a global network of double tax treaties. Included in that network is a bilateral tax treaty with the United States. The U.S.- Cyprus Income Tax Treaty is unusual in that it permits a Cypriot holding company with no Cypriot ownership to qualify for benefits of the treaty. The U.S.- Cyprus Income Tax Treaty generally provides the same tax benefits as the U.S.- Russian Income Tax Treaty.
The Meaning of FDAP Income
Foreign persons are subject to U.S. federal income tax 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 known as “FDAP;” and 2) income that is effectively connected to a U.S. trade or business. FDAP income is subject to a 30 percent withholding tax that is imposed on a non-U.S. taxpayer’s gross income. Effectively connected income is subject to tax on a net basis at the graduated tax rates applicable to U.S. taxpayers.
For a non-U.S. taxpayer to be eligible for reduced withholding tax rates on FDAP income under a U.S. income tax treaty, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy a limitation on benefits (or “LOB”) provisions contained in the tax treaty. The principal target of a LOB provision is a corporation that is organized in a treaty country by a resident of a non-treaty country merely to obtain the benefits of that country’s income tax treaty. A LOB provision denies such corporations the benefits of the treaty. Therefore, even if a corporation qualifies as a resident of the treaty country, that corporation is not entitled to treaty benefits unless it also satisfies the requirements of the treaty’s LOB provision. For example, under the LOB provision found in Article 22 of the U.S. Model Treaty, a corporation that is a resident of a treaty country generally is entitled to treaty benefits only if the corporation meets one of the following additional requirements: 1) more than 50 percent of the corporation’s stock is regularly traded on a recognized stock exchange (i.e., the corporation is a publicly traded company) and the corporation’s primary place of management is in its country of incorporation, 2) the corporation is a 50 percent or more owned by 5 or fewer companies entitled to treaty benefits, or 3) the corporation meets both a stock ownership test (at least 50 percent of the corporation’s stock is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50 percent of the corporation’s gross income is used to make deductible payments to persons who are not residents of either country).
For example, let’s assume that FORco, a foreign company, is incorporated in foreign country F. Let’s also assume that FORco owns all the shares of its U.S. subsidiary, USAco. FORco is owned 45 percent by Nonresident, a citizen and resident of foreign country F, and 55 percent by Kong, a Hong Kong individual. The United States has a treaty with foreign country F, but does not have a tax treaty with Hong Kong. USAco pays a dividend to FORco. Although FORco would ostensibly be entitled to withhold at only 5 percent controlled company rate under the treaty, the dividend from USAco is not entitled to the benefits of the treaty and withholding must occur at the 30 percent statutory rate. More specifically, FORco fails to satisfy the LOB article because only 50 percent of the FORco shares are owned by a resident of country F, Nonresident, who is entitled to treaty benefits.
The LOB or Lack-of a LOB Contained in the U.S.- Cyprus Tax Treaty
The purpose of LOB provisions in tax treaties is to prevent treaty-shopping. To qualify for treaty benefits under a LOB, a specified percentage of an entity’s shares must be owned, directly or indirectly by a resident or residents of the applicable treaty country. As typically the case in international tax planning, there are always exceptions to the general rule. One such exception to this general rule is the U.S.- Cyprus Income Tax Treaty. The U.S.-Cyprus Income Tax Treaty contains an unusual LOB provision, under which a Cypriot corporation is not eligible for the benefits of the treaty unless more than 75 percent of the number of shares of each class of the corporation’s shares is owned, directly or indirectly, by one or more individual residents of Cyprus treaty, and certain other requirements are met (LOB Provision 1). However, the U.S.-Cyprus treaty also provides that LOB Provision 1 does not apply to a Cyprus corporation and the conduct of its operations does not have as a principal purpose obtaining benefits under the treaty (LOB Provision 2).
In 2013, the Internal Revenue Service (“IRS”) issued an internal legal memorandum. The IRS internal legal memorandum concluded that a U.S. individual was entitled to treat dividends (at a favorable treaty rate) received from a Cyprus holding company even though the entity had no Cypriot ownership. Under the facts of the legal memorandum, a U.S. individual owned an interest in a Cyprus company (“HoldCo”). The remaining shares were owned by persons who were not residents of the United States or Cyprus. HoldCo, which owned an operating company in a third country, was apparently established in Cyprus for reasons unrelated to the treaty.
HoldCo did not qualify under LOB Provision 1 because none of its shares were owned by individual residents of Cyprus. The legal memorandum concluded that LOB Provision 2 was satisfied because there was no principal purpose of obtaining benefits under the U.S.-Cyprus treaty and HoldCo was a “qualified foreign corporation” that was entitled to favorable U.S. tax treatment. The legal memorandum did not state why the establishment of a Cyprus holding company did not have a principal purpose of obtaining benefits under the U.S.-Cyprus Income Tax Treaty.
Given the wording of the U.S.-Cyprus Income Tax Treaty’s LOB, and the IRS’s apparent broad interpretation of the term “there was no principal purpose of obtaining benefit” under the U.S.-Cyprus Income Tax Treaty, it is not too difficult to envision a number of strategies that would permit a Cyprus company owned by residents of Russia to conduct business operations in Cyprus and hold investments in the United States, or engage in business in the United States and still qualify to utilize the U.S.- Cyprus Income Tax Treaty.
Often the terms of a U.S. tax treaty modify the tax results that one would otherwise obtain under the Internal Revenue Code. Correctly taking a treaty position can in certain result in substantial tax savings. On the other hand, taking an incorrect treaty position can result in the assessment of significant penalties and interest. If you are considering taking a treaty position involving a U.S. bilateral income tax treaty, you should consult with an experienced international tax attorney to assist you. We have substantial experience advising clients regarding the U.S.- Russia Income Tax Treaty and U.S.- Cyprus Income Tax Treaty.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.