LOB: When Tax Treaty Derivative Benefits Provisions Don't Apply

You find in Article 22 of the US 1996 Model Treaty of most tax treaties entered into by the United States a limitation on benefits clause (LOB). This clause, which has the purpose to prevent the application of the benefits of the treaties to treaty shopping structures, added a certain degree of complexity to the application of treaties in intricate corporate structures. It is interesting to note that the 2003 changes in the OECD Commentaries on Art. 1 of the OECD Model include already a number of similar clauses to those provided under the US Model. Therefore it can be said that the interest of any analysis of the practical issues arising from the application of the LOB clause goes well beyond the treaties signed with the US.

In that regard, I would like to call upon the attention of Ruth Mason (Associate Professor of Law of Connecticut Law School) recent article When Tax Treaty Derivative Benefits Provisions Don't Apply. Here is an abstract:

The U.S.-U.K tax treaty¸ like several other recent treaties, has a limitations on benefits (LOB) clause that contains a derivative benefits provision. Under derivative benefits, a company that qualifies as a resident under Article 4 of the Treaty - but fails to qualify under the LOB clause due to its foreign ownership - may nevertheless be entitled to treaty benefits if the foreign owner is an “equivalent beneficiary.”
An equivalent beneficiary is a beneficial owner that is resident in a third country with which the United States also has a tax treaty. However, for certain items of income, a beneficial owner does not automatically qualify as an equivalent beneficiary simply because its country has a tax treaty with the United States. For those items of income (dividends, interest and royalties), the third country’s treaty must offer withholding rates “at least as low” as the rate available under the claimed treaty.
What happens when the equivalent beneficiary’s treaty with the United States provides higher withholding rates than does the claimed treaty? What withholding rate applies? There are two choices. The United States could apply: (1) the higher of the two treaty withholding rates or (2) the statutory withholding rate. This article describes the derivative benefits problem in detail and considers which rate should apply.

Comment:
According to the author there seems to be disagreement about the correct withholding tax rate to be applied in cases where a company fails the third test of a derivative benefits provision (LOB clause). The author seems to defend, instead of the domestic withholding tax (30% in the case of US), the application of the rate under the equivalent beneficiary’s treaty (5% in the example given). This result is said to be the “right” result, as a matter of policy and from an interpretive perspective. Nevertheless, the author acknowledges that the issue is far from clear and assert that the US Treasury should clarify, which of the withholding taxes apply.

Allow me to make a side comment. First of all, taking into account that tax treaties are bilateral by nature it is difficult from the outset to conceive a fallback to a rate included in a third treaty when a particular treaty provision is said to be non-applicable. Tax treaties restrict domestic law and therefore if for any reason they are inapplicable (such as by the application of the LOB clause), domestic law should apply (irrespective of the final result).

Secondly, it is also difficult to conceive the application of a rate included in a third treaty, in a situation when you even fail to have a resident under Art. 1 of such treaty. In the given example, the UK company (even though controlled by French shareholders) cannot be said to be a resident of France for the purposes of the treaty between US and France and therefore the treaty (and rates therein) do not apply.

Finally, I would like to recall the (recently changed) US position in cases of dual resident companies and make an analogy with the issue at stake. Ignoring for now specific rules contained in the US-UK treaty for dual resident companies, according to Rev. Ruling 2004-76, a dual resident company, resident for example both in the UK and France under the domestic laws of those countries, is not entitled to claim benefits under the U.S. treaty with the UK, if under the tie-breaker rule of the UK-France treaty it is treated as a resident of France and not of UK.

The US tax authorities arrived to such result by (restrictively) construing the term “liable to tax by reason of residence” of Art. 4(1), as excluding the possibility of a dual resident company to gain access to the treaty network of the “loser” state (in this case UK). Although this interpretation may be criticised (*), in the case under discussion (LOB) it reinforces the argument that unless the UK company is a also considered a resident of France (for example by having there the place of effective management) the rate included in the treaty between US and France should not apply.

In the end, I agree that 1the result of applying the domestic rate when derivative benefits provisions don’t apply is quite harsh. Nevertheless, such “inadequate” result should be corrected by amending the provision itself and not by any interpretative construction.

(*) Interesting to note that the same result (as regards dual resident companies) was achieved by the Supreme Court of the Netherlands (BNB 2001/295)