Alliance Has Tax Treaty Concerns Regarding Debt-Equity Regs

This letter is submitted on behalf of the International Alliance for Principled Taxation (IAPT or Alliance) in response to the invitation to comment on the proposed regulations under Section 385 of the Internal Revenue Code, issued on April 4, 2016 (the Proposed Regulations).

The IAPT is a group of major multinational corporations based throughout the world, and representing business sectors as diverse as consumer products, media, telecommunications, oilfield services, computer technology, energy, beverages, software, IT systems, and publishing. The group's purpose is to promote the development and application of international tax rules and policies based on principles designed to prevent double taxation and to provide predictable treatment to businesses operating internationally. We very much appreciate the opportunity to provide comments on the Proposed Regulations.

Our comments focus exclusively on the interaction between the Proposed Regulations and U.S. tax treaties.

Introduction

The Proposed Regulations contain a number of provisions under which certain related party indebtedness could be recharacterized as stock and treated as such for all federal tax purposes.¹ Treasury officials have indicated in public remarks that this same recharacterization will apply for purposes of U.S. tax treaties. That treatment could affect in particular two issues that lie at the heart of tax treaties: (i) the withholding tax rate to be applied by the source State to payments on the instrument; and (ii) the double taxation relief to be given by the residence State.

The IAPT believes that serious questions surround the issue of whether the recharacterization contemplated by Proposed Regulations will in fact routinely apply for purposes of the provisions of U.S. treaties that govern withholding rates and double taxation relief. Since the publication of the Proposed Regulations in April, there has been much commentary about the extent to which the Proposed Regulations go beyond the traditional application of section 385 and jurisprudence on debt-equity distinctions in the United States. For the reasons outlined below, the IAPT is concerned that this characteristic of the Proposed Regulations will cause them to come into potential conflict with treaty concepts of "dividends" and "interest" and will give rise to risks of double taxation. To avoid this, we urge a reconsideration of the standards in the Proposed Regulations to bring them more in line with internationally recognized standards for distinguishing debt from equity.

Treaty Treatment of Dividends and Interest

The vast majority of U.S. treaties provide for reduced withholding rates on U.S. source dividends paid to residents of the other Contracting State. The most commonly applicable rates are zero or 5 percent for so-called "direct investment" dividends (i.e., dividends paid to a corporate shareholder that typically must own some minimum threshold of the voting stock of the payor corporation) and 15 percent for other dividends (i.e., so-called "portfolio" dividends). In a few cases the prescribed withholding rates on dividends are higher than that, and in a handful of cases the withholding rate on portfolio dividends is lower than 15 percent.

The vast majority of U.S. treaties also provide for reduced withholding rates on U.S. source interest paid to residents of the other Contracting State. While the U.S. Model Treaty position has long favored a zero rate on interest, many U.S. treaties allow some positive rate of reduced withholding on interest, with 5 percent or 10 percent being the most commonly allowed rates on interest other than contingent interest.

It is almost invariably the case under U.S. treaties that the allowable rate of U.S. withholding tax on interest is lower than the allowable rate of U.S. withholding tax on portfolio dividends. Very frequently, the allowable rate of U.S. withholding tax on interest is also lower than the allowable rate of U.S. withholding tax on direct investment dividends.

As a result, if the Proposed Regulations apply under treaties to recharacterize indebtedness of a U.S. corporation to equity, the result could be to expand U.S. taxing jurisdiction in two significant ways. First, payments on the instrument, including not only payments of stated interest but also repayments of stated principal, may become subject to U.S. withholding tax as "dividends". Second, the rate of U.S. withholding tax would typically be higher than the rate that would apply to payments of interest. Because the recharacterized instruments typically will not carry voting rights and will not be characterized as voting stock, the relevant dividend withholding rate under treaties will often be the higher portfolio dividend rate, unless the holder otherwise owns sufficient voting stock to qualify for the direct investment rate. Because the Proposed Regulations would operate to recharacterize indebtedness issued to related corporations that are not direct shareholders of the issuer corporation, they would very frequently require application of the portfolio dividend rate.

Thus, a very common result if the recharacterization authorized by the Proposed Regulations applied under treaties would be that instead of a zero percent U.S. withholding tax on interest (and no U.S. withholding tax on principal), all payments on the instrument would be subjected to the 15 percent U.S. withholding tax applicable to dividends (assuming adequate earnings and profits).

Treaty Definitions of Dividends and Interest

The U.S. treaty definitions of "dividends" and "interest" have varied somewhat over time. The definition of "dividends" in the 1981 Draft U.S. Model Income Tax Treaty was as follows:

More than 25 U.S. treaties currently in force include definitions of "dividends" that are based on the pre-1996 U.S. Model wording. A considerably smaller number (fewer than 20) include definitions that are based on the post-1996 U.S. Model wording. Other U.S. treaties have no definition or one that differs from both Models.

The definition of "interest" in the 2016 U.S. Model Income Tax Treaty is as follows:

Application of Treaty Definitions to Cases Covered by the Proposed Regulations

There can be no question but that the definition of dividends in U.S. treaties, whether based on the pre-1996 or post-1996 wording of the U.S. Model, gives some deference to the characterization of a payment under U.S. domestic law for purposes of determining whether that payment can appropriately be withheld upon as a dividend. The important question is whether that deference is entirely unfettered, and whether a treaty partner is required to respect a characterization prescribed in section 385 regulations, no matter what those regulations may say or how broadly they may be drafted.

The IAPT believes the simple answer to that question is no. We believe it is critical in this regard to understand the international context in which the treaty provisions have been developed and interpreted, including in particular guidance provided by the OECD.

The question of whether domestic law could intervene to recharacterize a debt-claim as stock and recharacterize payments thereon as dividends under the OECD Model Tax Convention was analyzed in detail by the OECD in its 1986 report, "Thin Capitalisation" (Thin Capitalisation Report). Several conclusions were reached in that analysis.⁴

First, the majority view was that the exclusion of "debt-claims" from the first part of the dividends definition prohibits the treatment of interest as dividends pursuant to thin capitalization rules under that language. Second, it was agreed that payments on a debt instrument could be considered to fall under the part of the dividends definition relating to "income from other corporate rights which is subjected to the same taxation treatment as income from shares", but only in certain cases.⁵ Third, the cases in question were those where the contributor of the loan "effectively shared the risk of the company's business". Fourth, the question of whether the contributor of the loan effectively shared the risk of the borrowing company's business will normally have to be established by all relevant circumstances. Several factors were identified as potentially relevant for this purpose:

One can clearly see certain adjustments in subsequent treaty practice that were directly traceable to the analysis in the Thin Capitalisation Report. In the next update of its Model Tax Treaty (in 1996), the United States dropped the reference to "corporate rights" from its definition of dividends and inserted language in its interest definition to address the potential overlap between Articles 10 and 11. For its part, the OECD amended the Commentary on Article 10 in its next update to the OECD Model Tax Convention (in 1992) by adding new paragraph 25, which reads:

Recommendation Regarding Alignment with Treaty Definitions of Dividends and Interest

Accordingly, the IAPT recommends that the standards in the Proposed Regulations be reconsidered in order to bring them closer to the traditional multi-factor analysis that has hitherto always prevailed under section 385 and general debt-equity jurisprudence. Otherwise, we believe there is a strong risk that U.S. treaty partners, seeing how far the Proposed Regulations' standards are from the basic inquiry of whether the creditor is effectively sharing the risks of the company, will have a justifiable basis for disagreeing that the Proposed Regulations can have the effect of allowing the United States to withhold at treaty dividend rates in lieu of treaty interest rates. As mere regulations, of course, the section 385 rules would not constitute the "supreme law of the land" that could override previously negotiated treaties, so the United States would be obliged to fight out the merits of its position in competent authority proceedings.

Double Taxation Relief Implications of Potential Conflict between United States and Treaty Partner on Characterization of Payments

The implications of such a potential disagreement between the United States and its treaty partners extend, of course, beyond the withholding rate applicable to payments on the instrument. The issue of the treaty partner's obligation to give double taxation relief is also at stake.

Regardless of whether a treaty partner generally uses a credit or exemption method for providing double taxation relief in its treaties, the relevant article typically provides that the treaty partner, as the residence State, will provide relief on interest income under the treaty only in the form of a credit for the U.S. withholding tax. As indicated above, the withholding rate on interest is likely to be lower than the withholding rate on dividends under most treaty scenarios implicated by the Proposed Regulations. While the same type of obligation may also be true of dividends, there are many treaties that call for the treaty partner as residence State to exempt intercorporate dividends entirely or to give an indirect credit for the underlying U.S. corporate tax paid by the dividend-paying corporation. In some cases, those latter benefits are available only if the dividend recipient owns some threshold percentage of the voting stock of the dividend-paying corporation. In any event, though, the treaty partner would almost invariably have to give greater double taxation relief for payments properly characterized as dividends under a treaty than for interest payments.

Where there is a conflict between the United States and its treaty partner as to the characterization of a payment as interest (or principal repayment) or dividends, the question obviously arises as to what the extent is of the treaty partner's obligation to give double taxation relief.

In the Thin Capitalisation Report, the OECD said that the residence State would be obligated to give relief based on treating the payment as a dividend where the double taxation relief article specifically referred to income defined as dividends under Article 10 and the source State's rules conformed to the Report's conclusions about treating the interest as dividends. Where the source State's rules go beyond the Report's conclusions in treating interest as dividends (i.e., where they apply beyond situations where the contributor of the loan effectively shared the risks of the borrowing company's business), the residence State would not be obligated to give double taxation relief based on dividend treatment. This could mean that the residence State would only have to give a credit for the withholding tax applicable under the treaty to interest payments. Such relief is unlikely to provide full relief from the juridical double taxation that will likely arise due to the higher dividend withholding rate, and it will not provide any relief from the recurrent corporate taxation that would arise with respect to the distributed profits. In other words, if the standards of the Proposed Regulations are not viewed by the treaty partner as consistent with the standards for treating interest as dividends under Article 10, the effect of the Proposed Regulations will likely be serious double taxation of both the juridical and economic type.

Subsequent to the Thin Capitalisation Report, language was added to the Commentary on Article 23 of the OECD Model Tax Convention to address generally the obligations of the residence State to give double taxation relief in situations where the two States classify the income item differently.⁷ That guidance indicates that the residence State, in giving double taxation relief, should in certain cases follow the source State's classification of the income item where differences in the domestic law of the two States cause the item to be classified under different treaty articles by the two States. Where, however, the different classification is due not only to differences in domestic law but also to different interpretations of the treaty (e.g., different views as to whether a particular domestic law rule in the source State allows the recharacterization of interest as dividends), the residence State is not obligated to follow the source State classification. In such cases, where the residence State does not believe that the source State has taxed "in accordance with the Convention", the two States are encouraged to resolve the issue through the mutual agreement procedure.

Recommendation Regarding Alignment with Treaty Definitions for Purposes of Ensuring Double Taxation Relief

As just discussed, the Proposed Regulations could give rise to serious juridical and economic double taxation if U.S. treaty partners have a legitimate basis for believing that the recharacterization standards under the Proposed Regulations are too far removed from the basic question of whether the creditor is effectively sharing in the risks of the borrowing company's business. The IAPT therefore recommends that the Proposed Regulations be amended to be in line with that basic standard in order to reduce or eliminate the possibility of that double taxation.

Nondiscrimination Issue

A great many U.S. treaties also include a Nondiscrimination Article which contains language along the following lines: "Except where the provisions of paragraph 1 of Article 9 (Associated Enterprises), paragraph 5 of Article 11 (Interest), or paragraph 4 of Article 12 (Royalties) apply, interest, royalties, and other disbursements paid by a resident of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of the first-mentioned resident, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State."⁸ Paragraph 5 of Article 11 refers to situations where, "by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the interest, having regard to the debt-claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship".

Thus, such a Nondiscrimination provision prevents the United States from denying a deduction for interest paid to a resident of the treaty partner where interest paid to a U.S. resident under the same conditions would be deductible, unless the situation involves the payment of greater than arm's length interest as described in Article 11(5). The Proposed Regulations raise a concern in this regard, as they would deny interest deductions in certain cases involving payments by a U.S. corporation to a related foreign corporation, while interest paid in the same circumstances by the U.S. corporation to a related U.S. corporation would remain deductible.⁹ There are no grounds on which it could be plausibly argued that the denial of interest deductions under the Proposed Regulations is based upon an application of the arm's length standard. Accordingly, the effect of the Proposed Regulations may be in conflict with treaties containing such Nondiscrimination protection (and thus may have to bow to such treaties).

Once again, the IAPT appreciates the opportunity to provide comments on the Proposed Regulations.

² The 1963 OECD Model Tax Convention had been the same, except that it used the words "assimilated to income from shares by the taxation law of the State" instead of "which is subjected to the same taxation treatment as income from shares by the laws of the State".

³ A very similar definition can be found in Article 11 of the OECD Model Tax Convention ("The term "interest" as used in this Article means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article.").

⁴ See Thin Capitalisation Report, paragraph 56 et seq.

⁵ The Thin Capitalisation Report referenced a "narrow interpretation" of the "income from other corporate rights" language which would have excluded its application to interest payments on debt-claims, but that narrow interpretation was rejected in the context of the Report's conclusions and the Report recommended removing the source of the ambiguity that narrow interpretation could cause.

⁶ Section 385(b) reads as follows:

⁸ See, e.g., Article 24(4) of the 2006 U.S. Model Income Tax Treaty.

⁹ See, e.g., Prop. Reg. § 1.385-1(e), which treats members of a consolidated group as one corporation and therefore exempts payments between members of such a U.S. group from the interest deduction denial.