In a recent internal legal memorandum (the ILM), the IRS concluded that a US individual was entitled to treat dividends received from a Cypriot holding company with no Cypriot ownership as qualified dividend income (QDI), and thereby is eligible for reduced US income tax rates.
Cyprus, a member of the European Union, is generally regarded as a favorable finance and holding company location, due to its relatively low income tax regime and favorable withholding tax network.
The US-Cyprus income tax treaty contains a relatively unusual Limitation on Benefits (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, and certain other requirements are met (LOB Provision 1). However, the US-Cyprus Treaty also provides that LOB Provision 1 does not apply to a Cypriot corporation if the establishment, acquisition and maintenance of the Cypriot corporation and the conduct of its operations does not have as a principal purpose obtaining benefits under the treaty (LOB Provision 2).
Under the facts of the ILM, a US individual (the “taxpayer”) owned an interest in a Cypriot 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 established in Cyprus for reasons unrelated to the Treaty. The taxpayer claimed that dividends received from HoldCo were QDI.
Dividends received by U.S. individuals from a “qualified foreign corporation” are treated as QDI and are eligible for a reduced tax rates. A qualified foreign corporation includes a foreign corporation that is eligible for the benefits of one of the income tax treaties that has been approved for this purpose in published guidance.i The US-Cyprus Treaty is an approved treaty. Accordingly, the taxpayer would be able to claim the reduced tax rates applicable to QDI if HoldCo were eligible for the benefits of the U.S-Cyprus Treaty.
HoldCo did not qualify under LOB Provision 1 because none of its shares were owned by individual residents of Cyprus. However, the ILM concluded that LOB Provision 2 was satisfied because there was no principal purpose of obtaining benefits under the US-Cyprus Treaty. As a result, the ILM concluded that HoldCo was a “qualified foreign corporation” and dividends that the taxpayer received from HoldCo would be treated as QDI.
The ILM does not describe why the establishment of the Cypriot holding company did not have a principal purpose of obtaining benefits under the US-Cyprus Treaty. Perhaps the US taxpayer was a minority owner of HoldCo and did not have the power to choose its location. Regardless, the ILM highlights this relatively unusual, purely subjective test under the treaty’s LOB provisions and confirms that a US taxpayer that receives dividends from a Cypriot holding company that can substantiate its qualifying subjective intent may be eligible for QDI treatment.
i Notice 2011-64, 2011-37 I.R.B. 231 (September 12, 2011).