Income Tax Treaty Only Third Signed with Latin American Jurisdiction
Since the U.S.-Chile Free Trade Agreement came into force in 2004, bilateral trade between these two countries has more than doubled. In fact, according to the Chilean Foreign Investment Committee, the United States is Chile’s second largest goods trading partner overall, and the largest foreign investor in Chile, accounting for 24 percent of foreign direct investment in Chile from 1974-2010.
A more recent development that will likely lead to increased inbound investment by Chilean investors is the U.S.-Chile income tax treaty (the “Treaty”) that was signed in February of 2010. Although it is not yet in effect, the treaty with Chile – the first between the two countries – would only be the third comprehensive income tax treaty that the United States has signed with a Latin American jurisdiction. Currently, the United States only has income tax treaties in effect with Mexico and Venezuela.
Benefits of Treaty to Inbound Chilean Investors
The primary benefits generally afforded under the Treaty to inbound Chilean investors are the reduced U.S. withholding tax rates on payments of dividends, interest, and royalties. Presently, these payments would be subject to 30 percent U.S. withholding tax. Under the Treaty, the U.S. withholding tax rates are reduced to as low as five percent for dividends; four percent for interest; and two percent for royalties. In addition, a Chilean investor that is engaged in a U.S. trade or business (and therefore taxable on its net income effectively connected to such trade or business) may be able to avoid U.S. federal income tax under the Treaty by claiming that no portion of its trade or business income is attributable to a permanent establishment in the United States. Similar to most modern U.S. income tax treaties, for a foreign investor to be able to claim treaty benefits, such investor must (i) be a “resident” of Chile for purposes of the Treaty, and (ii) satisfy the Treaty’s limitation on benefits (LOB) article (i.e., anti-treaty shopping provision).
One of the more unique provisions of the Treaty deals with back-to-back loan arrangements under Article 11(4). Under this article, the Treaty allows interest payments made pursuant to back to back loan arrangements to be eligible for reduced withholding tax rates of 10 percent rate. Under the conduit financing regulations contained in Regulation Section 1.881-3, treaty benefits would be completely denied and a 30 percent U.S. withholding tax rate would apply to the interest payment. It is not entirely clear whether Article 11(4) is only intended to be effective from a Chilean withholding tax perspective. For example, in the U.S.-U.K. income tax treaty, treaty benefits are completely denied with respect to any payment made pursuant to a conduit arrangement. The technical explanation of the U.S.-U.K. treaty indicates that the U.S. is expected to apply its domestic laws (i.e., the conduit financing regulations) in interpreting the U.S.-U.K. conduit provisions.
In general, a conduit financing transaction would, for example, involve back-to-back loans made for the sole purpose of obtaining U.S. treaty benefits on a payment of U.S.-source interest. Currently, such a back-to-back loan arrangement that has a tax avoidance motive would be collapsed and treated as a direct loan from the third party lender to the United States and the “conduit” would be disregarded. This would have the effect of causing the interest payment to be subject to a 30 percent U.S. withholding tax (assuming such third party is resident in a non-treaty jurisdiction).
Until further guidance is issued, the Treaty appears to allow all interest payments made pursuant to a back-to-back loan arrangement to be eligible for a reduced withholding tax rate of 10 percent (but not the four percent rate). Obviously, this is much more favorable than the 30 percent U.S. withholding tax that typically would apply in a back-to-back loan situation. Assuming this article actually overrides the conduit financing regulations under Regulation Section 1.881-3, this unique provision would appear to be the only one of its kind in any U.S. income tax treaty to grant a reduced U.S. withholding tax rate in a back-to-back loan situation and could lead to some interest tax planning possibilities. This is especially true in light of the fact that one of the types of taxpayers who is eligible for this reduced rate (who would also appear to be able to satisfy the Treaty’s stringent LOB provision) would be a Chilean entity that derives substantially all its income from the active and regular conduct of a lending or finance business involving transactions with unrelated parties.