Foreign investors in the U.S. tend to have the same goals as their U.S. counterparts. Like U.S. taxpayers, foreign investors seek to minimize their income tax liabilities associated with their U.S. real estate and business investments. However, foreign investor’s objectives are clouded by the fact that they are not U.S. persons for tax purposes. In addition, foreign investor’s objectives may be complicated by income taxes of their home countries. Furthermore, the U.S. has a special income tax regime that is applicable to foreign persons. Specifically, if a non-U.S. person derives certain types of passive income, it is typically taxed at a flat 30 percent rate (without an allowance for deductions), unless an applicable tax treaty reduces this rate. On the other hand, if the U.S. activities of the foreign person rise to the level of constituting a “U.S. trade or business,” the foreign person will be taxed much like a U.S. person. This article addresses how tax treaties may be utilized to reduce a foreign person’s global tax liability. This article also addresses the recent developments in tax treaties. As an example of whether U.S. income taxation of a foreign investor would be impacted by a U.S. Income Tax Treaty, we shall address whether a foreign investor could utilize the U.S.-Hungarian Income Tax Treaty or the U.S.-Polish Tax Treaty.
U.S. Taxation of Foreign Persons
Two different U.S. tax regimes apply to non-U.S. taxpayers. First, non-residents engaged in a trade or business in the U.S. are taxed on income that is effectively connected with a trade or business. Such income is taxed at applicable graduated U.S. individual rates. A different tax regime applies to income that is not effectively connected with a trade or business in the U.S. Under this regime, a flat 30 percent tax is imposed on U.S. source fixed or determinable annual or periodic income such as (interest, dividend, rents, annuities, and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP income). This tax is imposed on gross income, with no deductions allowed. In general, this tax is collected by withholding. The 30 percent tax may be reduced or eliminated by bilateral income tax treaties to which the U.S. is a party.
Impact of Tax Treaties
Even though the statutory rate of withholding on U.S. source payments of FDAP income to a foreign person is 30 percent, for the most part, income tax treaties will reduce and in some cases eliminate the U.S. withholding on FDAP income. For a non-U.S. taxpayer to be eligible for treaty benefits, the individual generally must be considered a “resident” of a particular treaty jurisdiction and must satisfy a so-called “limitation on benefits” (LOB) provision in the treaty. Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of similar nature.” 1
Under most “modern” income tax treaties, a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that is at least 50 percent owned by citizens or residents of the U.S. or by residents of the jurisdiction where the corporation is formed and not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are neither citizens nor residents of the U.S. or residents of the jurisdiction where the corporation is formed. However, in many cases, there is no such residency requirements under older income tax treaties in which the U.S. has negotiated with foreign countries.
U.S. Tax Planning Opportunities Utilizing Income Tax Treaties Without LOB Provisions Prior to the 2012 Calendar Year
Currently, it is the policy of the U.S. to include a LOB provision when negotiating a new tax treaty. With that said, certain older income tax treaties do not contain LOB provisions. As of the 2011 calendar year, the income tax treaties with foreign countries in which the U.S. did not contain LOB provisions where: 1) Egypt; 2) Greece; 3) Hungary; 4) Korea; 5) Morocco; 6) Pakistan; 7) the Philippines; 8) Poland; 9) Romania; and the former U.S.S.R. (which now applies to Armenia, Azerbaijan, Belarus, Georgia, Krgyztan, Moldova, Tajikstan, Turkmenistan, and Uzbekistan. The benefits of these treaties were to reduce the rates for U.S. income tax purposes. For example, the U.S. treaties with Egypt, Hungary, and Poland reduce the withholding rate on payments of U.S. source dividends to as low as five percent for federal income tax purposes. In addition, the treaties with Greece, Hungary, and Pakistan completely eliminate the U.S. withholding tax on payments of U.S. source royalties. The combination of these reduced withholding rates, coupled with favorable local tax benefits in some of the foreign jurisdictions, provided significant worldwide tax benefits to a U.S. inbound foreign investors.
Repatriating U.S. Profits to a Foreign Jurisdiction Utilizing Global Treaties to Minimize Worldwide Tax Liabilities
As discussed above, payments of U.S. source dividends to a foreign corporation are generally subject to a 30 percent federal withholding tax. While many treaties reduce or eliminate this withholding rate, not all U.S. foreign investors are residents to qualify for a treaty that provides for these reduced rates. These foreign individuals may utilize a strategy of establishing a company in a jurisdiction with a treaty with the U.S. that has no LOB provision and provides for a reduction in the U.S. withholding tax.
For example, prior to the 2012 calendar year, instead of a Bermuda resident investing directly in a U.S. corporation, the Bermuda resident was able to invest in the U.S. through a Hungarian corporation. Using this approach, a dividend paid from the U.S. would only be subject to a five percent U.S. federal withholding tax and the dividend received in Hungary would be completely exempt from Hungarian corporate income tax as a result of its favorable participation exemption.2 Moreover, a dividend paid out of Hungary could be completely exempt from Hungarian withholding tax.3 Since US-Hungary tax treaty entered into force on September 18, 1979 contained no LOB provisions, just about any non-U.S. person, regardless of residence eligible to take advantage of this structure. Prior to the 2012 calendar year, because of the favorable provisions in the US-Hungary tax treaty, foreign investors often utilized a Hungarian corporation as a vehicle to invest in the U.S.
Not only did foreign investors utilize the Hungarian-U.S. treaty to limit their exposure to taxes on FDAP gains, foreign investors often utilized the Hungarian-U.S. treaty to limit their exposure to gains realized from the disposition of real property. In order to better understand how foreign investors utilized the Hungarian-U.S. treaty to limit their exposure to U.S. tax on gains from real property transactions, we will first discuss the U.S. tax implications of foreign investors in the U.S. real estate market.
Foreign persons are typically not subject to U.S. income tax on U.S. source capital gains unless the gains are effectively connected to a U.S. trade or business.4 However, the Internal Revenue Code treats any gain realized by a foreign person on the disposition of a U.S. real property interest (“USRPI”) as if it were effectively connected to a U.S. trade or business. A USRPI is broadly defined by the Internal Revenue Code as: 1) a direct interest in real property located in the U.S. and 2) an interest (other than an interest solely as a creditor) in any U.S. corporation that constitutes a U.S. real property holding corporation (a corporation whose USRPIs make up at least 50 percent of the total value of the corporation’s real property interests and business assets).5
The regulations promulgated under Internal Revenue Code Section 897 provide an example as follows: “a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired. The example states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.” The example concludes that Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments because these payments are considered to consist solely of principal and interest for U.S. income tax purposes.6
Therefore, the example stated in the Treasury Regulations concludes that the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a USRPI for the purposes of Section 897 of the Internal Revenue Code because the amount is considered to be interest rather than gain under Internal Revenue Code Section 1001.
By characterizing a contingent payment on a debt instrument as interest for U.S. income tax purposes, the Income Tax Regulations promulgated under Internal Revenue Code Section 897 may permit non U.S. taxpayers to avoid U.S. income tax on gain arising from the sale of U.S. real estate. As such, a non U.S. individual could lend money from a company established in a jurisdiction such that has a treaty with the U.S. with no LOB provisions such as Hungary and have that interest on the loan tied to gain on the sale of the property. The interest that was tied to the gain of the sale of the real property was completely exempt from U.S. income tax under an applicable Hungarian-U.S. income tax treaty.
However, Hungary had a 16 percent corporate tax rate. In order to reduce this tax, foreign investors would establish a “financial branch” in a “low-tax” jurisdiction. Hungary has tax treaties with Switzerland and Luxembourg. Both these jurisdictions have a very favorable branch taxing regime. Consequently, investors utilizing the Hungarian-U.S. tax treaty to minimize U.S. taxes would register a branch in either Switzerland or Luxembourg. A finance branch registered in either of these two jurisdictions reduced the effective tax rate on interest income to as low as two percent. Therefore, by having a Hungarian corporation own a finance branch in either Switzerland or Luxembourg and by allocating loans and interest from those loans to such a financial branch, rather than to the Hungarian company directly, the foreign income tax imposed on the receipt of interest income was reduced significantly.
Under the above discussed financial structure, any income received by a foreign financial branch in either Switzerland or Luxembourg was exempt from corporate income tax in the jurisdiction of the corporation’s home country under respective income tax treaties.7
The benefit of the previous treaty with Hungary entered into force on September 18, 1979 was that it the treaty contained no “anti-triangular” provisions in the income tax treaties. Typically, an “anti-triangular” typically prevents a non U.S. taxpayer from utilizing treaty benefits if the income tax benefit received is attributed to a establishment located in a third jurisdiction and the combined tax rate of both jurisdictions is lower than the U.S. tax rate.
Recent Developments Regarding the Tax Treaty with Hungary
Recently, the U.S. entered into a new bilateral tax treaty with Hungary. The new treaty includes the LOB provision that is included in many other treaties entered into by the U.S. The inclusion of limitations on benefit provisions significantly eliminates the use of Hungary as a treaty shopping jurisdiction. It is no longer possible to place a Hungarian corporation between the U.S. and a third low tax country in order to significantly diminish global tax obligations. With the adoption of the new tax treaty with Hungary, foreign investors’ ability to treaty shop for international tax planning is limited further and very few opportunities now exist for planning in this context. Although the newly negotiated bilateral U.S.-Hungarian tax treaty is a blow to foreign investors, other opportunities still exist. The remaining countries with tax treaties with the U.S. that do not include limitations on benefits rules are Poland, Greece, the Philippines, Romania, and certain countries of the former U.S.S.R.
We started this article discussing how foreign investors were taking advantage of the U.S.- Hungarian tax treaty to reduce the U.S. income tax liability on gains from U.S. source dividends. Even though it is no longer possible to take advantage of the bilateral U.S.- Hungarian tax treaty to reduce taxes on U.S. source dividend gains, a similar type of plan can still be achieved through the use of a Polish corporation. The U.S.-Polish treaty currently provides for a five percent withholding rate on U.S. source dividends.8 Dividends can then be repatriated out of Poland tax-free to a branch office located in a legal European tax haven jurisdiction such as the island country of Cyprus. Cyprus may be an excellent jurisdiction to repatriate funds out of Poland to due to the fact that the jurisdiction has no withholding tax on dividends.
We also discussed how foreign investors were utilizing the U.S.-Hungarian bilateral treaty to reduce their exposure to U.S. taxes resulting from the gains in real estate. Although foreign investors can no longer take advantage of the U.S.-Hungarian tax treaty to reduce their exposure to U.S. taxes on gains in real estate holdings, the current bilateral U.S.-Polish treaty provides similar benefits to foreign investors as the now defunct U.S.- Hungarian bilateral tax treaty enacted in 1979. For example, suppose a foreign investor realizes a gain on a debt instrument on real property classified as interest under Section 897 of Internal Revenue Code. Like with the previous bilateral U.S.- Hungarian tax treaty, under current U.S.-Polish tax treaty, the foreign investor can lend money from a Polish company and have the gain of the real property completely exempt from U.S. income tax.
As discussed above, the Income Tax Regulations provide that a foreign person can utilize a foreign corporation to lend money to a U.S. individual without realizing taxable gain of a USRPI for purposes of Section 897. Under the U.S.-Polish bilateral treaty, a foreign investor can establish a Polish corporation to lend money to a U.S. individual holding real property. The Polish corporation could secure a mortgage on the U.S. property. Under the loan agreement, the Polish corporate lender would receive fixed monthly payments from the domestic borrower, constituting repayment of the principal plus interest, and a percentage of any appreciation in the value of the real property at the expiration of the loan. The Income Tax Regulations of Section 897 potentially allow a foreign investor to lend money from a company formed in Poland and completely exclude the gain on the real property from U.S. income tax.
In addition, if the transaction is property arranged, the foreign investor could mitigate or avoid Polish corporate income tax which currently has a corporate tax rate of 19 percent. In order to mitigate Polish corporate tax, a “finance branch” may be established in low-tax third party jurisdiction. Poland has bilateral tax treaties with Switzerland, Luxembourg and the United Arab Emirates. These jurisdictions have a very favorable branch taxing regime. Consequently, a “finance branch” could be registered in either of these countries to reduce the effective tax rate on the gains from U.S. real estate activities to a marginal tax rate of less than two percent.9
Under such planning, any income derived by the “finance branch” is exempt from Polish corporate tax under the respective tax treaty. Unlike many newer bilateral income tax treaties with other jurisdictions (including the recent treaty with Hungary), the bilateral U.S. treaty with Poland has no “anti-triangular” provisions. In general, the purpose of this provision is to prevent non-U.S. taxpayers from claiming treaty benefits if the income received by the non-U.S. treaty party is attributed to a permanent establishment in a third jurisdiction.
As the result of favorable world-wide income tax treaties, foreign investors in the U.S. may be able to arrange their business transactions in the U.S. without realizing any U.S. tax liability. The transaction may also be planned to significantly reduce global income taxes. Particular attention must be paid to both the tax treaties of different countries and also the additional tax savings in planning the use of multiple tax treaties and multiple entities to legally avoid the taxes that would otherwise be paid.
To better understand this intricate area of tax law, consult with a tax attorney at Moskowitz, LLP by calling (415) 394-7200 or via our Tax Law Firm’s website.
Article 4(1) of the U.S.-Netherlands Income Tax Treaty.
In general, all dividends received by a Hungarian corporation will be exempt from corporate income tax unless the paying corporation is a “controlled foreign corporation” (CFC), as that term is defined for Hungarian tax purposes. A CFC is defined in Hungary as a foreign corporation that is subject to an effective tax rate below 10.67 percent (which is 2/3 of the 16 percent Hungarian corporate tax rate), unless that foreign corporation has a real economic presence in the jurisdiction.
The exemption from withholding tax on dividends out of Hungary applies only if the recipient is a corporation. Therefore, the individual can own the shares of the Hungarian corporation through a low-tax jurisdiction, such as the British Virgin Islands or the Cayman Islands.
IRC Section 871(a)(2).
IRC Section 897(c)(2).
Treas. Reg. Section 1.897-1(h).
See Article 23(1)(a) of the Hungary-Switzerland Income Tax Treaty; Article 24(1)(a) of the Hungary-Luxembourg Income tax Treaty.
Poland currently has a 19 percent corporate income tax rate. Poland grants a foreign tax credit for foreign taxes paid as long as the Polish corporation owns at least 75 percent of the U.S. corporation.
See Article 23(1)(a) of the Poland-Switzerland Income Tax Treaty; Article 24(2)(a) of the Poland-Luxembourg Income Tax Treaty; and Article 24(1)(a) of the Poland-UAE Income Tax Treaty.