This column provides an informal exchange of ideas, questions, and comments arising in everyday tax practice.
Since Section 1(h)(11) was enacted as part of the Jobs and Growth Tax Relief Reconciliation Act of 2003, questions have been raised on exactly how to interpret the section's legislative history. Under this provision, a dividend received by a U.S. individual taxpayer (directly or through a pass-through entity) from a domestic corporation or a "qualified foreign corporation" (QFC) is subject to a maximum U.S. federal income tax rate of 15%.
Under Section 1(h)(11)(C)(i)(II), a QFC includes a foreign corporation that is eligible for the benefits of a comprehensive income tax treaty with the U.S. which the Secretary determines is satisfactory for this purpose and which contains an exchange-of-information provision. According to the legislative history, "[t]he term ‘qualified foreign corporation’ includes a foreign corporation that is eligible for the benefits of a comprehensive income tax treaty with the United States which the Treasury Department determines to be satisfactory for purposes of this provision, and which includes an exchange of information program.... The conferees further intend that a company will be eligible for benefits of a comprehensive income tax treaty within the meaning of this provision if it would qualify for the benefits of the treaty with respect to substantially all of its income in the taxable year in which the dividend is paid." (H. Rep't No. 108-126, 108th Cong., 1st Sess. 41-42 (2003) ("Conference Report") (emphasis added).)
The IRS has issued three separate Notices indicating under which tax treaties corporations are treated as QFCs for this purpose: Notice 2003-69, 2003-2 CB 851 ; Notice 2006-101, 2006-2 CB 930 ; and, most recently, Notice 2011-64, 2011-2 CB 231 . In all three of these Notices, which include Cyprus among the list of qualified foreign jurisdictions, the IRS has stated that in order to be treated as a QFC, a foreign corporation must be "eligible for benefits of one of the U.S. income tax treaties listed in the Appendix [of the Notice]." In both Notice 2003-69 and Notice 2006-101, the Service interpreted that phrase to mean that "the foreign corporation must be a resident within the meaning of such term under the relevant treaty and must satisfy any other requirements of that treaty, including the requirements under any applicable limitation on benefits provision."
In Notice 2011-64, however, the IRS added a sentence indicating that "[f]or purposes of determining whether it satisfies these requirements, a foreign corporation is treated as though it were claiming treaty benefits, even if it does not derive income from sources within the United States." (emphasis added). As authority, the IRS cited to the Conference Report, which, as noted above, provides that a company will be eligible for treaty benefits if it "would qualify" for benefits under the treaty. The IRS, however, made no reference to the remainder of the sentence from the Conference Report, which indicates that a company will be eligible for treaty benefits if it would qualify for the benefits of the treaty "with respect to substantially all of its income in the taxable year in which the dividend is paid."
There is no guidance on what it means for "substantially all" of a corporation's income to be eligible for treaty benefits when no portion of the corporation's income is actually derived from U.S. activities or U.S. sources. Nevertheless, Notice 2011-64, which was issued on 8/18/11, is being made effective retroactive to tax years beginning after 2002. Thus, the IRS has added a gloss on its interpretation of the legislative history of Section 1(h)(11) almost ten years after the provision was first enacted, even though the prior guidance (Notice 2003-69 and Notice 2006-101) gave absolutely no indication that this was the Service's interpretation of the relevant congressional intent.
Why is this issue significant? Recently, the IRS has begun to challenge whether dividends received by U.S. taxpayers from corporations that are resident in Cyprus are eligible for qualified dividend rates. Cyprus has a very favorable holding company regime which provides that most dividends received by Cypriot holding companies are exempt from corporate income tax, and Cyprus generally imposes no withholding tax on outbound dividends. Moreover, Cyprus is a member of the EU and therefore Cypriot corporate residents can benefit from the EU parent-subsidiary directive. The Service is taking the position that dividends received by U.S. shareholders from some Cypriot corporations are not eligible for qualified dividend treatment because, in its view, the Cypriot corporations fail to satisfy the limitation on benefits (LOB) provision of the U.S.-Cyprus Income Tax Treaty (the "Treaty").
In general, the first paragraph of the Treaty's LOB provision (Article 26(1)) indicates that a corporation that is resident in Cyprus will not be eligible for treaty benefits unless (1) more than 75% 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 (2) the gross income of the Cyprus corporation is not used in substantial part, directly or indirectly, to make deductible payments to persons who are residents of a state other than the U.S. or Cyprus and who are not citizens of the U.S. Typically, U.S. taxpayers using Cyprus as a holding company jurisdiction will fail to qualify under this provision because the shareholders of such company will rarely, if ever, be residents of Cyprus.
Under the second paragraph of the LOB provision, however, the first paragraph will not apply "if it is determined that the establishment, acquisition and maintenance of such person and the conduct of its operations did not have as a principal purpose obtaining benefits under the Convention." (Emphasis added.) Based on this second paragraph, the Treaty's LOB provision will be satisfied if obtaining benefits under the Treaty was not a principal purpose of establishing the Cypriot holding company. By its terms, this clearly is a subjective test that can trump the objective test in the first paragraph of the LOB provision. And the qualified dividend 15% rate is technically a statutory benefit provided under Section 1(h)(11) rather than a treaty benefit "under the Convention."
Nevertheless, the IRS is currently challenging the claim of qualified dividend benefits for dividends from all Cypriot holding companies paid to U.S. taxpayers, unless the taxpayers can satisfy the Service's version of the LOB provision (described in more detail, below). It is not difficult to see why the Service would do so. The problem is that the Treaty as currently drafted simply does not support the specific positions that the IRS is taking in these challenges.
In one reported audit, the Service is taking the position that a dividend received from a Cypriot holding company that was established to own an operating company in a treaty jurisdiction (e.g., Germany) in order to reduce German withholding taxes is also not eligible to be treated as a qualified dividend. Under these facts, the U.S. shareholder of the German operating company would have been eligible to receive qualified dividends if it received the dividends directly from the German operating company, and therefore the purpose of the Cypriot company is clearly not to obtain treaty benefits under the Treaty. Rather, the sole purpose for establishing the Cypriot holding company was to reduce German withholding taxes, which obviously could not be affected by the Treaty. Therefore, it was somewhat surprising that the IRS would challenge the ability of a U.S. taxpayer to obtain qualified dividends in that particular case.
(To avoid this problem, the taxpayer could have filed a check-the-box election on Form 8832 to treat the Cypriot holding company as a disregarded entity for U.S. tax purposes. In that event, foreign withholding taxes still would have been eliminated but the IRS would have been prevented from arguing that the taxpayer failed to qualify under the LOB provision of the Treaty. See below, however, for a possible argument under Section 894(c) that would result in the disallowance of qualified dividend benefits even if the Cypriot holding company is disregarded for U.S. tax purposes.)
As noted above, Cyprus imposes no withholding tax on outbound dividends under its local law. Therefore, if one accepts the view that qualified dividends are a statutory benefit under U.S. law and not a benefit conferred by the Treaty, there are technically no treaty benefits being claimed when a dividend is paid from a Cypriot corporation to a U.S. taxpayer. Under this interpretation, it would seem that the second paragraph of the LOB provision of the Treaty could be considered met by a Cypriot holding company, even though the company is not owned by Cyprus residents and does not conduct any active trade or business in Cyprus.
The IRS appears to have a different interpretation of this provision. Rather, based on the "would qualify" language from the Conference Report, the IRS arguably is reading into the Treaty's LOB provision an active trade or business test that does not appear in the text of the Treaty. First, the IRS is seeking to treat the Cypriot holding company as if it were claiming treaty benefits (to determine if it "would qualify" in the event treaty benefits were in fact claimed), even though it is not deriving any income from sources within the U.S. and thus technically has no use for traditional treaty benefits such as reduced withholding tax rates. Then, the Service seems to be arguing that these nonexistent claims for benefits are the basis for the subjective intent that prevents the taxpayer from satisfying paragraph 2 of the LOB provision.
This would seem logically impossible: How can a taxpayer intend to do something that is merely deemed to occur? If this logic is followed through to its conclusion, the second paragraph is rendered superfluous, and the only means by which a Cypriot company can satisfy the LOB provision is by meeting the ownership test of the first paragraph. Thus, under this interpretation the IRS is essentially reading the second paragraph out of the LOB provision entirely by deeming the paragraph's requirements impossible to meet.
The IRS backtracks somewhat from this extreme reading, citing to the Technical Explanation of the Treaty, which states that "[the second paragraph] would be met, for example, if a Cyprus company owned by residents of third countries conducts business operations in Cyprus and holds investments in the United States, or engages in business activities in the United States, which are related or incidental to those business activities. For example, if the Cyprus company lends money to a supplier in the United States in order to assure a source of supply, and thereby derives interest income from the United States, that income could be considered incidental to its business activities."
The Service thus appears to be arguing that the foregoing lone example from the Technical Explanation constitutes the only means of meeting the second paragraph of the LOB provision in the Treaty, in this sense converting the subjective second paragraph test of intent into an active trade or business test. Many other U.S. treaties do contain active trade or business tests in their LOB provisions, but the Treaty is not one of them.
Moreover, the IRS ignores the remainder of the paragraph of the Technical Explanation to which it cites, which goes on to provide that "the test of paragraph (2) would also be met if the aggregate Cypriot tax burden is equal to or greater than the tax reductions claimed under the [Treaty]. The test could also be satisfied in other ways." Where a Cypriot holding company is used to obtain qualified dividends, the Cyprus tax burden is zero (because of the participation exemption that is available in Cyprus for dividends received), and so is the tax reduction claimed under the Treaty since Cyprus has no withholding tax. Thus, the above excerpt from the Technical Explanation does not appear to prevent a Cypriot holding company with no active trade or business in Cyprus from satisfying the LOB provision under these facts. On the contrary, it explicitly says the test can be met in other ways.
As noted above, the Service's arguments for denying qualified dividend benefits purport to be based on the "would qualify" language of the Conference Report, but do not seem to follow logically therefrom. A more persuasive argument for what was intended by the words "would qualify" is simply that a treaty's residence and LOB provisions, if any, must be satisfied when testing whether a foreign corporation is a QFC.
This logical reading is entirely consistent with the Service's prior interpretation of this language in both Notice 2003-69 and Notice 2006-101, in which the IRS stated that in order for a foreign corporation to be eligible for benefits under an applicable income tax treaty, "the foreign corporation must be a resident within the meaning of such term under the relevant treaty and must satisfy any other requirements of that treaty, including the requirements under any applicable limitation on benefits provision."
Furthermore, if a foreign corporation is required to test whether it is eligible for treaty benefits based on a hypothetical receipt of U.S. source income, there is no guidance on exactly where that income should be treated as coming from. One possibility (since the IRS is testing inbound concepts in the outbound context) is to reverse the structure and to treat the hypothetical receipt of income as coming from the ultimate beneficial U.S. owner that is receiving the purported qualified dividend. In this scenario, no dividend received from a foreign corporation that is resident in a treaty jurisdiction would be eligible for qualified dividend rates if such foreign corporation is owned by a hybrid entity (i.e., an entity treated as a corporation for foreign income tax purposes but as a flow-through entity for U.S. federal income tax purposes), such as a single-member disregarded LLC or S corporation. Treaty benefits would be denied under Reg. 1.894-1(d) , which provides that treaty benefits are allowed on an item of U.S. source income only if that income is "derived" by a resident of an applicable treaty jurisdiction.
For example, based on this interpretation, a U.K. operating company that is owned by a disregarded U.S. LLC would not be eligible to pay a qualified dividend. This is because a hypothetical payment of U.S. source income made by the ultimate beneficial U.S. owner to the U.K. operating company through the disregarded U.S. LLC would not be eligible for treaty benefits under the U.S.-U.K. income treaty—the item of income would not be "derived" by a resident of the U.K. The same result would seem to apply if the U.K. operating company were owned by a multi-member LLC taxed as a partnership, an S corporation, or a grantor trust, because in all of these situations the income would not be treated as being derived by a resident of the U.K. Clearly, this was not the intent of Congress when Section 1(h)(11) was enacted almost ten years ago.
To eliminate the confusion surrounding the correct interpretation of the legislative history of Section 1(h)(11) (which likely will sunset after this year), Treasury or the IRS should issue further guidance on what it means for a taxpayer to be eligible for treaty benefits for purposes of qualifying under this section. It is hoped this guidance actually will support the language from the Conference Report, as opposed to solely being directed at taxpayers attempting to claim qualified dividend benefits from corporations that are resident in Cyprus.