For purposes of this week’s blog, it will be beneficial just to recap on the purpose of a DTA. The major purpose of DTA is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Due to the fact that DTAs often modify US and foreign tax consequences substantially, the relevant DTA must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction.
Article 10 of the US/Australia DTA is a great example of this.
This week we will be looking at the tax implications of declaring a dividend in the context of Article 10 of the US/Australia DTA.
INTERPRETING ARTICLE 10 OF THE DTA – DIVIDENDS
Dividends are distributions made by a company of something of value to a shareholder. Both the US and Australia levy withholding tax when a dividend is paid to a foreign shareholder.
Under US domestic tax law, a foreign person is generally subject to 30% US tax on the gross amount of certain US-source income. All persons (‘withholding agents’) making US-source fixed, determinable, annual, or periodical (FDAP) payments to foreign persons generally must report and withhold 30% of the gross US-source FDAP payments, such as dividends.
Under Australian domestic tax law, dividends paid to an Australian non-resident recipient is subject to a flat withholding tax to the extent they are unfranked and are otherwise not assessed in Australia.
Article 10 however limits the tax that the source country may impose on these dividends payable to beneficial owners’ resident in the other country.
Article 10(1) preserves the right of a shareholder’s country of residence to tax dividends arising in the other country by permitting Australia or the US to tax its residents on dividends paid to them by a company that is resident in the other Contracting State.
Article 10(2) allows the Contacting State of the company to tax dividends to which a resident of the other Contracting State is entitled subject to the limitations in Article 10(2) and 10(3).
Important to note is that Article 10(2) also requires that if either the US or Australia significantly modifies their laws regarding taxation of corporations or dividends they must consult with each other to determine any appropriate amendment to Article 10(2).
Article 10(2)(a) stipulates that where the shareholder who is beneficially entitled to the dividend is a company resident in the other Contracting State and directly owns shares representing at least 10% of the voting power of the company paying the dividend then the withholding tax rate is limited to 5% of the gross dividend.
The term ‘beneficially entitled’ is not defined in the DTA and therefore the domestic law of the country imposing the tax should be considered.
The term ‘voting power‘ is also not defined but must be determined to ascertain if the 10% shareholding test is satisfied.
The US Department of Treasury’s technical explanation of the Protocol that replaced Art 10 of the Convention states the following:
“Shares are considered to be voting shares if they provide the power to elect, appoint or replace any person vested with the powers ordinarily exercised by the board of directors of a US corporation.”
In Australia voting power is considered to refer to the voting power on all types of shares and not only in relation to the power to replace members of the board of directors.
In determining the voting power for the purposes of Article 10(2) only shares that are held ‘directly’ by the beneficial shareholder can be taken into account.
Accordingly, indirect interests are not to be taken into account. However, the US Department of Treasury’s technical explanation of the Protocol when discussing Article 10(2) states the following:
“Companies holding shares through fiscally transparent entities such as partnerships are considered for purposes of this paragraph to hold their proportionate interest in the shares held by the intermediate entity. As a result, companies holding shares through such entities may be able to claim the benefits of sub-paragraph (a) under certain circumstances. The lower rate of withholding tax applies when the company’s proportionate share of the shares held by the intermediate entity meets the 10 percent threshold. Whether this ownership threshold is satisfied may be difficult to determine and often will require an analysis of the partnership or trust agreement.”
The voting power test in Article 10 is therefore likely to be applied differently in the US and Australia unless the reference to “beneficially entitled” is interpreted to override the requirement that the payee company holds the shares “directly”.
Article 10(2)(b) limits the withholding tax rate on dividends derived by a resident from shares held in a company resident in the other Contracting State to 15%. Accordingly, this rate will apply to individuals, trusts, partnerships and companies that cannot rely on Article 10(2)(a) or the exemption in Art 10(3) discussed below.
Article 10(3) is quite often misinterpreted. This Article stipulates that a shareholder company resident in the US or Australia is exempt from withholding tax on dividends if it owns 80% or more or the voting power of the company paying the dividends for a 12-month period ending on the date the dividend is declared. However, the exemption is subject to the shareholder company being:
(a) a qualified person as defined in Article 16(2)(c), or
(b) entitled to benefits under the Limitation of Benefits Article.
In contrast to Article 10(2), voting power for the purposes of Article 10(3) is limited to shares that are held “directly” by the beneficial shareholder and therefore excludes indirect ownership through corporate chains.
The shareholder company will be a “qualified person” if:
1. its principal class of shares is listed on a recognized stock exchange and is regularly traded on one or more stock exchanges. A recognized stock exchange is a recognized stock exchange under Australian or US law and any stock exchange agreed by the ATO and IRS as explained in Article 16(6), or
2. at least 50% of the vote and value of the shares in the shareholder company must be owned directly or indirectly by five or fewer companies that are listed on a recognized stock exchange as defined in Article 16(6). Importantly in addition, where the shares in the shareholder company are held indirectly, each intermediate owner must be a resident of either Australia or the US.
Where a shareholder company is not a qualified person the exemption from withholding tax may still be available provided that the ATO or IRS makes a determination under Article 16(5).
Article 10(4) provides that dividends paid by a Regulated Investment Company (RIC) or Real Estate Investment Trust (REIT) are not eligible for the 5% maximum rate of withholding tax in Art 10(2)(a) or the exemption from withholding tax in Art 10(3). Accordingly, the 15% withholding rate will generally apply to these entities.
Article 10(5) excludes from the general source country withholding tax limitations under Art 10(2), (3) and (4) dividends paid with respect to holdings that form part of the business property of a permanent establishment as defined in Article 5 or fixed base situated in the source country.
Article 10(6) defines “dividends” to mean income from shares and amounts subject to the same taxation treatment as income from shares under the laws of the country where the company making the distribution is a resident.
In Australia the rules for defining what constitutes equity in a company and what constitutes debt are set out in ITAA97 Div 974 of the ITAA 1997 that apply from 1 July 2001.
In the case of the US, the term dividends include amounts treated as a dividend under US law upon the sale or redemption of shares or upon a transfer of shares in a reorganisation. Further, a distribution from a US publicly traded partnership, which is taxed as a corporation under US law, is a dividend for purposes of Article 10. However, a distribution by a US LLC is not a dividend for purposes of Article 10 if it is not taxable as a corporation under US law.
Article 10(7) states that where a company which is resident for example in the US and derives profits or income from Australia, Australia is not permitted to tax dividends paid by the company unless either:
1. the person beneficially entitled to the dividends is a resident in Australia; or
2. the shares in respect of which the dividends are paid is effectively connected with a permanent establishment in Australia.
Therefore, Article 10(7) overrides section 44(1)(b) of the ITAA 1936 which permits Australia to tax dividends paid to non-residents to the extent of profits derived from sources within Australia.
Similarly, it overrides the ability of the US to impose taxes under Code s 871 and Code s 882(a) on dividends paid by foreign corporations that have a US source under Code s 861(a)(2)(B).
Article 10(7) also provides that the Contracting States cannot impose tax on a company’s undistributed profits even if the dividends are wholly or partly paid out of profits in the relevant Contracting State unless Article 10(8) applies.
However, Article 10(7) does not restrict a State’s right to tax its resident shareholders on undistributed earnings of a corporation resident in the other State. The authority of the US to impose the foreign personal holding company tax, the taxes on subpart F income and on an increase in earnings invested in US property, and the tax on income of a passive foreign investment company that is a qualified electing fund is in no way restricted by this provision.
Article 10(8) permits Australia and the US to impose a branch profits tax on a company that is a resident in the other State. This tax is in addition to other taxes permitted by the Convention.
Currently, Australia does not impose a branch profits tax. However, if Australia were to impose such a tax, the base of such a tax would be limited to an amount analogous to the US dividend equivalent amount.
Article 10(9) lastly provides that the branch profits tax permitted by Article 10(8) shall not be imposed at a rate of withholding tax exceeding the maximum direct investment dividend rate of withholding tax of 5% in Article 10(2)(a).
As you can see, Article 10 of the DTA is comprehensive and one should be cautious when applying it to a specific situation.