US-AU DTA: Article 16 – Limitation of Benefits
INTRODUCTION
In this week’s blog we will be discussing the technical Limitation of Benefits (LoB) Article (Article 16) of the US/Australia DTA.
Article 16 states that, in addition to being a resident of the US or Australia, taxpayers need to satisfy the requirements of Article 16 to obtain the benefits of the DTA.
In particular, the benefits of the DTA are only available if the resident is:
- A qualified person (Article 16(2));
- Actively engaged in a trade or business (Article 16(3)); or
- Entitled to treaty relief because the IRS or ATO makes a determination (Article 16(5)).
The purpose of these restrictions is to prevent residents of third countries from using interposed companies or other entities resident in either Australia or the US to access treaty benefits, also commonly referred to as treaty shopping.
Treaty shopping is the use by residents of third countries of legal entities established in either the US or Australia with a principal purpose of obtaining the benefits of the US/Australia DTA.
INTERPRETING ARTICLE 16 OF THE DTA – LIMITATION OF BENEFITS
Article 16(1) stipulates that except as otherwise provided in Article 16 only residents of the US or Australia for the purposes of the DTA that are qualified persons are entitled to the benefits otherwise available under the DTA.
The benefits otherwise available under the DTA to residents are all limitations on source-based taxation under Article 6 through 15 and Article 17 through 21, the treaty-based relief from double taxation provided by Article 22 (Relief from Double Taxation), and the protection afforded to residents of a Contracting State under Article 23 (Non-discrimination).
The limitation in Article 16 does however not apply where a person is not required to be a resident in order to enjoy the benefits of the DTA. For example, Article 26 (Diplomatic and Consular Privileges) applies to diplomatic and consular privileges regardless of residence.
Article 16(2) lists the eight categories of resident that will constitute a qualified person for a taxable year and thus will be entitled to all benefits of the DTA provided that they otherwise satisfy the requirements for a particular benefit. It is therefore important to note that the tests must be satisfied for each year that benefits under the DTA are sought.
Article 16(2)(a) – Individuals
Article 16(2)(a) states that individual residents of a Contracting State will be a qualified person and hence entitled to rely on the DTA.
However, the definition of US resident in Article 4(1)(b)(ii) excludes citizens who are also a resident of another country with which Australia has a DTA. In addition, an individual that receives income as a nominee on behalf of a third country resident, may be denied the benefits of the DTA due to the beneficial ownership requirement in Article 10 for example, despite meeting the requirement in Article 16(2)(a).
Article 16(2)(b) – Governmental bodies
Article 16(2)(b) states that the Contracting State, any political subdivision or local authority of the state, or any agency or instrumentality of the state will be a qualified person and hence entitled to rely on the DTA.
Article 16(2)(c)(i) – Publicly traded companies
Article 16(2)(c)(i) states that a resident company will be a qualified person in the following circumstances:
- Its principal class of shares is listed on a US or Australian stock exchange; and
- Those shares are regularly traded on one or more recognized stock exchanges.
Article 16(2)(c)(ii) – Subsidiary companies
Article 16(2)(c)(ii) states that a resident company will be a qualified person if:
- At least 50% of the aggregate vote and value of its shares are owned directly or indirectly by five or fewer companies that are qualified persons due to Article 16(2)(c)(i); and
- In the case of indirect ownership, each intermediate shareholder is a resident of either the US or Australia.
Article 16(2)(d) – Other listed entities
Article 16(2)(d) states that certain publicly traded entities (other than companies) and entities beneficially owned by certain publicly traded entities or companies may be qualified persons and hence entitled to rely on the DTA.
Article 16(2)(d)(i) – Publicly traded entities
Article 16(2)(d)(i) states that a resident entity that is not an individual or a company is a qualified person if:
- The principal class of units is listed or admitted to dealings on US or Australian stock exchange; and
- These units are regularly traded on one or more recognized stock exchanges.
Article 16(2)(d)(ii) – Other Entities
Article 16(2)(d)(ii) states that a resident entity that is not an individual or a company will be a qualified person if at least 50% of the beneficial interests in the entity are owned directly or indirectly by five or fewer companies that are a qualified person due to Article 16(2)(c)(i) or publicly owned entities that satisfy the requirements of Article 16(2)(d)(i).
Article 16(2)(e) – Tax exempt organizations
Article 16(2)(e) states that a resident religious, charitable, educational, scientific or other similar organizations is a qualified person if:
- It is organized under the laws of the US or Australia; and
- Was exclusively established and maintained for a religious, charitable, educational, scientific or other similar purpose.
Article 16(2)(f) – Pension funds
Article 16(2)(f) states that a pension fund is a qualified person if:
- It is organized under the laws of either the US or Australia;
- Established and maintained to provide pensions or similar benefits to employed or self-employed persons pursuant to a plan; and
- More than 50% of the beneficiaries, members or participants are individuals resident in either the US or Australia.
Article 16(2)(g) – Unlisted entities
Article 16(2)(g) states that a person other than an individual that is a resident of either the US or Australia is a qualified person and hence entitled to rely on the DTA if both an ownership and base erosion test are satisfied.
However, one or more of the following categories of qualified persons must principally own the unlisted entity directly or indirectly:
- Individuals who are residents in the US or Australia (Article 16(2)(a));
- Government bodies of the US or Australia (Article 16(2)(b); and
- Entities resident in either the US or Australia that satisfy public listing and trading requirements in Article 16(2)(c)(i) and Article 16(2)(d)(i)).
Ownership test — companies
Article 16(2)(g)(i) requires that 50% or more of the aggregate voting power and value of the company must be owned directly or indirectly on at least half the days of the company’s taxable year by certain qualified persons.
Ownership test — trusts/partnerships
Article 16(2)(g)(i) requires that 50% or more of the beneficial interests of entities other than companies must be owned directly or indirectly on at least half the days of the entity’s taxable year by certain qualified persons.
Base erosion test
Article 16(2)(g)(ii) disqualifies a person that satisfies the requirement in Article 16(2)(g)(i) if 50% or more of the unlisted entity’s gross income for the taxable year is paid or accrued (directly or indirectly) to a person or persons who are not residents of either Contracting State in the form of payments deductible for tax purposes in the payer’s state of residence.
Article 16(2)(h) – Headquarters companies
Article 16(2)(h) states that a resident of the US or Australia that is a recognized headquarters company (RHC) for a multinational corporate group (MCG) is a qualified person and hence entitled to rely on the DTA.
A RHC is a US or Australian resident company where:
- It has a substantial involvement in the supervision and administration of companies forming the MCG.
- The MCG being supervised is engaged in an active business in at least five countries and each company generates at least 10% of the gross income of the MCG.
- The gross income from any single country where a MCG member carries on business activities must be less than 50% of the gross income of the MCG.
- No more than 25% of the gross income of the RHC can be derived from the other Contracting State.
- The supervision and administrative activities for the MCG are carried out by the RHC independently of any other person.
- Generally applicable taxation rules apply in its country of residence.
- Income derived in the other Contracting State is attributable to the active business activities carried on by MCG members in that state.
Article 16(2)(h)(i) – Supervision and Administration
Article 16(2)(h)(i) requires that to be a RHC, the company must provide in its state of residence a substantial portion of the overall supervision and administration of the MCG.
Article 16(2)(h)(ii) – Active business
Article 16(2)(h)(ii) requires that the MCG supervised by the headquarters company must consist of corporations that are residents in, and engaged in active trades or businesses in, at least five countries. In addition the business activities carried on in each of the five countries (or groupings of countries) must generate at least 10% of the gross income of the MCG
Article 16(2)(h)(iii) – Single country income limitation
Article 16(2)(h)(iii) requires that the business activities carried on in any one country other than the headquarters company’s state of residence must generate less than 50% of the gross income of the MCG. If the gross income requirement under this clause is not met for a taxable year, the taxpayer may satisfy this requirement by averaging the ratios for the four years preceding the taxable year.
Article 16(2)(h)(iv) – Gross income limitation
Article 16(2)(h)(iv) requires that no more than 25% of the headquarters company’s gross income may be derived from the other Contracting State.
Article 16(2)(h)(v) – Independent supervision of MCG
Article 16(2)(h)(v) requires that the headquarters company have and exercise independent discretionary authority to carry out the supervision and administration functions for the MCG.
Article 16(2)(h)(vi) – Taxation rules
Article 16(2)(h)(vi) requires that the headquarters company be subject to the generally applicable income taxation rules in its country of residence.
Article 16(2)(h)(vii) – Income derived from the other Contracting State
Article 16(2)(h)(vii) requires that the income derived in the other Contracting State be derived in connection with or be incidental to the active business activities referred to in Article 16(2)(h)(ii).
Article 16(3) states that a resident of a Contracting State that is not a qualified person under Article 16(2) is a qualified person for certain items of income that are connected to an active trade or business conducted in the other Contracting State.
In broad terms, the benefits of the DTA will be available if the person resident in the US or Australia:
- Is engaged in the active conduct of a trade or business in their state of residence;
- The income derived in the other Contracting State is derived in connection with or incidental to the trade or business conducted in their state of residence; and
- The trade or business activity in the person’s state of residence is substantial in relation to the activity in the state of source of an item of income.
Article 16(3)(a) firstly requires that a resident of the US or Australia must be engaged in the active conduct of a trade or business in their state of residence. However, a business of making or managing investments for the resident’s own personal account is not regarded as an active trade or business unless these activities are banking, insurance or securities activities carried on by a bank, insurance company or a registered, licensed or authorised securities dealer.
Secondly, the income derived in the other Contracting State must be derived in connection with or incidental to the trade or business conducted in the state of residence.
Article 16(3)(b) states that where a person or an associate carries on a trade or business in the other Contracting State which gives to an item of income the trade or business carried on in the state of residence must be substantial in relation to the activity in the state of source of the income.
The substantiality requirement is intended to prevent a narrow case of treaty shopping abuses in which a company attempts to qualify for benefits by engaging in de minimis connected business activities in the treaty country in which it is resident.
The substantiality requirement only applies to income from related parties.
Article 16(3)(c) states that where a person is engaged in the active conduct of a trade of business then the following will be deemed to be part of that activity:
- Partnership activities provided the person is a partner, and
- Activities of connected persons.
There are three circumstances in which a person will be connected to another person are, firstly, if either person possesses at least 50% of the:
- Beneficial interest of the other;
- Aggregate vote and value of a company’s shares; or
- Beneficial equity interests of the company.
Secondly, if another person possesses directly or indirectly, at least 50% of the:
- Beneficial interest;
- Aggregate vote and value of a company’s shares; or
- Beneficial equity interest in the company in each person.
Thirdly, a person is connected to another person if the relevant facts and circumstances indicate that:
- One has control of the other; or
- Both are under the control of the same person or persons.
The above rule is of particular importance to holding companies since they will generally not be able to satisfy Article 16(3)(a) due to the fact that they are managing investments for their own account.
Article 16(4) is an anti-avoidance provision and denies the benefits of the DTA where a company has issued shares that entitle the holders to a portion of the income from the other state that is larger than the portion of such income that holders would otherwise receive.
Article 16(5) states that the competent authorities of the US and Australia can grant the benefits of the DTA to a resident of the relevant Contracting State if they are not a qualified person in accordance with Article 16(2). However, to exercise this discretion the IRS or ATO has to determine that the establishment, acquisition or maintenance of such a person and the conduct of its operations did not have the principal purpose of obtaining the benefits of the DTA.
Article 16(6) defines the term “recognized stock exchange” as:
- The NASDAQ System owned by the National Association of Securities Dealers and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Exchange Act of 1934
- The Australian Stock Exchange and any other Australian stock exchange recognized as such under Australian law, and
- Any other stock exchange agreed upon by the competent authorities of the Contracting States.
Article 16(7) lastly states that nothing in Article 16 restricts, in any manner, the ability of the Contracting States to enact and enforce the anti-avoidance provisions in their domestic tax laws.
CONCLUSION
The Limitation on benefits clause is drafted with the intention of avoiding treaty shopping.
When planning an international structure it is therefore crucial to ensure compliance with Article 16. Failure to plan properly could result in a loss of valuable benefits and can render the structure ineffective.
To achieve optimal results, immediate business concerns of the client should be carefully balanced with the long-term goals to ensure the establishment of activities in the most favorable environment.
Our team of International Tax specialists at Asena Advisors, will be able to assist you with your international tax planning and ensure that Article 16 is adhered to.