Tag: ownership

Multi-Member LLC

Posted on by Peter Harper

Multi-Member LLC

In our previous articles, we have discussed the single-member LLC and the advantages and disadvantages of owning and operating such an entity, not to mention its default tax treatment. Today, we will be discussing what it means to form and control a multi-member LLC (MMLLC), which is simply a limited liability company with more than one member. 

Understanding Multi-Member LLCs?

While there are similarities between a single-member LLC (SMLLC) and an MMLLC, there are also many differences. But before we elaborate on the details and differences between the two, it may be beneficial to talk more about the history of this entity type. 

History of Multi-Member LLC

Even though the first state to authorize the creation of the LLC was Wyoming in 1977, it was in 1996 that all 50 states in the U.S. had LLC statutes. Through Revenue Ruling 88-76, the IRS decided in 1988 that Wyoming LLCs were taxable as partnerships. And even today, this is the default tax treatment of an LLC with more than one member – a partnership. 

What is a Multi-Member LLC?

This type of LLC has two or more owners ( or members) that share control of the company. Unless electing S Corporation tax treatment, there can be an unlimited quantity of members within a multi member LLC. The LLC may also decide on how (and what percentage of) profits and losses shall be distributed among its members, customarily done through its operating agreement.

Who Can Form a Multi-Member LLC?

Members can be either individuals, corporations, or even other LLCs. 

How Multi-Member LLCs Work

Now that we have discussed a bit about the history of this entity type and what it is, it is time to explain how such entities work. 

Ownership

This LLC is comprised of two or more owners ( or members) that share control over the company. The LLC is its own legal entity that is separate from its owners. Unless it decides to elect for S Corporation tax treatment, there could be an unlimited number of members within an MMLLC. The LLC may decide on how (and what percentage of) profits and losses shall be distributed among its members.

Personal Asset Protection

An MMLLC offers asset protection for the owners’ personal assets because it is a separate legal structure. Indeed, the biggest reason why many people form an MMLLC is the limited liability that it offers its owners. Specifically, the owners’ personal assets cannot be appropriated to pay the debts of the LLC. Owners may, however, be held personally responsible within certain situations (such as when they “pierce the corporate veil”), and in this scenario, they would potentially incur personal liability. 

Profit Distribution to Owners

MMLLC owners are entitled to a distributive share of the profits in the entity, and typically, these profits are in proportion to the percentage interest each owner has in the company. Using this example, if one member owns 70 percent of a multi-member LLC and another member owns 30 percent, then the first person will be entitled to 70 percent of the company’s profits, and the second person will be entitled to 30 percent of the company’s profits. Since the LLC is a flexible entity structure, you can divide profits and losses by way of a particular allocation using something other than the percentage of membership interest. In this scenario, each member might be entitled to a percentage of profits that is different from their percentage of ownership in the business. However, again, this should be clearly stated. While an LLC is not required to distribute profits to its owners, the entity’s owners will still be on the hook for reporting their share of the LLC profits and then paying tax on these profits. 

Income Tax Treatment

The default tax treatment of an MMLLC is similar to that of an SMLLC in that it is a pass-through entity, with the profits being allocated to the owners and thus flowing through to their personal tax returns. How it is different is that instead of the income, expenses, and profits being reported on a Schedule C (as for an SMLLC), the income, expenses, and profits are reported on Form 1065 (partnership tax return), and each member of the LLC receives a Schedule K-1 (and must then report this information on their personal return) reporting their share of the LLC’s profit or loss. 

Federal Income Taxes and the Multi-Member LLC

A multi-member LLC’s default federal tax treatment is that of a partnership. And, just like a single-member LLC, an MMLLC does not pay taxes on its business profits. Instead, the owners (members) individually pay tax, which is based on their share of the profits, on their personal returns. As stated in the previous section, an MMLLC is required to file a Form 1065 (partnership return), and each member receives a K-1, on which they will see their profits or losses associated with the partnership. Finally, each member must then report the profits on Schedule E of their personal return Form 1040. In terms of taxes payable, members will need to pay not only federal taxes but also (Social Security and Medicare) on their share of the LLC’s earnings.

You may then decide that you like that an MMLLC is a pass-through entity but that you hate paying so much self-employment tax. In this scenario, the owners could file Form 2553 for the MMLLC to be taxed as an S Corporation, whereby the profits and losses are still passed through to members’ individual returns (filed via Schedule E of Form 1040). However, the difference here is that the owners must only pay a self-employment tax on their wages and salaries, not on their profit distributions. Typically, the owners would pay themselves a salary, and then whatever profit was left over would flow through to their personal returns. 

However, an MMLLC’s owners may decide to have the entity not be treated as a partnership. In this scenario, members can elect to have their business taxed as a C-Corp, so the entity will no longer be a pass-through entity. It will pay corporate tax on its profits (presently, the federal corporate tax rate is 21%). To do this, owners must file Form 8832 to change the default tax treatment of the entity. 

State Income Taxes and the Multi-Member LLC

This is where things can vary quite a bit. At the state level, tax laws can vary for LLCs. For instance, some states levy fees on LLCs, such as a minimum or franchise tax. Contrary to its name, a franchise tax is not assessed against a business operating as a franchise. A franchise tax is charged to LLCs, corporations, and partnerships into the form of a fee for the concession to form and conduct business in that state. 

Who Manages a Multi-Member LLC?

What is excellent about this entity structure is its flexibility. Members of an MMLLC get to decide how it is structured and who manages the entity. Some MMLLCs elect one or more members, or even a third party, to manage the business. This type of MMLLC is called a manager-managed MMLLC. On the other hand, if the LLC members are running the entity equally, the entity is called a member-managed MMLLC. 

Involvement

If two or more individuals are managing the company, then you should be able to demonstrate that each manager is involved with the company’s business decisions and operations. 

Formation

Multi-member LLC members can be individuals (whether they are Americans or not, and whether they live in the U.S. or not), corporations, or other LLCs. It is important to note that LLCs have organized on a state level, not the federal level.  

Compliance

MMLLCs are required to file Form 1065 (unless they elected to be taxed as an S Corporation, which requires a Form 1120-S filing, or a C Corporation, which requires a Form 1120 filing) as well as potentially a state return. 

Bankruptcy

When an individual declares bankruptcy, the court possesses the power to seize a large quantity of assets, including those related to the LLC. However, if the LLC is multi-member, the court cannot seize company assets without the unanimous agreement of other LLC members, as this would result in the court taking one person’s assets because of another’s misconduct.

Divorce

There are scenarios in which spouses own a multi-member LLC. Thus, couples often meet in court to divide their assets when a divorce occurs. It is good practice to stipulate how much of the company each member owns (or spouse, in this case). In this scenario, the court may rule that each spouse will retain the share stated in the operating agreement.

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Management Options

Again, one of the best things about an LLC is its flexibility. Thus, with an MMLLC, you can decide how the business is managed.

Member-Managed LLC vs. Manager-Managed LLC

As described previously, in a member-managed LLC, the members participate in running the business. As such, when making big decisions, such as entering into contracts or purchasing expensive equipment, the majority approval of all its members is necessary.  

In a manager-managed LLC, on the other hand, the members are able to agree on electing a manager, either one particular LLC member or members, or even a third party, to whom they grant authority to manage the business’ day-to-day decisions and operations. 

Basic Steps to Form a Multi Member LLC

While every entity is different, and you may take slightly different steps in forming an entity, the below are best practices and should be followed at a minimum. 

Choose a Business Name.

The new LLC name needs to be distinguishable from all other registered entities for tax purposes. You can start searching on the Secretary of State’s business search tool.

Apply for an EIN (Employer Identification Number).

As LLCs are pass-through entities, an application for a new EIN number needs to be obtained if the LLC will be multi-member or if the election is made by its members to be taxed as a corporation.

File Your LLC’s Articles of Organization.

While it may differ from state to state, this document needs to meet articles of organization, such as detailing the name and address of the LLC, the contact details and names of the owners, the application date, and a description of the new business.

Create an Operating Agreement.

This internal document needs to be drafted by members and will set out the rules for ownership and management of the newly formed LLC. It will detail what will happen if additional members are introduced to the LLC, if the LLC will be liquidated, or if members leave the LLC.

Apply for the Necessary Business Licenses and Permits.

Suppose the nature of the business requires the LLC to obtain business licenses or permits to operate. In that case, the relevant agencies need to be contacted to ensure that the licenses or permits are transferred from the sole proprietor to the newly formed LLC.

Open a Separate Bank Account for Your Business.

A bank account for any new business needs to be opened in the name of your LLC to ensure a clear separation between the LLC funds and the members’ personal funds. This also eases the management of assets and allows for more accurate recordkeeping.

Ongoing Compliance Obligations

As with any business entity, owning a multi-member LLC means that there are certain obligations that its members must adhere to. Some of those include renewing any licenses or permits (if required), paying state franchise fees, filing entity tax returns, updating the state the LLC is organized in if there are significant changes, filing an annual report, and so forth.

What are the Benefits of a Multi-Member LLC?

There are numerous benefits to owning an MMLLC. One is limited liability, as an LLC is considered a separate entity from its members. Subsequently, members are not personally liable for the business’s debts and other legal liabilities (i.e., they have limited liability protection). Further, members of LLCs include the business profits in their individual returns because the LLC is classified as a pass-through entity. Additionally, members may be able to apply the 20% pass-through deduction to business profits.

What are the Drawbacks of a Multi-Member LLC?

At the same time, there can be a few drawbacks to having such an entity. Members of LLCs receive units in proportion to their contribution/LLC agreement, and these units are more challenging to transfer than stocks in a corporation. This difficulty in transferring ownership is one of the reasons that external investors/venture capitalists prefer investing in corporations over LLCs.

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Why Should I Have a Multi-Member Operating Agreement?

It could be argued that any entity should have one. Still, it becomes crucial for a multi-member LLC to have an LLC operating agreement, if for no other reason than to avoid ambiguity in the ownership and management structure, profit distribution, and even what happens when/if the company is liquidated or its members leave. 

What Should a Multi-Member Operating Agreement Include?

Certain sections are crucial to include. Those include the following:

Article I: Company Formation

This section deals with the formation of the company itself, and it should include information on the list of members and the company’s ownership structure. In addition, it should outline whether the members have equal or different amounts of ownership.

Article II: Capital Contributions

This section covers each member’s initial capital contribution in starting the LLC, whether the contribution is in cash or other assets that are contributed to the business. The total value of the contributions should be clearly listed. 

Article III: Profits, Losses, and Distributions

This section describes how profits and losses are allocated (whether they are ownership percentages or some special allocation) and whether the profit distributions are on an annual basis or more often. 

Article IV: Management

This section addresses managing the company (whether the firm is member-managed or manager-managed) and how each member will vote, with a transparent system of appointing managers and how individual members will be assigned other specific duties. 

Article V: Compensation

This section discusses the topic of compensation. For instance, if the LLC is to be taxed as a corporation, any members can receive a salary for the labor they have performed in the business, along with profit distributions. If the LLC is to be taxed as a partnership, members receive distributions on the basis of their ownership interest in the company.

Article VI: Bookkeeping

The agreement should be clear on whether and which LLC member/members can check the LLC’s books and records, such as financial documents and board meeting minutes.

Article VII: Transfers

This section discusses removing or adding new members to the LLC. Additionally, it states if and when members of the LLC can transfer their ownership in the company. Finally, this section should also clearly specify what happens in the event of death, bankruptcy, or divorce. It cannot be expressed enough on the importance of accounting for these types of scenarios, as, despite everyone’s best efforts, business and life are unpredictable, and in order to protect each member’s share and business interests, these situations and how to handle them should be stated in this document. 

Article VIII: Bank Account

This is something that gets overlooked often but is quite apparent. As stated previously, this is essential for any new business to ensure a clear separation between the LLC funds and the members’ personal funds. Additionally, this eases the management of assets and allows for more accurate recordkeeping.

Article IX: Dissolution

This section explains the circumstances if the LLC may be dissolved, and if so, the process of terminating the LLC should all the members vote to end it. 

How are Multi-Member LLCs and Their Owners Taxed?

What is the tax status for an MMLLC? A domestic LLC possessing at least two members is usually classified as a partnership for federal tax reasons unless it decides to file Form 8832 to be elected for treatment as a corporation. Each partner must pay taxes separately on the grounds of their operating agreement. Most agreements favor having the taxes corresponding to the membership interest. This means that each LLC member is required to pay taxes on their share of the LLC’s profits whether or not they receive their share of those profits. Unlike a corporation, even if a member or members have the need to leave profits in their LLC for any tax purposes, they can be liable for any income tax for their proportionate share of the LLC’s income. However, as discussed previously, the LLC that is classified as a partnership will be required to file Form 1065, U.S. Return of Partnership Income, with the IRS, as well as provide their members with a K-1 (a breakdown of each member’s profits and losses), and can be subjected to the same filing and reporting requirements as partnerships. Each state could use different tax regulations for an LLC, and the income derived by the LLC and be attributed towards a member or members can be taxed at the state level if it is sourced or derived from that state.

How Do I Pay Myself from a Multi-Member LLC?

You do not get paid a salary as the member/owner of an MMLLC. Instead, you pay yourself by withdrawing the profits made by the LLC as and when needed. This is also referred to as an owner’s draw.  

Single-Member vs. Multi-Member LLC

There are numerous differences between an SMLLC and an MMLLC. Some of those differences are discussed below.

LLC taxes

The default tax treatment of an SMLLC is that the owner must report the business’s profits and losses onto a Schedule C of IRS Form 1040 as personal income, and the small business itself does not report or pay taxes independently (nor does it file its own tax return). The LLC owner must also make payments onto self-employment taxes (Social Security and Medicare) on any and all taxable income coming from the business. 

An MMLLC, on the other hand, is required to file a return (Form 1065) and provide its members a Schedule K-1 form, which contains information the members will need to file their personal returns. Like with an SMLLC, business owners are subject to federal income tax, FICA taxes, and possibly even state income tax. 

Liability protections

Both SMLLCs and MMLLCs have liability protection by default. 

Multi-Member LLC vs. Partnership

Even though the default tax treatment for an MMLLC is for it to be taxed as a partnership, there remain differences between an MMLLC versus other entities that may also have more than one member.

Multi-Member LLC vs. LLP

While individuals can own MMLLCs, corporations, and other LLCs, a limited liability partnership (LLP) can only be owned by individuals. Further, in many states, an LLP can only be formed by certain professions, such as doctors and attorneys. On the other hand, multi-member LLCs can be created by and for nearly any profession. Finally, an LLP cannot change its tax classification, whereas MMLLCs can elect to be taxed as a partnership or corporation. 

Multi-Member LLC vs. LP

In a limited partnership (LP), general partners have unlimited liability and are personally liable for the business, whereas limited partners receive liability protection. In an MMLLC, all members have liability protection. Further, in an LP, only general partners can manage the business, whereas, in an MMLLC, all members can manage the business. 

Is it Better to be a Multi-Member LLC?

Generally speaking, it is more advantageous to be structured as an MMLLC than as an LLP or LP, for the reasons stated in the previous section. However, your needs (or the requirements set forth by your state for your industry/profession) may require you to go with something other than an MMLLC.

Which One is Right for Your Business?

This is a difficult question to answer within the confines of an article. You will have to consider your business’s unique goals, business structure, industry, and profit margin, among other things, to determine which entity type is best. However, this article hopefully elucidates many advantages of a multi-member LLC. 

Multi-Member LLC FAQ

Here are some quick additional facts about MMLLCs you should consider:

Does a Multi-Member LLC Need an EIN?

Yes, it does. The entity will need an EIN to do things such as file an income tax return. 

Can a Multi-Member LLC become a Single-Member LLC?

Yes, it can. The only official condition is the sale of the membership interest surronding the leaving member(s) towards the remaining member, as well as the filing of a new tax election form. 

How Do You Dissolve a Multi-Member LLC?

There are numerous steps you must take in order to ensure that your LLC is properly dissolved. Most MMLLCs will have to perform actions such as:

    • voting by members to dissolve the LLC;
    • filing a final return;
    • filing an Articles of Dissolution with the state the entity is doing business in;
    • settling any outstanding debts; and
    • distributing assets to LLC owners/members. 
For more advice on starting your own multi-member LLC, reserve a consultation with one of our advisors in our Contact Us section to the right.

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Peter Harper

US-AU DTA: Article 16 – Limitation of Benefits

Posted on by Peter Harper


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:

  1. A qualified person (Article 16(2));
  2. Actively engaged in a trade or business (Article 16(3)); or
  3. 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.

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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:

  1. 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
  2. The Australian Stock Exchange and any other Australian stock exchange recognized as such under Australian law, and
  3. 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.

Our team of International Tax specialists at Asena Advisors, will be able to assist you with submitting the relevant forms in the US and Australia to get access to these relief measures.  

Shaun Eastman

Peter Harper