Fiscally Transparent Entities and Treaty Benefits

Fiscally transparent entities, such as partnerships and certain estates and trusts, present special issues in the international tax context. Generally, a fiscally transparent entity is not entitled to claim the benefits of a tax treaty directly. Rather, the tax items at issue are treated as being derived by the owners of the fiscally transparent entity. As a result, the residence of the owners, rather than the entity, governs the availability of treaty benefits.

Because countries may take different views as to when an entity is fiscally transparent, the risk of both double taxation and double non-taxation is relatively high in this context. U.S. tax treaty policy and the corresponding requirements of the substantive rules of its treaties are generally intended to be read with certain relevant goals in mind. One relevant goal/rule is that tax treaties are generally intended to prevent a resident of a Treaty Country from claiming treaty benefits in circumstances where the resident investing in the entity does not take into account the item of income paid to the entity because the entity is not fiscally transparent in its State of residence. Thus, an item of income, profit or gain derived by or through such a fiscally transparent entity will be considered to be derived by a resident of a Treaty Country if a resident is treated under the taxation laws of that State as deriving the item of income.

This principle reflects rules and policies that are generally reflected within the regulations under Treas. Reg. section 1.894-1(d). Treas. Reg. 1.894-1(d)(3)(iii), for example, provides that an entity will be fiscally transparent under the laws of an interest holder’s jurisdiction with respect to an item of income to the extent that the laws of that jurisdiction require the interest holder resident in that jurisdiction to separately take into account on a current basis the interest holder’s respective share of the item of income paid to the entity, whether or not distributed to the interest holder, and the character and source of the item in the hands of the interest holder are determined as if such item were realized directly by the interest holder. As alluded to above, entities falling under this description in the United States include partnerships, corporations that have made a valid election to be taxed under Subchapter S of Chapter 1 of the Code (“S corporations”), common investment trusts under section 584, simple trusts and grantor trusts, as well as other entities, such as U.S. limited liability companies that may be treated as either partnerships or as disregarded as a separate entity for U.S. tax purposes.

What are Fiscally Transparent Entities?

For United States tax purposes, fiscally transparent entities may include partnerships, common investment trusts under section 584, and grantor trusts. U.S. limited liability companies (“LLC”s) that are treated as partnerships for U.S. tax purposes may also fall under the definition of a fiscally transparent entity.

How are Fiscally Transparent Entities Treated?

Generally, under U.S. tax treaties, an item of income derived by a fiscally transparent entity will be considered to be derived by a resident of a Contracting State if the resident is treated under the taxation laws of the Country where he is resident as deriving the item of income. For example, if a corporation resident in Country A distributes a dividend to an entity that is treated as fiscally transparent for U.S. tax purposes, the dividend will be considered derived by a resident of the United States only to the extent that the taxation laws of the United States treat one or more U.S. residents (whose status as U.S. residents is determined, for this purpose, under U.S. tax laws) as deriving the dividend income for U.S. tax purposes.

In the case of a partnership, the persons who are, under U.S. tax laws, treated as partners of the entity would normally be the persons whom the U.S. tax laws would treat as deriving the dividend income through the partnership. Thus, it also follows that persons whom the U.S. treats as partners but who are not U.S. residents for U.S. tax purposes may not claim a benefit for the dividend paid to the entity under a tax treaty generally. Although these partners are treated as deriving the income for U.S. tax purposes, they are not residents of the United States for purposes of the treaty. If, however, they are treated as residents of a third country under the provisions of an income tax convention which that country has with Country A (in the example above), they may be entitled to claim a benefit under that convention. In contrast, if an entity is organized under U.S. laws and is classified as a corporation for U.S. tax purposes, dividends paid by a corporation resident in Country A to the U.S. entity will be considered derived by a resident of the United States since the U.S. corporation is treated under U.S. taxation laws as a resident of the United States and as deriving the income.

These results would obtain even if the entity were viewed differently under the tax laws of Country A (e.g., as not fiscally transparent in the example above). These results also follow regardless of where the entity is organized (i.e., in the United States, Country A, or in a third country). For example, income from sources in Country A received by an entity organized under the laws of Country A, which is treated for U.S. tax purposes as a corporation and is owned by a U.S. shareholder who is a U.S. resident for U.S. tax purposes, is not considered derived by the shareholder of that corporation even if, under the tax laws of Country A, the entity is treated as fiscally transparent.
Rather, for purposes of the treaty, the income is treated as derived by an entity resident in Country A. These results also follow regardless of whether the entity is disregarded as a separate entity under the laws of one jurisdiction but not the other, such as a single owner entity that is viewed as a branch for U.S. tax purposes and as a corporation for tax purposes of Country A.

The taxation laws of a Treaty Country may treat an item of income, profit or gain as income, profit or gain of a resident of that Country even if, under the taxation laws of that Country, the resident is not subject to tax on that particular item of income, profit or gain. For example, if a Treaty Country has a participation exemption for certain foreign-source dividends and capital gains, such income or gains would be regarded as income or gain of a resident of that Country who otherwise derived the income or gain, despite the fact that the resident could be exempt from tax in that Country on the income or gain.

Where income is derived through an entity organized in a third state that has owners resident in one of the Treaty Country, the characterization of the entity in that third state is irrelevant for purposes of determining whether the resident is entitled to treaty benefits with respect to income derived by the entity.

Trusts

These principles also apply to trusts to the extent that they are fiscally transparent in either Treaty Country. For example, if X, a resident of Country A, creates a revocable trust and names persons resident in a third country as the beneficiaries of the trust, X would be treated as the beneficial owner of income derived from the United States under the Code’s rules. If Country A has no rules comparable to those in sections 671 through 679 then it is possible that under Country A’s law neither X nor the trust would be taxed on the income derived from the United States. In these cases, U.S. tax treaties may provide that the trust’s income would be regarded as being derived by a resident of Country A only to the extent that the laws of Country A treat residents of Country A as deriving the income for tax purposes.

These principles thus apply to trusts to the extent that they are fiscally transparent in either Contracting State. For example, suppose that X, a resident of Country A, creates a revocable trust in the United States and names persons resident in a third country as the beneficiaries of the trust. If, under the laws of Country A, X is treated as taking the trust’s income into account for tax purposes, the trust’s income would be regarded as being derived by a resident of Country A. In contrast, since the determination of deriving an item of income, profit or gain is made on an item by item basis, it is possible that, in the case of a U.S. non-grantor trust, the trust itself may be able to claim benefits with respect to certain items of income, such as capital gains, so long as it is a resident liable to tax on such gains, but not with respect to other items of income that are treated as income of the trust’s interest holders.

Fiscally Transparent Entities And Withholding

For purposes of claiming treaty benefits, if an entity is fiscally transparent for U.S. tax purposes and the entity is or is treated as a resident of a treaty country, it will derive the item of income and may be eligible for treaty benefits.

In such case, the entity is the payee for Chapter 3 purposes. The entity does not need to be taxed on such item, but the item must be accounted for as the entity’s income, not the interest holders’ income, under the law of the treaty country whose treaty it is invoking. It also must meet any other requirements for claiming benefits, including a limitation on benefits article, if any, in the treaty.

Such an entity should provide a Form W-8BEN-E in such circumstances. If, for Chapter 3 purposes, the payee is a foreign corporation or other non-flow-through entity for U.S. tax purposes, it is nonetheless not entitled to claim treaty benefits if the entity is fiscally transparent in its country of residence (that is, foreign reverse hybrid). Instead, any interest holder resident in that country will derive its allocable share of the items of income paid to the foreign reverse hybrid and may be eligible for benefits.

If an interest holder is a resident of a third country, the interest holder may claim treaty benefits under its treaty with the United States, if any, only if the foreign reverse hybrid is fiscally transparent under the laws of the third country. If an interest holder is entitled to treaty benefits under its country of residence, the payee may provide a Form W-8IMY and attach Form W-8BEN or W-8BEN-E from any interest holder that claims treaty benefits on such income.

The determination of whether an entity is fiscally transparent is made on an item of income basis (that is, the determination is made separately for interest, dividends, royalties, etc.). An interest holder in an entity makes the determination by applying the laws of the jurisdiction where the interest holder is organized, incorporated, or otherwise considered a resident.

An entity is considered to be fiscally transparent with respect to the income to the extent the laws of that jurisdiction require the interest holder to separately take into account on a current basis the interest holder’s share of the income, whether or not distributed to the interest holder, and the character and source of the income to the interest holder are determined as if the income was realized directly from the source that paid it to the entity. Subject to the standard of knowledge rules, a U.S. taxpayer may generally make the determination that an entity is fiscally transparent based on a Form W-8IMY provided by the entity.

For Chapter 3 purposes, the payees of a payment made to a fiscally transparent entity are the interest holders of the entity if the interest holders are claiming treaty benefits with respect to the payment.

For Chapter 4 purposes, if a U.S. taxpayer is making a withholdable payment to a fiscally transparent entity, the taxpayer must apply the rules of Chapter 4 to determine the payee and whether Chapter 4 withholding applies to the payment based on the payee’s Chapter 4 status. Thus, Chapter 4 withholding may apply to a withholdable payment made to a fiscally transparent entity based on the Chapter 4 status of the entity even when the interest holders in the entity would be eligible for reduced withholding under an income tax treaty with respect to the payment. Treaty benefits may be granted to the interest holder when the payment made is not subject to Chapter 4 withholding based on the Chapter 4 status of both the entity and the interest holder.