U.S. tax treaties are generally intended to confer benefits upon residents of the United States and its treaty-partner country. In keeping with this rationale, U.S. tax treaties generally contain a limitation-on-benefits (“LOB”) article that is intended to ensure that foreign entities only receive treaty benefits if they are sufficiently connected to one of the countries to the tax treaty. A treaty’s LOB article provides for several tests to ensure that a proper nexus exists to justify conferring treaty benefits.
Corporate residence is generally based upon the country of incorporation. This general rule gives rise to potential abuse where residents of non-treaty countries incorporate in a contracting state and seek to obtain treaty benefits through the incorporated entity. Such so-called “treaty shopping” concerns have given rise to the limitation-on-benefits clauses set out in U.S. tax treaties, which are one of the Treasury Department’s primary weapons to combat treaty shopping. Limitation-on-benefits provisions contain anti-treaty-shopping provisions that are intended to prevent residents of third countries from receiving benefits under a tax treaty.
Almost all U.S. tax treaties contain a LOB provision. The limitation-on-benefits provision sets forth a series of objective tests. The LOB article does not rely on a determination of purpose or intention but instead sets forth a series of objective tests. As such, under the U.S. approach, a resident of a Contracting State that satisfies one of the objective tests will receive benefits regardless of its motivations in choosing its particular business structure.[1]
At a high level, limitation-on-benefits provisions set out in U.S. tax treaties are generally consistent with Action 6 of the OECD/G20 anti-base erosion and profit shifting (BEPS) project, which generally requires that participating countries provide for anti-treaty-shopping provisions. The OECD requirements, however, also adopt a subjective test (the “principal purpose test”) and supplemental anti-conduit rules. The OECD’s rules are embodied in Article 7 of its Multilateral Instrument (MLI). While more than 90 countries are party to the MLI, the United States is not currently a signatory.
In addition to the limitation-on-benefits articles set forth in its tax treaties, the United States maintains other potential barriers to treaty benefits, including the anti-conduit regulations under section 7701(l); and hybrid entity rules under section 894(c), which apply to certain fiscally transparent entities; or the qualified residence rules under section 884, among others. Likewise, the “special tax regime” provisions set forth in the 2016 U.S. Model Income Tax Convention may impact the availability of treaty benefits where applicable.
[1] 2006 Technical Explanation to U.S. Model Income Tax Convention, art. 22.
