U.S. Approves Long-Awaited Tax Treaties with 4 Ally Countries by James W. Spencer, CPA
Posted on September 27, 2019 by
In the summer of 2019, the U.S. ratified updates to international tax treaties with four of the country’s allies that had been awaiting Senate approval for nearly a decade. The move yielded a collective sigh of relief from multinational businesses and their shareholders in Spain, Switzerland, Japan and Luxembourg that had been operating in an uncertain tax environment marked by competing rules and excessive tax burdens.
In response to this welcome development, multinational businesses, investors and shareholders should take the time to assess how these treaties impact their existing operations, including corporate structure, allocation of revenue and payments of dividends, and make changes, as necessary, to take advantage of treaty benefits.
The Importance of Tax Treaties
Tax treaties bridge the complex and often competing tax laws between two or more countries by defining which jurisdiction has the authority to impose tax on different categories of income, earnings and capital and at what rate. They help to protect the tax base of the participating country where income is earned without subjecting individuals and business taxpayers to double taxation on the same sources of revenue in their home country.
For example, in the absence of a treaty, an American corporation will pay a flat 21 percent tax on income it earns in the U.S. (the source country), while interest and dividends it pays to shareholders in a foreign country (the destination or residence country) will generally be subject to a 30 percent withholding tax. However, when a bilateral treaty exists, both countries may agree to a preferential withholding tax rate on dividends going to taxpayers or related companies in the other country, or they may exempt certain items of income from foreign taxes regardless of whether or not recipients are tax residents/citizens of that country. Similarly, dividends paid by a foreign entity to a U.S. taxpayer are eligible for more favorable tax treatment when the foreign entity operates in a country that has a tax treaty with the U.S. In the absence of a treaty, U.S. tax residents are subject to taxation on dividends received from a foreign source at the highest ordinary income tax rate of 37 percent.
In general, the more tax treaties a country has, the more likely they are to attract foreign investment. In this sense, treaties help to foster cross-border trade and investment while providing taxpayers with the transparency and certainty they need to more effectively plan for future growth and expansion.
What’s in the Updated Treaties?
A key provision contained in all of the recently ratified U.S. income tax treaties aims to improve the exchange of information between the IRS and the taxing authorities in the treaty countries. More specifically, the new protocol strengthens and broadens the exchange of information between the U.S. and its treaty partners to cover all “relevant” data requests, even those that are not necessarily tax-related. This information sharing provision has been the main reason why ratification has not occurred sooner, as Kentucky Senator Rand Paul has long argued that this requirement could infringe on U.S. taxpayers’ privacy rights.
Another important issue covered by the U.S.’s ratified treaties with Spain, Switzerland, Japan and Luxembourg is the establishment of mandatory and binding arbitration to resolve cross-border disputes between taxpayers and treaty partners more quickly and efficiently.
Among the key changes included in the U.S.’s newly ratified treaty with Spain is an elimination of a previous 10 percent withholding tax on cross-border payments of interest and royalties paid by U.S. or Spanish taxpayers to beneficial owners in the other country. In addition, dividend distributions may avoid withholding tax when shareholders have held at least 80 percent of the entity’s voting rights during the prior 12 months. The withholding rate is reduced from 15 percent to 5 percent when beneficial owners hold at least 10 percent of the dividend company’s voting rights and 15 percent for all other circumstances, including qualified dividends from real estate investments.
While the protocol retains capital gains tax treatment to sales/transfers of shares in a company holding real estate property or timeshare rights, it eliminates capital gains treatment to most all other transfers/sales in which a non-resident shareholder who incurs the gain actively participated, either directly or indirectly, in at least 25 percent of the entity’s capital.
The revised U.S. tax treaty with Switzerland introduces a withholding tax exemption for dividends paid to qualifying individual retirement accounts (IRAs) and similar arrangements, including Swiss Pillar 3a, depending on the relationship between the payor and the payee. In addition, the protocol mandates arbitration when taxing authorities cannot resolve a taxpayer matter after two years, and it expands exchanges of information that is relevant to tax law enforcement to include group requests under the Foreign Account Tax Compliance Act (FATCA). Under this provision, which aims to eradicate tax evasion, the IRS may request the Swiss Federal Tax Commission provide all information about non-consenting US accounts and foreign reportable amounts paid to Nonparticipating Financial Institutions (NPFFIs).
All cross-border payments of interest between taxpayers in the U.S. and Japan are exempt from withholding tax, while dividends may escape withholding tax when they are paid to a beneficial owner who holds 50 percent or more of the company’s voting stock. Additionally, the U.S. treaty with Japan changes the treatment of capital gains from the sale of real property in the same way as the treaty with Spain.
Taxpayers should recognize that the effective date of the information-sharing provision of the U.S./Luxembourg treaty is retroactive to Jan. 1, 2009. This means that a taxing authority in either country can obtain data, including bank information, from as far back as tax years beginning on or after January 1, 2009.
The U.S. currently has more than 60 income tax treaties with countries around the world, providing taxpayers in those jurisdictions with a level playing field for meeting their respective tax obligations without the risk of double taxation.
Next up on the Senate’s agenda are first-time treaties with Chile, Hungary and Poland that are expected to be finalized before the end of 2019. Under many of these treaties, taxpayers may qualify for reduced tax rates or a complete exemption from tax on certain sources of income. Understanding how to benefit from these tax treaties and maintain tax efficiency across borders require the expertise of professional accountants with deep experience in international tax laws.
About the Author: James W. Spencer, CPA, is a director of International Tax Services with Berkowitz Pollack Brant, where he focuses on a wide range of pre-immigration, IC-DISC, transfer pricing and international tax consulting issues for individuals and businesses. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.