There is a lot a talk in the tax world about how complexity in the tax code (i) decreases levels of voluntary compliance, (ii) increases costs of compliance for taxpayers, (iii) reduces perceptions of fairness, and (iv) increases difficulties in the administration of tax laws.
U.S. income tax treaties can be complex and challenging documents to read and understand. The reader must first get used to the terminology, such as “the Contracting States,” “the first-mentioned Contracting State,” “the other Contracting State,” etc.
The reader must also understand that U.S. income tax treaties include an overarching exception, called a “saving clause,” which provides that the treaty does not limit the U.S. taxation of U.S. citizens or U.S. residents. See, e.g., Article 1, paragraph 4 of the U.S. Model Income Tax Treaty. Of course, there are exceptions to this exception.
The benefits of income tax treaties are generally only available to residents of the two countries that have entered into the treaty. Further, to prevent treaty shopping, U.S. income tax treaties include a limitation on benefits article, which further limits the benefits of the treaty.
Limitation On Benefits
Under the limitation on benefits article of U.S. income tax treaties, the benefits of the treaty are available only if the resident meets additional requirements. Often, the treaty provides that the benefits of the treaty are available only if the resident is a “qualified person” (typically individuals, the governments of the two countries, certain publicly traded companies and their subsidiaries, pension funds, tax exempt organizations, and others meeting an ownership / base erosion test).
Further, even if the resident is not a qualified person as defined in the treaty, if the resident meets an active trade or business test, then it may qualify for benefits on certain items of income. Lastly, if the tax authority of the country that would otherwise impose the tax determines that treaty benefits should be allowed, then the benefits of the treaty would apply.
The above tests are the “standard” limitation on benefits tests. The tax laws of each country differ, and therefore some U.S. income tax treaties include additional tests.
In a situation called a “triangular case,” a resident of a treaty country has a permanent establishment in a third country and the profits of that permanent establishment are subject to a tax rate in the third country that is substantially below the tax rate that would have applied if the profits had been taxed in the resident’s own country. In this situation, the benefits of the treaty generally do not apply with respect to the profits earned by the permanent establishment in the third country.
Some treaties provide that the benefits of the treaty apply if a “derivative benefits” test is met. Other treaties provide that the benefits of the treaty apply if a “headquarters company” test is met.
The proposed income tax treaty between the United States and Hungary (the “Proposed Hungary Treaty”) was signed on February 4, 2010, and is accompanied by official understandings implemented by an exchange of diplomatic notes carried out on that same day. The Senate Committee on Foreign Relations held a public hearing on the Proposed Hungary Treaty on June 7, 2011.
The limitation on benefits article of the Proposed Hungary Treaty includes all of the standard limitation on benefits tests, as well as the triangular cases limitation and the derivative benefits and headquarters tests. The Joint Committee on Taxation’s written summary of this one article in the treaty spans a full 12 pages of single-spaced text.
One might wonder whether including all of these rules in the Proposed Hungary Treaty creates more costs as a result of complexity than it benefits by avoiding treaty shopping.