1. Holding Companies, ETVEs, theHolding Companies, ETVEs, the
United States’ LOB andUnited States’ LOB and
European Tax LawEuropean Tax Law
MadridMadrid May 30, 2012May 30, 2012
Yariv Brauner
University of Florida College of Law

2. IntroductionIntroduction
 Perception of tax treaties
 Treaty shopping
 Anti treaty shopping measures vs. domestic anti abuse
norms
 Dissatisfaction with available mechanisms
 United States breaks with the OECD orthodoxy and
introduces LOB
 LOB catches on, albeit in a non universal format

3. United States Tax Treaty PolicyUnited States Tax Treaty Policy
 Bilateral, separately negotiable, specific agreements
 Leader in OECD, yet does not shy from unilateral
action – including treaty override
 Strong culture of specific anti abuse (tax) policy
 Variety of treaty provisions that limit benefits
 Purpose clause
 Subject-to-tax, other residence restrictions, Transparent entities
 Beneficial ownership
 Anti-conduit, Anti dividend stripping
 Formal requirements

4. Aiken Industries v. Comm. (1971)Aiken Industries v. Comm. (1971)
Bahamas
Aiken (US) Ecuador
USCO Honduras
Loan

5. Aiken Industries (Cont.)Aiken Industries (Cont.)
Bahamas
Aiken (US) Ecuador
USCO Honduras
Back-to-back loans

6. Typical Netherlands Antilles SchemeTypical Netherlands Antilles Scheme
United States
• A 30% withholding tax would have been
imposed on interest paid by USCO to the
Netherlands Antilles, since no tax treaty
existed between the United States and the
Netherlands Antilles.
• A treaty existed, however, between the
United States and the Netherlands and
between the Netherlands Antilles
– The treaty provided for low, and eventually no
withholding tax on the payment of interest
• Dutch angle
• Trigger for portfolio interest exception

7. Other casesOther cases
 Bass case – oil and gas leases
 Intermediary was “managed as a viable concern
and not as simply a lifeless facade”
 SDI Netherlands
 Simple back-to-back royalties arrangement
 Complication of cascading royalties

8. Northern Indiana (1995)Northern Indiana (1995)
NIPSCO
Finance
(N.A.)
Eurobonds Market

9. Del Commercial Properties (1999)Del Commercial Properties (1999)
Delcom
(Ca.)
Cayman
N.A.
Dutch
Del
Commercial
(U.S.)
Bank Debt
Securities

10.  Chose not to reform the residence article
 Avoids interference/respect cries
 Rhetoric:
 A tax treaty is bilateral and not a treaty with the
whole world
 Allowing treaty benefits to others reduces U.S.
bargaining power in negotiating treaties with
new countries
United States Treaty Policy ShiftUnited States Treaty Policy Shift

11. Technical explanation to U.S. ModelTechnical explanation to U.S. Model
Income Tax Convention ¶282Income Tax Convention ¶282
 “A treaty that provides treaty benefits to any resident of a
Contracting State permits “treaty shopping”: the use, by residents
of third states, of legal entities established in a Contracting State
with a principal purpose to obtain the benefits of a tax treaty
between the United States and the other Contracting State. …
[T]his definition of treaty shopping does not encompass every
case in which a third state resident establishes an entity in a U.S.
treaty partner, and that entity enjoys treaty benefits to which the
third state resident would not itself be entitled. If the third country
resident had substantial reasons for establishing the structure that
were unrelated to obtaining treaty benefits, the structure would not
fall within the definition of treaty shopping set forth above.”

12. Technical explanation to U.S. ModelTechnical explanation to U.S. Model
Income Tax Convention ¶283Income Tax Convention ¶283
 “[T]he fundamental problem presented by this approach is that it is
based on the taxpayer’s intent, which a tax administration is
normally ill-equipped to identify. In order to avoid the necessity of
making this subjective determination, Article 22 sets forth a series
of objective tests. The assumption underlying each of these tests is
that a taxpayer that satisfies the requirements of any of the tests
probably has a real business purpose for the structure it has
adopted, or has a sufficiently strong nexus to the other Contracting
State (e.g., a resident individual) to warrant benefits even in the
absence of a business connection, and that this business purpose or
connection outweighs any purpose to obtain the benefits of the
Treaty”

13. Limitation on Benefits: Article 22Limitation on Benefits: Article 22
 Prevention of Treaty Shopping:
 Article 22 is included in the US model to prevent
situation where treaties were abused by non-
residents through “conduits” in the other treaty
country.
 Before the 1980's most US treaties did not contain
elaborate anti-treaty shopping mechanisms and
residents of third countries (with no treaty with the
US) were able to use these treaties and get reduced
withholding taxation.
 Beneficial ownership not a solution
 The first important example was the German treaty

14. Article 22 of U.S. ModelArticle 22 of U.S. Model
 As of 1996, article 22 of the Model stated the
U.S. ideal
 No actual treaty has a limitation on benefits article
identical to the Model
 U.S. ideas about the article have evolved over time
 Most countries are unwilling to accept the article
exactly as the United States proposes it

15. HistoryHistory
 1977 model applied only to certain types of income (interest,
dividends, royalties)
 Only if favorable treatment in residence state
 75% ownership test / no base erosion test
 1981 added base erosion test, and removed the favorable treatment
in residence state requirement
 1986 enactment of branch profits tax, yield to treaty only for
qualified residents, based on tests similar to ownership/base erosion
test
 1989 German Treaty adds the active business test and the
competent authority relief provision.
 Further specification of public company and base erosion tests

16. HistoryHistory
 1992 landmark Dutch treaty – significantly more detailed
 Partly because language transferred from technical explanation
to treaty
 New: extension of benefits to subsidiaries of public companies,
headquarters companies for MNEs included in some cases,
derivative benefits (70% EU) and EU activities attribution rule,
and triangular cases (in protocol)
 Ex.: U.S.s will impose a 15% WHT on interest and royalties
paid to a Dutch PE in a third country if that country's tax on
the interest and royalties, combined with any Dutch tax due
on the same income, is less than 60% of the applicable Dutch
corporate tax rate.
 1996 Model incorporated all of the above to the modern provisions
we know

17. HistoryHistory
 2006 model:
 substantiality determined solely on facts and circumstances – no
safe harbor
 Removed treaty interpretation to "connected with” or
“incidental to“ – left to domestic law
 look-through added to Art. 22(3)(c) for "activities conducted by
persons connected to a person". "Connection" determined by
facts and circumstances control standard, with 50% usually
enough

18. The Public Company TestThe Public Company Test
 A resident company will qualify for treaty benefits, if
 there is substantial and regular trading of its principal class
of stock on an approved stock exchange located in one of the
two treaty countries
 More than 50% vote and value
 Recognized stock exchanges include NASDAQ and any U.S.
exchange established under the Securities Exchange Act of
1934, exchanges in the other Contracting State (vary), and
other exchanges to be agreed on by the competent
authorities.
 Subsidiaries of public companies qualify as well if
owned 50% or more (each class) directly by the public
company, or indirectly if all intermediate owners are

19. The Public Company TestThe Public Company Test
 The assumption is that most of the SHs are residents, yet
even if not, regulation of public companies make them
unlikely to be used for tax avoidance
 Used to be “all of the shares” – but that was too limited
an exception
 “regularly traded” defined under the domestic law
 the class of shares must be traded in more than de minimis
quantities on at least 60 days of the taxable year.
 aggregate number of shares traded - at least 10% of the average
number of shares outstanding during the year.
 Trading may take place on more than one recognized exchange

20. The Ownership/Base Erosion TestThe Ownership/Base Erosion Test
 The 1996 Model LOB clause requires at least 50%
of equity holders to be qualified residents and more
than 50% of deductible payments to be paid to
qualified residents. – because not only shs can
benefit from investment in corp but also creditors
etc..

21. The Ownership TestThe Ownership Test
 Test met if more than a specified percentage (50/75%)
of the beneficial ownership of a person that is a
resident of a Contracting State under the Residence
article is owned by persons truly connected with a
Contracting State.
 First step: apply domestic anti-abuse norms to
determine ownership or beneficial ownership
 Norms such as the business purpose doctrine, the step-
transaction and substance-over-form doctrines, and conduit
principles

22. The Ownership TestThe Ownership Test
 Second step: apply the treaty rule - Paragraph 2(f)(i) of
Article 22 applies to entities (other than individuals)
 at least 50% of each class of its shares or other beneficial
interests
 is owned, directly or indirectly (so long as intermediate
owners qualify)
 for at least half the days of the taxable year
 by residents of either contracting state who are
 Individuals residents, including U.S. citizens; a Contracting
State and qualified government entities; publicly traded
companies or their qualified subsidiaries; certain exempt
organizations (including pension trusts) that primarily benefit
residents of a Contracting State , including pension trusts.

23. The Base Erosion TestThe Base Erosion Test
 The purpose is to determine whether the income
derived from the source State is in fact subject to such
state’s tax regime.
 An entity meets the base-erosion test if it does not
make payments that are
 deductible for income tax purposes in the entity's state of
residence
 paid or accrued, directly or indirectly, to persons other than
residents of either contracting state
 unless the payment is attributable to a PE in either State
 in the amount of 50% or more of the entity's gross income
for the taxable year.
 Defined under U.S. principles. Mentioned: “gross receipts less cost
of goods sold.”

24. Active Trade or Business TestActive Trade or Business Test
 Different from other tests that heavily focus on residence
 substitute for the more subjective “principal purpose”
test of earlier treaties. It attempts to somewhat
objectify/make more precise the query about the
business purpose behind the tested income generation
 This test is based on the nexus of the entity's business
activities to a Contracting State
 usually only relevant in cases in which an entity claiming
treaty benefits is not entitled to benefits under the
ownership/base reduction or public trading tests
 Subjective test, yet self-executing and does not require a
competent authority ruling or approval

25. Active Trade or Business TestActive Trade or Business Test
 Article 22(3) of the 1996 Model
 entity must be engaged in the active conduct of a trade
or business
 the income must be “connected with” or “incidental
to” that trade or business, and
 the trade or business must be “substantial in relation
to” the activity generating the income
 A company meeting all three prongs of the test will
enjoy treaty benefits, but only with respect to the
item(s) of income in question
 must be applied item by item

26. Active Trade or Business TestActive Trade or Business Test
 Active trade or business - specific unified group of
activities
 that constitute or could constitute an independent economic
enterprise
 carried on for profit
 only if the officers and employees of the corporation conduct
substantial managerial and operational activities
 Points to sec. 367 regs.’ definition
 Excludes headquarters companies - Not including business of
making or managing investments, unless these activities are
banking or insurance activities carried on by a bank or
insurance company

27. Active Trade or Business TestActive Trade or Business Test
 “In connection with”
 Income-producing activity must be a line of business
that “forms a part of” or is “complementary to” the
source country business
 It forms a part of such business if the two activities involve
the design, manufacture or sale of the same products or
types of products, or the provision of similar services
 It is complementary if they are “part of the same overall
industry and related in the sense that the success or failure
of one activity will tend to result in success or failure for
the other

28. Active Trade or Business TestActive Trade or Business Test
 Alternatively - “incidental to”
 facilitates the conduct of the trade or business in the source
state
 Example: investment of the T/B’s working capital
 Source country operations must be “substantial in
relation to” the income-producing activity. Note: in some
treaties apply only to the “In connection with” test.
 All facts and circumstances
 Safe Harbor: the size of the source country business must be
more than 7.5% of the size of the income-producing activity,
testing:
 asset value; gross income; payroll expenses

29. Active Trade or Business TestActive Trade or Business Test
 and the average of the three calculations for the
source country business must exceed 10% of the size
of the residence country.
 “value” is determined under the method the taxpayer
uses to keep its books for financial reporting in its
country of residence
 Technical explanation cites Treas. Regs. §1.884-5(e)(3)(ii)
(A).
 Tested only with respect to residence country
operations and proportinately to tested taxpayer’s
holding

30. Do Tax Treaties with LOB ProvisionsDo Tax Treaties with LOB Provisions
Infringe on EU Tax Law?Infringe on EU Tax Law?
 LOB clauses in tax treaties concluded by the
United States with Member States essentially
ignore the MFN elements in the freedoms
 Subject to derivative benefits clauses
 Open Skies judgments
 Nationality clauses similar to LOB ruled
incompatible with freedoms
 But, Matteucci (Case C235/87) – Cultural
Agreements.

31. Cont.Cont.
 The question became whether Tax Treaties
LOB are also incompatible with freedoms
 Malta (until recently..)
 No - ACT Group Litigation: nonresidents are not,
as such, comparable to residents (without
prejudicing their entitlement to become so by
exercising the ECT fundamental freedoms and
rights) – from a source country perspective.
 Distinguishing residence from nationality clauses
– residence is open to foreign nationals..

32. Cont.Cont.
 Even in case of incompatibility must check whether
justifiable obstacle to one of the freedoms
 D-case: a member state is not under the obligation to
extend the benefits of its DTCs to nationals of non-
contracting States, unless they are in a comparable
situation (residents..) So, the same rule applies to
both source and resident countries
 Finally, it comes down to distinction between
nationals (non residents) and residents
 No MFN in EU tax law

33. ConclusionConclusion
 Increase use of alternative treaty shopping
mechanisms, including LOB, not only by the United
States
 LOB language in the OECD Commentary
 The United States currently have treaties with LOB
with all EU member states (old treaty with Greece
an exception).
 Derivative benefits clauses relieve some pressure
 Taste for EU wide treaties or treaty negotiation?

34.  In many applications, the rules overlap the coverage of
limitation on benefit articles
 When the conduit rules apply, they purport to trump all
treaty provisions, including limitation of benefits
articles
 The conduit rules generally apply in back-to-back
situations
 A loans money to B, and B loans the same amount,
on similar terms, to C
Conduit RegulationsConduit Regulations

35.  The conduit rules only apply to “financing
transactions,” which are
 Loans
 Leases
 Licenses
 A few other types of transactions
Financing TransactionsFinancing Transactions

36.  The rules apply to “financing arrangements” which are
series of transactions in which:
 One person (the financing entity) advances money,
property, or a right to use property and
 Another person (the financed entity) receives the
property
 The transfer is effected thru one or more other
persons (intermediate entities)
Financing ArrangementsFinancing Arrangements

37.  An intermediate entity will be disregarded and a financing
arrangement deemed to be between the financing entity and
the financed entity if the participation of the intermediate
entity (if given effect) reduces U.S. withholding tax,
 The intermediate entity’s participation is for a tax avoidance
purpose, and
 The intermediate entity either
 Is related to the financing or financed entity or
 Participated in the transaction with the financed entity
only because of the transaction with the financing entity
ApplicationApplication

38. QuestionsQuestions
 Are the conduit rules consistent with the limitation of
benefits article of the treaty?
 The regs. say that they are interpreting these rules,
but this is technically problematic
 Are the rules a case of treaty override?
 If so, are they subordinate to limitation on benefits
articles of subsequent treaties?
 The conduit rules are prescribed by administrative
regulations, not statutes
 Can the U.S. Treasury override treaties by
regulations?

39. U.S. hybrid entity regulationsU.S. hybrid entity regulations
Reduced treaty withholding rate for U.S. source
income available only if income is “derived by” a
foreign recipient “resident” in the treaty partner
The entity is not fiscally transparent under the laws of
the entity’s jurisdiction;
 the interest holder establishes that the interest holder is
not fiscally transparent under the law of its residence;
The treaty partners have an agreement with respect to the
treatment that is specified in the treaty