The accelerating growth in global trade has occasioned the creation of new types of cooperative enterprises. For example, companies routinely form joint ventures or other partnership arrangements to engage in isolated projects or systematically to conduct business. Various forms of limited liability companies are also business and investment vehicles in the global arena. The application of treaties to these companies and vehicles gives rise to problems because tax treaties do not deal with attribution of income — they only allocate items of income between the two treaty countries. To the extent a treaty allocates income to the residence country of the company or individual earning or receiving the income, the determination to whom this income is taxed (that is, which company or individual is considered to earn or receive the income), is made under the domestic law rules of each of the treaty states. If these rules differ in their application in a given case, conflicting attribution will result.
3 These treaty application problems have always existed but have been exacerbated in recent years by the growth of elective entity classification in some countries. For example, under U.S. law an entity, whether foreign or domestic, in many cases is free to choose whether it will be treated as transparent or nontransparent for U.S. tax purposes. /1/ Consequently, an entity may be treated as transparent for U.S. tax purposes and as nontransparent for foreign tax purposes, or vice versa. Also, without such elective classification, inconsistencies result from different domestic entity classification rules. For purposes of discussion, an entity that is treated as transparent for tax purposes in one jurisdiction and as nontransparent in another is referred to as a “hybrid entity.” /2/ When there is no classification conflict, a transparent entity may be referred to as a partnership for purposes of discussion.
4 The problems resulting from a characterization difference between the two (and perhaps three) countries involved are threefold. In the first place, if the entity and the persons participating in the entity (“participants”) are residents of different countries, it is possible that each of the two countries taxes the income to its resident(s), typically without any relief for the tax imposed by the other country (except perhaps to the extent it was sourced in the other country). Second, if the source country taxes the income to the participants, but the residence country of the entity and of the participants taxes the income to the entity (or vice versa), the individual income tax rate applied may be substantially higher than the corporate tax rate to which the entity is subject with respect to the income in its country of residence (again, or vice versa). Third, particularly if the residence country of the recipient of the income relieves double taxation through a foreign tax credit, if the source country taxes the entity for the income, and the residence country of the participants taxes these participants, the latter country may not grant double taxation relief because the foreign tax was not imposed on the participant but on the entity.
I. Article 4(1)(d) of 1996 U.S. Model and IRC Section
894(c) Regulations
5 While the current OECD model tax treaty does not contain provisions to deal effectively with these issues, the 1996 U.S. model provides a solution, at least to the first of the issues mentioned above. This solution is provided through an addition to the OECD definition in article 4 of the term “resident.” With respect to the residence of partnerships and partners, article 4(1)(d) of the 1996 U.S. model income tax treaty provides as follows:
An item of income, profit or gain derived through an entity that
is fiscally transparent under the laws of either Contracting
State shall be considered to be derived by a resident of a State
to the extent that the item is treated for purposes of the
taxation law of such Contracting State as the income, profit or
gain of a resident.
6 This provision is not easily understandable. It does not matter under the law of which of the two treaty states the entity that receives the income is organized, or whether it is organized under the law of a third state. The only thing that matters is that if one of the two treaty states considers the receiving entity to be transparent, the treaty applies if the income under consideration is taxed to a resident of either state (that resident being the entity itself or the participants in that entity).
7 The formulation accommodates a series of different structures. For example, if the source of income is in one treaty state that treats the entity (which is a resident of a third state) as the recipient of the income, but the participant’s residence state taxes the income to the participants, the provision effectively requires the source state to treat the participants as the recipients of the income although under its own domestic law the source state may treat the entity as the recipient of the income.
8 The U.S. model treaty article discusses a series of triangular cases and considers first what the outcome is under the current OECD model treaty. Next, with respect to each case, the article focuses on the impact of the special U.S. model treaty provision on residence of partnerships and partners (article 4(1)(d)). This discussion will not consider the approach taken in the OECD Report on the Application of the OECD Model Convention on Partnerships, issued August 16, 1999. (For prior coverage, see Tax Notes Int’l, Aug. 16, 1999, p. 623, 1999 WTD 157-2, or Doc 1999-27066 (3 original pages). This report will be the subject of a later article.
9 Before discussing the cases in section 3 of this article, we will briefly examine the origin of this U.S. treaty provision: the regulations promulgated in 1996 under IRC section 894(c). The approach taken in U.S. model treaty article 4(1)(d) is consistent with the approach taken in the regulations under IRC section 894(c). Essentially, the latter provisions deny any reduced treaty withholding rate to an item of income derived by a nonresident company or individual through a U.S. or foreign (treaty country or third country) partnership or other fiscally transparent entity if (i) the residence country of the company or individual deriving the income does not include the item in the income of a resident entity itself or of a resident participant of that entity; (ii) the treaty does not address the applicability of the treaty to income derived through a partnership; and (iii) the foreign country does not impose tax on a distribution of such item from the partnership to a partner. /3/