NEW US NETHERLANDS TAX TREATY BY PETER KIRPENSTEIJN

NEW US/NL TAX TREATY REGULATIONS

by Peter Kirpensteijn

Recent treaty negotiations between the United States and The Netherlands resulted in a new protocol to the existing US/NL tax treaty. This protocol makes certain regulations already effective in 2004. Others become effective as from 1 January 2005.

1. The most important changes and effective date

In July 2004, the Netherlands First Chamber of Parliament accepted a bill regarding a new protocol to the 1994 US/NL tax treaty (hereinafter the “2004 Protocol”). This finalised the NL formalities that are constitutionally required for amending the current US/NL tax treaty.

Important amendments that are discussed in this paper are:

a. No US or NL dividend withholding tax for dividends distributed to qualifying parents (see paragraph 2). The US have accepted a 0% dividend withholding tax rate only in four other tax treaties, i.e. with Mexico, Australia, Japan and the United Kingdom.

b. No US branch profits tax for certain qualifying NL companies with US branches (see paragraph 4);

c. New regulations applicable to so-called hybrid entities (see paragraph 5);

d. A new “Limitation on benefits” article (see paragraph 6);

The 2004 Protocol shall enter into force on the later of the dates on which the respective Governments have notified each other in writing that the formalities constitutionally required in their respective States have been complied with. This notifications have not yet taken place.

As to the 2004 Protocol becoming effective, two regulations apply:

a. In respect of taxes withheld at source, for amounts paid or credited:

On or after the first day of the second month next following the date on which the Protocol enters into force.

b. In respect of other taxes:

For taxable periods beginning on or after the first day of January in the year following the date of entry into force of the Protocol. It may be expected that this shall be 1 January 2005.

2. The US-NL connection

The Netherlands have and always had a strong trading connection with the United States. The cumulative investments made by NL companies in the United States per the end of 2002 totaled to nearly 155 billion US dollar. This makes The Netherlands, after the United Kingdom and France, the biggest investor in the United States. Companies in the United States at their turn invested a total amount per the end of 2002 of more than 145 billion Dollar in The Netherlands. After the United Kingdom, The Netherlands appear to receive the most inbound US investments[1].

One of the consequences of the strong US/NL trading connection was that one of The Netherlands first tax treaties for the avoidance of double taxation was concluded with the United States. That was in 1948.

Tax treaties meet various purposes. The most important purpose is that they include regulations aiming to prevent certain income being taxed twice. These rules may be seen as allocation rules. They allocate the various types of income to the Contracting States for taxation. Tax treaties also include rules that maximize domestic tax rates. This often relates to so-called withholding taxes on dividends, interest and royalties. The tax treaty rates of these withholding taxes are usually substantially lower than the domestic rates.

Other purposes of a tax treaty are the avoidance of discrimination and the exchange of information between the Contracting States.

In 1994, the 1948 US/NL tax treaty was replaced by a complete new treaty. The 1994 tax treaty introduced a new approach against tax treaty abuse. The Netherlands always took (and still takes) the position that in principle residents of a Contracting State should be able to invoke the regulations of a pertinent tax treaty. For the United States, this was not enough. They had adopted the policy that additional conditions should be met, even by tax residents of one of the Contracting States, in order to invoke the tax treaty rules. These additional conditions became known as the “limitation on benefits regulations”. The Netherlands accepted this approach by agreeing on including a limitation on benefits article in the 1994 US/NL tax treaty.

The limitation on benefits article 26 of the 1994 US/NL tax treaty included very complex and detailed regulations introducing a period of uncertainty as to the tax consequences of certain transactions that were entered into between Netherlands and United States enterprises. Furthermore the limitation on benefits article proved to have an adverse effect on the administrative burden of US and NL enterprises.

As a consequence, more or less immediately after the (new) 1994 US/NL tax treaty became effective, a need arose to amend and simplify its content, mainly its limitation on benefits article. However, it negotiations for amending the 1994 US/NL tax treaty only started in 2002. This was because of two circumstances.

First, the United States had in the meantime accepted limitation on benefits rules that were less strict and often much easier to implement in tax treaties with other countries (such as Switzerland and Luxemburg).

Secondly, the United States made in 2001 a major change in their foreign policy regarding their position towards the taxation of dividends distributed by US companies. Previously the United States strongly adhered to the position that those dividends should always be subject to a United States dividend withholding tax. Under their tax treaties, they were willing to substantially reduce the US dividend withholding tax rate, but never to nil.

In 2001 this policy changed. It appeared that the United States were under strict conditions willing to except that certain dividends could be distributed by US companies to their foreign parents free from US tax. The first tax treaty in which this new view was implemented was the tax treaty with the United Kingdom.

3. 0% dividend withholding tax rate

The 1994 US/NL tax treaty allows the Contracting State, in which the distributing company was located, to levy a 15% dividend withholding tax[2] on dividends distributed to its shareholder. This rate is reduced to 5%[3], if the parent is a company and holds directly at least 10% of the voting power of the distributing company.

Under the 2004 Protocol the 15% rate and the 5% rate are maintained. However, the 2004 Protocol introduces the possibility to distribute dividends free from withholding tax[4]. This 0% dividend withholding tax rate is, however, subject to strict conditions so that the 0% dividend withholding tax rate is only available in exceptional circumstances:

a. The parent company should be a tax resident of the other State;

b. The parent company should be the beneficial owner of the dividends;

c. The parent company should directly own shares representing 80 percent or more of the voting power in the distributing company;

d. The parent company should have owned these shares already for a period of 12 months or more prior to the day on which the dividends are declared and;

e. Either,

· prior to 1 October 1998 the parent company (in)directly already owned shares representing 80 percent or more of the voting power in the distributing company[5],

· the parent company meets (i) the Stock Exchange test, or (ii) the Derivative Benefits test, or (iii) may invoke the Discretionary Relief provision. These three tests are included in the new Limitation on Benefits article included in the 2004 Protocol.

The stock exchange test[6]

Simply said, this test demands that the parent company is quoted on a recognized stock exchange in The Netherlands or in the United States and that its shares are regularly traded on this stock exchange[7]. A company also meets this stock exchange test if it is itself not quoted on a Netherlands or United States stock exchange but is a subsidiary of a company that does meet the stock exchange test.

The derivative benefits test[8]

If the parent company does not meet the stock exchange test, then nevertheless the 0% dividend withholding tax rate could be invoked if the derivative benefits test is met. Briefly said, this test implies that, a certain part of the parent company’s income is not accruing to shareholders that would not qualify for the same tax treatment if they would directly own the distributing company (i.e. a base erosion test) and

· A NL parent company’s shares are for at least 95% owned by (at max 7) shareholders that are resident of the United Kingdom, Mexico, the United States or the Netherlands[9];

· A US parent company’s shares are at least 95% owned by (at max 7) shareholders residents of a member of the European Union, Mexico, the United States or the Netherlands.

In more detail, the derivative benefits test contains the following two conditions:

First, at least 95% of the parent company shares[10] are held, directly or indirectly, by seven of fewer persons who are equivalent beneficiaries[11].

Equivalent beneficiaries

First, the shareholder(s) of the parent company should be resident of a member state of the European Union (including The Netherlands) or of a European Economic Area state or of a party to the North American Free Trade Agreement.

Secondly, said shareholder(s) should, if it would own the distributing company directly, be able to invoke the pertinent tax treaty because it meets analogous limitation on benefits tests or if no limitation on benefits article is included in said tax treaty it should meet the limitation on benefits conditions included in the NL/US tax treaty as if it were a NL tax resident.

Thirdly, said shareholder should, if it would own the distributing company directly, be entitled to equivalent benefits under the pertinent tax treaty and entitled to claim the same dividend withholding tax rate.

Secondly, the parent company should meet a base erosion test[12].

Base erosion test

This test stipulates that less than 50% of the parent company’s gross income of the taxable year in which the dividend is received, is paid or accrued (directly or indirectly) to persons who are not equivalent beneficiaries in the form of payments that are tax deductible fot that parent company. The test excludes arm’s length payments made in the ordinary course of business for services or tangible property and payments in respect of financial obligations to a bank. In the latter case, if the bank is not a tax resident of The Netherlands or the United States, then such payment is attributable to a permanent establishment of that bank in either The Netherlands or the United States.

Discretionary relief

If neither the Stock exchange test, nor the Derivative benefits test can be met, then nevertheless the parent company may qualify for the 0% dividend withholding tax rate by requesting a determination from the competent authorities of the country in which the distributing company is resident[13].

Interesting of this possibility is that the discretionary relief is granted if the parent company meets a somewhat different Derivative Benefits test than the one explained above[14]:

First, 30% of the parent company’s shares[15] are owned by qualifying NL or US residents;

and

Secondly, at least 70% of the parent company shares[16] are held, directly or indirectly, by seven of fewer persons who are equivalent beneficiaries[17].

and

Thirdly, the parent company meets the base erosion test as explained above.

Note that the above test differs in that it uses 70% instead of the 95%-condition included in the Derivative Benefits test of the limitation on benefits article.

4. 0% US branch profits tax

The 1994 Tax Treaty included a regulation covering the United States branch profit tax[18]. Note that Netherlands tax law does not include such branch profit tax so that the Treaty regulation is only applicable to,

· Netherlands companies that have a permanent establishment in the United States; or

· Netherlands companies that are subject to tax in the United States on income from or capital gains realized on real property located in the United States (hereinafter “Property Income”).

Under the Treaty the branch profit tax rate is 5 percent.

Under the 2004 Protocol the 5% US branch profits tax is reduced to 0% if the following conditions are met[19]:

a. prior to 1 October 1998 the company already had a permanent establishment generating Property Income[20], or

b. the company meets (i) the Stock Exchange test, or (ii) the Derivative Benefits test, or (iii) may invoke the Discretionary Relief provision. These three tests are included in the new Limitation on Benefits article of the 2004 Protocol and explained in paragraph 3 above.

5. Hybrid entities

The 2004 Protocol adds a new paragraph 4 to the “Basis of Taxation” - article 24. This new paragraph covers the treaty application of income that is transferred from one Contracting State to another through an entity that is qualified differently by each Contracting State. These entities are referred to as “Hybrid Entities”. One State may qualify such entity as transparent for tax purposes, where the other State qualifies the entity as being non-transparent. This qualification difference may either result in that income being taxed twice, or not taxed at all.

Under the new rule, the country of source in principle follows the qualification of the country of residence.

Exceptions to this general rule exist if income is generated in the “source state” and the hybrid entity is also located in that state:

a. The domestic law of the source state qualifies the hybrid entity as non-transparent, whereas the domestic law of the other state (in which the participants of the hybrid entity are residing) qualifies said entity as transparent.

Under the general treaty rule, the source state should treat the entity as a transparent entity. However, The Netherlands and the United States have agreed in the Memorandum of Understanding, that under these circumstances the source state maintains its right to tax the income realised by the hybrid entity. This situation may arise when the United States apply their “check-the-box- rules”, resulting in e.g. NL companies being treated as transparent for US tax purposes. If such checked company receives dividends from its NL subsidiary, then the dividend is taxed under the NL tax rules at the parent’s level and when the NL parent distributes this dividend to its US individual participants, The Netherlands shall withhold 15% NL dividend withholding tax.

b. In the mirror situation, the domestic law of the source state qualifies the hybrid entity as transparent, whereas the domestic law of the other state (in which the participants of the hybrid entity are residing) qualifies said entity as non-transparent.

The participants are in principle not allowed to invoke the tax treaty rules. They are not liable to tax with respect to the income realised by the hybrid entity. In the memorandum of Understanding its is however agreed that the competent authority of the source state may grant the benefits of the tax treaty to the participant in the hybrid entity, if said income would have been exempt if it would be realised directly by the participant. This understanding is included to eliminate the “overkill” of the hybrid entity regulations in the tax treaty for exempt pension funds.

6. New article 26: limitation on benefits

The regulations in the limitation on benefits article basically are anti-treaty shopping regulations. In all other tax treaties concluded by The Netherlands, tax regulations may be invoked by tax residents of one of the Contracting States. These tax treaties contain no limitation on benefits regulations other that in circumstances it is required that the recipient of the income is the beneficial owner of that income (this condition is for example imposed in the treaty regulations covering taxation on dividends, interest and royalties).

For The Netherlands, the limitation on benefits regulations were introduced in the 1994 US/NL tax treaty. These regulations are now replaced by the 2004 Protocol that introduces a new limitation on benefits article.

In order to determine whether a tax resident may invoke the (amended) US/NL tax treaty, the following steps have to be made:

First, the US/NL tax treaty is available to those persons that for purposes of the NL/US tax treaty are qualified persons and meet the other specific conditions imposed by the pertinent treaty rule. In addition to being a tax resident, a qualified person meets one of the definitions included in article 26, paragraph 2.

Secondly, persons that are not qualified persons may nevertheless invoke the tax treaty rule applicable to a specific item of income, if it meets on of the following tests:

· The Derivative Benefits test[21]; or

· The Activity test[22]; or

· The Head Quarter test[23]; or

· The Shipping and Air Transport test[24]

Thirdly, if a person still does not qualify for invoking a tax treaty rule, then he may submit a request for Discretionary Relief[25] to the competent authorities of the country of source.

For individuals and States, a political subdivision or local authority thereof, and companies that are engaged in an active conduct of a trade or business, shipping companies and so-called headquarter companies, the amendment in the 2004 Protocol brings no substantial changes.

Different rules are, however, introduced for:

a. Publicly traded companies;

b. Subsidiaries of publicly traded companies;

c. The ownership and base erosion test

With a Derivative Benefits test the 2004 Protocol introduces an additional test to qualify for the treaty benefits.

Publicly traded companies

A publicly traded company that meets the direct stock exchange test is a qualified person. This test requires that the principal class of the company’s shares (and any disproportionate class of shares) is listed on a recognized stock exchange in the US or in The Netherlands and is regularly traded on one or more recognized stock exchanges, unless the company has no substantial presence in the State of which it is a resident.

Recognized Stock Exchange

New in this test is that the term Recognized Stock Exchange includes, in addition to the Amsterdam stock exchange, the stock exchanges in Paris and Brussels, together forming the Amsterdam stock exchange Euronext.

Substantial Presence

Furthermore, the requirement of substantial presence is new. This requirement is included to prevent so-called “inversion transactions”[26] and third party treaty shopping.

Substantial presence of a company in the resident State is measured on the basis of two criteria, namely[27],

· The place were the company’s stock is traded; and

· The company’s primary place of management and control

The 2004 Protocol and the relating Memorandum of Understanding contain explanations on the meaning and content of these two criteria.

Subsidiaries of publicly traded companies

Tax resident companies which are not quoted but owned by quoted companies may be qualified persons if they meet the Indirect Stock Exchange test[28].

Indirect Stock Exchange test

This test requires that shares representing at least 50 percent of the aggregate voting power and value (and at least 50 percent of any disproportionate class of shares) of the company are owned directly or indirectly by five or fewer companies that qualify for the Direct Stock Exchange test, provided that, in the case of indirect ownership, each intermediate owner is a resident of either The Netherlands or the United States.

A comparison with the Indirect Stock Exchange test of the 1994 US/NL tax treaty reveals that the new Indirect Stock Exchange test is substantially different:

a. A positive difference is that the test uses a “50% or more”-condition, whereas the 1994 US/NL tax treaty used a “more than 50%”-condition. This change facilitates joint-venture structures.

b. A second positive difference is that the 2004 Protocol does not include tests that are applicable to conduit companies. Under the 1994 US/NL tax treaty the subsidiary of the quoted company was no allowed to be a conduit, as defined, and if it was it had to satisfy the conduit base reduction test. The new regulations that are applicable to companies with quoted parents do not contain regulations with respect to conduits.

c. A less positive difference is that under the 1994 US/NL tax treaty a NL subsidiary of quoted (ultimate) parents met the Indirect Stock Exchange test and therefore could invoke the tax treaty rules, if part of its shares were (in)directly held by quoted EU companies. Under the 2004 Protocol this is no longer possible..

The Ownership and Base Erosion test

A company that meets the Ownership[29] and Base Erosion test[30] is a qualified person, unless it is a quoted company with no substantial presence.

Ownership test

On at least half the days of the taxable year at least 50 percent of the aggregate voting power and value (and at least 50 percent of any disproportionate class of shares) of the above company are (in)directly owned by qualified persons because they are

· Individuals[31];

· A State, or a political subdivision or local authority thereof[32];

· A company meeting the Direct Stock Exchange test[33];

· Exempt pension trusts[34]; or

· Not-for-profit organisations[35].

Base Erosion test

Less than 50 percent of the person's gross income for that taxable year is (in) directly paid or accrued to persons who are not residents of either State in the form of payments that are deductible for the purposes of the taxes covered by this Convention in the State of which the person is a resident (but not including arm's length payments in the ordinary course of business for services or tangible property and payments in respect of financial obligations to a bank, provided that where such a bank is not a resident of a State such payment is attributable to a permanent establishment of that bank located in one of the States).

P. Kirpensteijn

Udink & De Jong

August 2004

[1] Explanatory notes to the Amendment protocol Act; 2003/04, 29 632; nr.3, paragraph 3.2

[2] Article 10 (2) (b).

[3] Article 10 (2) (a).

[4] Article 10 (3).

[5] The date of 1 October 1998 is the moment where the United States published its policy to refrain from levying dividend withholding tax if certain conditions would be met.

[6] Article 26 (2) (c).

[7] It should be noted that the meaning of recognized stock exchange includes, in addition to the Amsterdam stock exchange, the stock exchanges in Paris and Brussels, together forming the Amsterdam stock exchange Euronext.

[8] Article 26 (3).

[9] If the 0% dividend withholding tax rate is in future included in more US tax treaties, then shareholders in those countries may be added.

[10] Representing voting power and value and representing at last 50% of any disproportionate class of shares.

[11] Article 26 (8) (f).

[12] Article 26 (3) (b).

[13] Article 26 (7)

[14] See Memorandum of Understanding to the 2004 Protocol, paragraph XXIV

[15] Representing voting power and value.

[16] Representing voting power and value and representing at last 50% of any disproportionate class of shares.

[17] Article 26 (8) (f).

[18] Article 11.

[19] Article 11 (3)

[20] The date of 1 October 1998 is the moment where the United States published its policy to refrain from levying dividend withholding tax if certain conditions would be met.

[21] Article 26 (3)

[22] Article 26 (4)

[23] Article 26 (5)

[24] Article 26 (6)

[25] Article 26 (7)

[26] Inversion refers to the tax driven move of a (quoted) top holding company from the US to e.g. The Netherlands, whereby otherwise the group structure remains the same and often also the place of effective management and control does in principle not change.

[27] Article 26 (8) (d).

[28] Article 26 (2) (c) (ii)

[29] Article 26 (2) (f) (i)

[30] Article 26 (2) (f) (ii)

[31] Article 26 (2) (a)

[32] Article 26 (2) (b)

[33] Article 26 (2) (c) (i)

[34] Article 26 (2) (d)

[35] Article 26 (2) (e)