An LOB provision is an anti-abuse provision that sets out
which residents of the Contracting States are entitled to the treaty’s benefits.
The purpose of an LOB provision is to limit the ability of third country
residents to obtain benefits under the said treaty. This type of use of the
treaty, where third country residents establish companies in a Contracting State
with the principal purpose to obtain the benefits of the treaty between the
Contracting States, is commonly referred to as ‘treaty shopping’.
The introduction of LOB provisions in recent Indian treaties
is indicative of a policy to discourage treaty shopping. Recently, India
renegotiated the India-Singapore Income Tax Treaty (Singapore Treaty) and the
India-UAE Income Tax Treaty (UAE Treaty) through separate Protocols that add LOB
provisions in each, effective in 2005 and 2008, respectively. Although it is too
early to tell how extensive this shift in policy will become, for now India
seems to be following a similar path taken by the United States starting in the
early 1980s when it began renegotiating its income tax treaties and insisting
that treaty partners agree to having LOB provisions in the renegotiated
treaties. For the U.S., it believes that such provisions are effective in
stopping aggressive international tax planning that uses its treaties for the
benefit of third country residents.
A look at the LOB Provisions in the
India-Singapore and India-UAE Treaties :
The recent LOB provision added to the Singapore Treaty is
illustrative of India’s new direction. The India-Singapore Comprehensive
Economic Co-operation Agreement (‘CECA’) was signed on June 29, 2005. As part of
the CECA, Singapore and India agreed on a Protocol and the tax treaty was
amended. The amendments introduced by this Protocol came into force from August
1, 2005.
The Protocol provides that capital gains arising to a
resident of a Contracting State from the sale of property and shares (other than
immovable property or property forming part of a permanent establishment) in the
other Contracting State would be taxed only in the Contracting State where the
alienator is resident.
In other words, when the Singapore company divests its
interest in the Indian company, it will be exempt from Indian capital gains tax.
However, to prevent third country residents from misusing the capital gains
exemption by establishing a holding company in Singapore, an LOB provision was
also added to the treaty.
The LOB provision is very limited in scope, in that it only
impacts capital gains tax and not other benefits provided by the treaty. Under
the LOB provision, a resident company of Singapore will not be entitled to the
capital gains exemption if the primary purpose for the company’s establishment
was to obtain the capital gains exemption. In addition to this test that looks
at a taxpayer’s motive for its holding structure, the provision includes a
second test which provides that companies (referred to as ‘shell’ companies)
that have no or negligible business operations, or with no real or continuous
business activities in Singapore, would not qualify for the capital gains
exemption under the treaty. Under a safe harbour rule, a Singapore company would
not be a shell if : (1) it was listed on recognised stock exchanges of India or
Singapore, or (2) its total annual expenditure on operations in its state of
residence is equal to or more than S$ 200,000 or Rs.50,00,000, as the case may
be, in the 24 months immediately before the date its capital gains arise. It is
not entirely clear whether the Singaporean company still has to satisfy the
motive test even if it passes the safe harbour rule.
In contrast to the Singapore Treaty, the LOB provision added
to the UAE Treaty is broader in scope in that it applies to all benefits
under the treaty. The LOB provision provides that a company would not be
entitled to treaty benefits if “the main purpose or one of the main purposes of
the creation of such entity was to obtain the benefits . . .” of the treaty.
Once again the intention behind the provision is to curb the use of holding
companies that do not have bona fide business activities in India/UAE
from being granted treaty benefits. However, unlike the Singapore Treaty, the
UAE Treaty does not give any guidelines on what is required to prove that a
company has sufficient business activities to obtain treaty benefits. As a
result, this LOB provision will surely create unnecessary uncertainty as to the
application of the treaty. The treaty partners may need to provide some guidance
on this at some point.
From a policy standpoint it appears that India will continue
to request some form of an LOB provision to be added in its treaties in future
treaty negotiations, including renegotiations of existing treaties (such as
Cyprus and Mauritius) where it perceives misuses taking place, making
tax-efficient inbound investment planning for foreign companies more
challenging.
Overview of LOB Provisions in U.S. Treaties :
With the growth of Indian companies, more and more such
companies are seeking to expand overseas and in this regard the United States is
the largest market for expansion. The United States is a high-tax jurisdiction
and has one of the most complex tax systems in the world. As a consequence, an
Indian company expanding into the United States should understand the U.S. tax
system and the tax costs to a foreign investor.
A foreign investor in a U.S. company will generally receive
return on his investment in the form of capital gains from the divestment of the
U.S. business, or the receipt of dividends, interest, royalties and other types
of investment income. As the United States does not tax capital gains on the
sale of capital assets, such as stock in a company (unless the company has
certain U.S. real property assets), foreign investors will not generally have to
concern themselves with U.S. capital gains tax issues on divestment of U.S.
stock.
On the other hand, dividends, interest, and royalties and
other types of investment income would be subject to a relatively high 30% U.S.
withholding tax. Thus, an Indian company would have to focus on how to reduce or
eliminate the 30% U.S. withholding tax on such U.S. investment income.
Finding ways to reduce or eliminate this tax cost is challenging from a U.S. perspective. The best way of lowering the 30% U.S. withholding tax is to access the benefits of a U.S. income tax treaty, which can provide reduced rates from 0% to 25%, depending on the treaty. In this regard, the U.S. has gone through many challenges over the years as a result of foreign investors creating elaborate schemes designed to lower this tax by accessing one of its many income tax treaties by treaty shopping. To counter treaty shopping, the U.S. has negotiated to have LOB provisions included in its treaties including the US-India Income Tax Treaty-(‘India Treaty’). The LOB provisions limit the treaty residents who may be granted treaty benefits. Importantly, the United States has also made changes to its domestic tax laws that complement the measures taken with its income tax treaties, such as, promulgating anti-conduit regulations, and interest earning stripping rules, and through a rich history of case law and rulings have developed substance over form, economic substance and business purpose doctrines that serve to curb tax transactions that are viewed as abusive. For purposes of this discussion, we will focus only on the U.S Treaty LOB provisions.
1. U.S. LOB provisions:
Broadly, the LOB provisions of most U.S. income tax treaties provide that resident companies of the two Contracting States are entitled to treaty benefits (such as reduction or elimination of the 30% US withholding tax rate on investment income) only if they satisfy one of the tests under the LOB provision of the treaty in question. Although each treaty is unique, there are generally at least three objective tests found in most U.S. income tax treaties, namely: (1)the Publicly Traded Company Test, (2) Ownership /Base-erosion Test, and (3) the Active Trade or Business Test. Further, the LOB provisions will typically have a clause providing that benefits may also be granted if the competent authority of the Contracting State from which benefits are claimed determines that it is appropriate to provide treaty benefits in that case. This little used clause gives the Competent Authority of the Contracting State involved discretion to grant treaty benefits in cases where even though the treaty resident cannot satisfy any of the objective tests, it should nonetheless be granted treaty benefits.
We have seen that without the benefit of a U.S. income tax treaty, an Indian investor would be subject to a 30% U.S. withholding tax on its U.S. sourced investment income. Fortunately, the tax treaty with India (‘India Treaty’) provides relief by reducing the 30% U.S. withholding tax rate for dividends, interest and royalties to 15%, 15% and 15/ 10%, respectively. There are also other U.S. income tax treaties that provide even better benefits, such as the UK Treaty, which can provide zero withholding tax on these three types of income if certain other requirements are met. The key to obtaining these reduced rates though is qualifying for treaty benefits under the respective LOB provision.
2. The U.S.-India Treaty LOB Provision – Article 24 :
The current tax treaty with India (‘India Treaty’) entered into force in December 1990. As with its other treaties, the United States wants to ensure that under the ‘India Treaty’, only ‘qualified residents’ of either treaty country obtain treaty benefits. The paragraphs of Article 24 (LOB) that relate to companies are intended to guarantee that only Indian or U.S. resident companies that have substantial substance and strong business connections or activities in India or the United States may be entitled to use the treaty.
In this regard, Article 24, paragraph 1, provides an Ownership /Base-erosion Test that is a two-prong test, both of which must be satisfied. Under the first prong of the test, more than 50% of each class of an Indian company’s shares must be owned, directly or indirectly, by individual residents who are subject to tax in either India or the United States, or by the government or government bodies of either Contracting State. Under the second prong of the test, the Indian company’s gross income must not be used in ‘substantial’ part, directly or indirectly, to meet liabilities (such as interest or royalties liabilities) in the form of deductible payments to persons, other than persons who are residents, U.S. citizens or the government or government bodies of either Contracting State. The term ‘substantial’ is not defined under the treaty, however, deductible payments that are less than 50% of the company’s gross income will generally not be considered substantial. This provision is generally focussed on stopping situations where third country lenders or licensors use the treaty to obtain the reduced 15% and 15/10% U.S. withholding tax rate for interest and royalty payments, respectively.
Paragraph 2 of Article 24 provides that an Indian company will qualify for treaty benefits, regardless of its ownership (as is required under the Owner-ship/Base-erosion Test), if it is engaged in an active trade or business in India and the item of income for which treaty benefit is being claimed is connected with or incidental to such trade or business. A company in the business of managing investments for its own account will not be treated as carrying on an active trade or business, unless it’s in the banking or insurance business. This treaty does not define the term ‘active trade or business’, but as discussed below, some guidance is available in the U.S. Treasury Technical Explanation to the ‘U.K. Treaty’ (which is the official guide to the U’K, Treaty by the United States) which provides a definition that the U.s. would likely apply consistently to all its treaties. This test is applied separately to each item of income of the Indian company, compared to the Ownership/Base-erosion Test and the Publicly Traded Company Test (discussed below), where if these tests are satisfied, then all the income of the treaty resident is entitled to all treaty benefits.
The third test under Article 24 is the Publicly Traded Company Test under paragraph 3. Under this test, a publicly traded Indian corporation can qualify for treaty benefits if its principal class of shares is sub-stantially and regularly traded on a recognised stock exchange (e.g., the NASDAQ or New York Stock Exchange in the United States or the National Stock Exchange in India).
3. The U.S.-U.K. Treaty LOB Provision – Article 23 :
The current tax treaty with U.K. (‘UK Treaty’) entered into force in March 2003. It is illustrative of the United States’ more recent policy towards its income tax treaties, which is to extend significant tax breaks to its treaty partners. In this regard, the UK Treaty can provide zero withholding tax on dividends (0%, 5%, or 15%), interest (0%) and royalty (0%) payments if certain requirements are met. These reduced rates generally make it a very desirable treaty to access. Under its LOB provision, however, the U.S. has ensured that only certain categories of residents are granted these treaty benefits. The LOB provision is more extensive than the ‘India Treaty’; providing more tests under which a resident may qualify for treaty benefits, but in all cases it provides a high bar requiring that only those companies with significant substance and business activities or connections in the United Kingdom qualify.
Under paragraphs 2(c), 2(f),and 4 of Article 23, there is a Publicly Traded Company Test, an Ownership / Base-erosion Test, and an Active Trade or Business Test, respectively.
Although these LOB tests are similar to the LOB tests under the ‘India Treaty’, there are some important differences under the Publicly Traded Company Test. Under this Publicly Traded Company Test, a publicly traded company includes companies whose principal class of stock is listed on a ‘recognised stock exchange’, just like under the ‘India Treaty’. However, the recognised stock exchanges under this Publicly Traded Company Test include not only exchanges in the Contracting States, but also the stock exchanges of Ireland, Switzerland, Amsterdam, Brussels, Frankfurt, Hamburg, Johannesburg, Madrid, Milan, Paris, Stockholm, Sydney, Tokyo, Toronto and Vienna. In addition, this Publicly Traded Company Test includes a subsection that allows certain subsidiaries of a publicly traded company to qualify for the ‘U.K. Treaty’ benefits. Under this part of the test, a company resident in one of the Contracting States that is at least 50% held by vote and value by five or fewer publicly traded companies that qualify for treaty benefits under the Publicly Trade Company Test may also qualify for ‘U.K. Treaty’ benefits (e.g., a wholly-owned U.K. subsidiary of a Ll.K, publicly traded company whose shares are regularly traded on the London Stock Exchange). Thus, the Publicly Traded Company Test allows more publicly traded companies and their subsidiaries that are residents of either Contracting State to qualify for UK Treaty Benefits than those under the ‘India Treaty’.
The Active Trade or Business Test in both treaties is substantially the same. However, unlike the ‘India Treaty’, the U.S. Treasury Technical Explanation to the ‘u.K. Treaty’ does provide a definition of an active ‘trade or business’ for purposes of qualifying for treaty benefits under this test. In this regard, from a U.S. perspective, a U.K. company will be treated as carrying on an active trade or business if it carries on a ‘specific unified group of activities that constitute an independent economic enterprise carried on for profit.’ In addition, ‘a corporation will be considered to carryon a trade or business only if the officers and employees of the corporation conduct substantial managerial and operational activities.’ Further, any company whose function is to make or manage investments for its own account will not be treated as carrying on an active trade or business (unless it’s in the banking, insurance or securities business). The Technical Explanation makes clear that headquarters operations are considered in the business of managing investments, and therefore, the United States will not treat such companies as qualifying for treaty benefits under this test.
In addition to the tests above, the ‘U.K. Treaty’ also has Derivatives Benefits Test that is not found in the ‘India Treaty’. This test expands the types of resident companies that may qualify for ‘U’K. Treaty’ benefits. It allows a resident company that cannot satisfy one of the other tests to qualify for treaty benefits if it is owned by third country residents that meet certain requirements. Under this test, a resident company will be entitled to treaty benefits with respect to an item of income, profit or gain if: (1) at least 95% of vote and value of the company is owned, directly or indirectly, by 7 or fewer persons who are ‘equivalent beneficiaries’; and (2) less than 50% of the company’s gross income for the taxable period in which the item of income, profit or gain arises is paid or accrued, directly or indirectly, to persons who are not equivalent beneficiaries, in the form of deductible payments. The treaty defines an ‘equivalent beneficiary’ as a resident of an EU country or of a European Economic Area state (e.g., France, Ireland, Germany, or the Netherlands, etc.) or NAFTA states (Canada and Mexico). The equivalent beneficiary must also be entitled to all the benefits of a tax treaty between an EU country, a European Economic Area state or NAFTA state and the Contracting State from which the ‘U.K. Treaty’ benefits are claimed (the ‘Third Country Treaty’). Further, with respect to claiming treaty benefits for dividends, interest, or royalties, the equivalent beneficiary must be entitled under the Third Country Treaty to a rate of tax on the income for tvhich benefits are being claimed that is at least as low as the rate applicable under the ‘U.K. Treaty’.
The Derivatives Benefits Test can be illustrated with the following example. A U.K. resident company owns a U’.S. subsidiary and is owned 100% by a publicly traded company in France. The U.S. subsidiary pays a dividend to the U.K. resident company. Under the ‘U.K. Treaty’, the u.K. resident company does not satisfy any of the other LOB tests. Its French parent, however, does qualify for benefits under the U.S.-France Income Tax Treaty, which provides a 5% withholding tax rate on dividend payments. Thus, the U.K. resident company will be entitled to the ‘U.K. Treaty’ benefits for dividend payments it receives from the U.S. subsidiary. The treaty rate will be limited to 5% and not the 0% the ‘Ll.K. Treaty’ provides, because that is the lowest rate its French parent would be granted under the U.S.-France Income Tax Treaty.
4. How to Structure Investments into the United States:
Because of LOB provisions it may be that, the most tax-efficient way for an Indian company to reduce the U.S. tax on dividends, interest, royalties and other investment income is to hold its U.S. investment directly and to try and qualify for benefits under the ‘India Treaty’. However, if the company has extensive operations in another country that has a treaty with the United States which gives better treaty benefits than the ‘India Treaty’, then it may be worthwhile considering using that treaty. The ‘UK Treaty’ is the best example of such a treaty.
Planning Example:
An Indian corporation in the pharmaceutical business owns 100% of an existing U.K. subsidiary that in turn owns 100% of a U.S. subsidiary. The U.K. subsidiary owns a factory in the United Kingdom that produces a variety of products that are marketed and distributed in a number of European countries by third parties and in the United States by the U.S. subsidiary. The Ll.S, subsidiary regularly makes dividend distributions to the U.K. subsidiary, which it uses to expand in its U.K. manufacturing operations. Assuming certain requirements are satisfied under Article 10 (Dividends), the U.K. subsidiary should be able to qualify for treaty benefits under the Active Trade or Business Test to reduce the U.S. withholding tax on dividends from 30% to zero. This is a better withholding tax result than if the Indian corporation had directly invested in the U.S. subsidiary and obtained a 15% U.S. withholding tax rate on dividend distributions from the U.S.
Conclusion:
The tax environment in India is very challenging from an inbound and outbound perspective today. India is keen to receive its share of the tax revenues available in cross-border transactions. To this end it seems to be heading on a policy path similarly taken by the U.S. years ago to allow only a clearly identified group of persons access to its income tax treaties and the tax benefits they provide. The use of LOB provisions in Indian income tax treaties will be something to take into consideration by foreign investors to avoid being treated as treaty shopping. For Indian companies expanding into the U.S., they will have to take a closer look at its tax treaties and the challenging requirements set out by the LOB provisions within them to effectuate tax-efficient structures for their overseas business operations.
