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Treaty Abuse – Doctrine Into Practice (January 13, 2004) Any cross-border financing (“CBF”) is at risk of attack if it relies on a treaty for a result not intended by the two negotiating governments. We have recommended that our clients keep this basic principle in mind when assessing any current or potential CBF, because a US court may well consider it in deciding if a CBF is legitimate. For example, the US § 894 regulatory Preamble (1997) says: [S]tated simply, tax treaties contemplate that income relieved from taxation in the source country will be subject to tax in the treaty country. This principle is central to the interpretation of treaty provisions in determining the extent to which payments … are eligible for benefits under tax treaties. The US Treasury has reiterated this principle in regulations twice since then. In the domestic reverse hybrid (“DRH”) regulations, the principle was asserted to mean that if the US eliminates its withholding tax on interest, it expects its treaty partner to tax that income on a reasonably equivalent basis to interest income. The UK holds a similar view. A senior Inland Revenue official at a private dinner in London last spring said that the proper role of treaties was to eliminate double taxation, not all taxation, and Inland Revenue would evaluate transactions accordingly. The US-UK consensus on this treaty principle may directly affect some CBFs currently in use. While we were preparing a second opinion recently on a UK-US financing, an IRS official told us that it constituted a potential treaty abuse because it produced a deductible US payment but a UK non-income receipt. Our source said that the IRS had discussed the transaction with an Inland Revenue official who also considered it to be a treaty abuse. These views are not surprising since the financing was indistinguishable from the following IRS description of a DRH in the Preamble to the final DRH regulations: The overall effect of these [DRH] transactions if respected, would be (1) a deduction under US law for the “outbound” payment of an item of income, (2) the reduction or elimination of U.S. withholding tax on that item of income under an applicable treaty, and (3) the imposition of little or no tax by the treaty partner on the item of income. This result is inconsistent with the expectation of the United States and its treaty partners that treaties should be used to reduce or eliminate double taxation of income. If such financings come under attack by either the US or UK, it will be yet another warning that a treaty abuse potential cannot be ignored in assessing a potential CBF. (For further information, contact either Dan Burt or John Staples) Disclaimer: We call these "client letters" because we use them to keep our clients informed. We also send them to friends of the firm and other people who have asked to receive them. We have posted these items on our website so people can get an idea of what kind of firm we are. Your reading of these letters does not create an attorney-client relationship with us. Please contact us if you have any questions... |
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