Generally, a 30% U.S. withholding tax applies to payments of U.S. sourced income made to foreign persons. If the foreign person qualifies for benefits under an income tax treaty with the U.S., the withholding tax rate may be reduced.
In order to qualify for benefits under an income tax treaty, a foreign person must satisfy the limitation on benefits (“LOB”) article of the treaty. LOB provisions are aimed at eliminating treaty shopping.
If a foreign entity qualifies for a reduced rate of U.S. withholding tax provided by a treaty, it must generally provide Form W-8BEN-E to the U.S. payor. Among other things, on Form W-8BEN-E the foreign entity certifies under penalties of perjury that it qualifies for benefits under the relevant income tax treaty. Form W-8BEN-E is not filed with the IRS. Instead, the U.S. payor retains Form W-8BEN-E to substantiate the reduced rate of withholding in the case of an audit.
Form 1042-S must be filed annually by U.S. payors who have made payments of U.S. sourced income to foreign persons. In general, the form reports to the IRS the amount of income, type of income, name of recipient, and amount of U.S. tax withheld (if any).
Recently the IRS released new versions of Form W-8BEN-E and Form 1042-S. In the past, a foreign entity claiming treaty benefits did not need to identify which specific LOB provision it satisfied. It would simply certify that it satisfied at least one of the LOB provisions in the relevant treaty. Form W-8BEN-E now requires that a foreign entity claiming treaty benefits specifically identify which LOB provision it satisfies. The U.S. payor is now required to communicate this information to the IRS on the updated Form 1042-S, which now asks for the coinciding LOB code in box 13j.
In Part III of Form W-8BEN-E, there are 10 different boxes that represent the most commonly relied upon LOB provisions. The boxes include governments, tax-exempt pension trusts or pension funds, other tax-exempt organizations, publicly-traded corporations, subsidiaries of publicly-traded corporations, etc.
The LOB provisions most commonly utilized by closely held companies include the ownership-base erosion test, the derivative benefits test, and the active trade or business test. These three tests are discussed below.
Ownership-Base Erosion Test
The ownership-base erosion test generally requires that more than 50% of the vote and value of the company's shares be owned, directly or indirectly, by residents of the same country as the company. This is the “ownership” prong of the test.
In general, the second requirement is that less than 50% of the company's gross income is accrued or paid, directly or indirectly, to persons who are not residents of the same country as the company. This is the “base erosion” prong of the test.
For an example of why the base erosion prong of the test is needed to counter treaty shopping, see the chart below.
Derivative Benefits Test
The derivative benefits test is generally limited to NAFTA, EU, and EEA country treaties, and may apply to all benefits or only to certain items of income (interest, dividends, and royalties). It generally requires that more than 95% of the aggregate vote and value of the company's shares be owned, directly or indirectly, by seven or fewer equivalent beneficiaries. Equivalent beneficiaries are ultimate owners who are resident in a NAFTA, EU, or EEA country and are entitled to identical benefits under their own treaty with the U.S. under one of the ownership tests included within the LOB article (other than the ownership-base erosion test).
In addition, the derivative benefits test requires that less than 50% of the company's gross income be paid or accrued, directly or indirectly, to persons who would not be equivalent beneficiaries.
For an example of the derivative benefits test from the U.K. – U.S. Income Tax Treaty, see the chart below.
Active Trade or Business Test
The active trade or business test generally requires that the company be engaged in an active trade or business in its country of residence, that its activities in that country be substantial in relation to its U.S. activities, if the payer is a related party, and the income be derived in connection with or incidental to that trade or business.
For an example of the active trade or business test from the Switzerland – U.S. Income Tax Treaty, see the chart below.
It is important to note that the U.S. has income tax treaties with over 60 countries. Every treaty is different. While the Form W-8BEN-E lists 10 different LOB provisions, the relevant treaty may only include some of the LOB provisions or include other additional tests. For example, a corporation resident in Cyprus cannot rely upon the active trade or business test, because the Cyprus – U.S. Income Tax Treaty does not include that test in its LOB article.
In addition, there is variance between the treaties in how certain tests are applied, e.g., the ownership-base erosion test in one treaty may be different than the ownership-base erosion test in another treaty.
Any foreign entity claiming treaty benefits should carefully analyze the tax treaty it is relying upon to determine which limitation on benefits provision it meets. On the new Form W8-BEN-E, the foreign entity must certify to the U.S. payor which specific limitation on benefits provision it satisfies. The U.S. payor will report that limitation on benefits provision to the IRS on the updated Form 1042-S.
We have created a flowchart related to the LOB provisions in the Mexico – U.S. Income Tax Treaty. The flowchart is available for free at Tax-Charts.com, where flowcharts related to the LOB provisions in several other treaties are also available.