Article 28 assures that source — U.S. Income Tax Treaty

to the Convention are limited to the intended beneficiaries-residents of the other Contracting State -and are not extended to residents of third States not having a substantial business in, or business nexus with, the other Contracting State. For example, a resident of a third State might establish an entity resident in a Contracting State for the purpose of deriving income from the other Contracting State and claiming source State benefits with respect to that income. Absent Article 28, the entity would generally be entitled to benefits as a resident of a Contracting State, subject, however, to such limitations (e.g., business purpose, substance-over-form, step transaction or conduit principles) as may be applicable to the transaction or arrangement under the domestic law of the source State.

The structure of the Article is as follows: Paragraph 1 lists a series of attributes of a resident of a Contracting State, the presence of any one of which will entitle that person to benefits of the Convention in the other Contracting State. Several of these, which will be discussed first, are purely objective tests. One, in subparagraph (c), is more subjective, and requires some elaboration and interpretation. Paragraph 2 provides that benefits may be granted even to a person not entitled to benefits under the tests of paragraph 1, if the competent authority of the source State so determines. Paragraph 3 defines the term "recognized stock exchange" as used in paragraph 1. Paragraph 4 authorizes the competent authorities to develop agreed applications of the Article and to exchange information necessary for carrying out the provisions of the Article.

A memorandum of understanding was developed by the negotiators indicating how the provisions of the Article are to be understood both by the competent authorities and by taxpayers in the Contracting States. It is anticipated that as the competent authorities and taxpayers gain more experience with the concepts in this Article, some of which are relatively new, further guidance will be developed and made public.

Two categories of persons eligible for benefits from the other Contracting State under

subparagraphs (a) and (b) of paragraph 1 are

(1) individual residents of a Contracting State and (2) the Contracting States, political subdivisions or local authorities thereof.

It is most unlikely that persons falling into these two categories can be used to derive treatybenefited income, as the beneficial owner of the income, on behalf of a third-country person. If an individual is receiving income as a nominee on behalf of a third-country resident, benefits will be denied with respect to those items of income under the articles of the Convention which grant the benefit, because of the requirements in those articles that the beneficial owner of the income be a resident of a Contracting State.

Under subparagraph (d) a corporation which is a resident of a Contracting State is entitled to treaty benefits from the other Contracting State if there is substantial and regular trading in the corporation's principal class of shares on a recognized stock exchange. The term "recognized stock exchange" is defined in paragraph 3 of the Article to mean, in the United States, the NASDAQ System and any stock exchange which is registered as a national securities exchange with the Securities and Exchange Commission, and, in Germany, any German stock exchange on which registered dealings in shares take place. Paragraph 3 also provides that the competent authorities may, by mutual agreement, recognize additional exchanges for purposes of subparagraph 1(d).

Subparagraph (e) of paragraph 1 provides a two-part test, the so-called ownership and base erosion tests, both of which must be met for entitlement to benefits under this subparagraph. under these tests, benefits will be granted to a resident of a Contracting State other than an individual, if both

(1) more than 50 percent of the beneficial interest in the person (or, in the case of a corporation, more than 50 percent of each class of its shares) is owned, directly or indirectly, by persons who are themselves entitled to benefits under the other tests of paragraph 1 (other than subparagraph (c)), or by U.S. citizens, and

(2) more than 50 percent of the person's gross income is not used, directly or indirectly, to make deductible payments to persons, other than persons who are themselves eligible for benefits under the other tests of paragraph 1 (other than subparagraph (c)), or to U.S. citizens.

It is understood that the term "gross income" is to be interpreted as in U.S. law. Thus, in general, the term should be understood to mean gross receipts less cost of goods sold.

The rationale for this two-part test is that since treaty benefits can be indirectly enjoyed not only by equity holders of an entity, but also by that entity's various classes of obligees, such as lenders, licensors, service providers, insurers and reinsurers, and others, it is not enough, in order to prevent such benefits from inuring substantially to third-country residents, merely to require substantial ownership of the entity by treaty country residents or their equivalent. It is also necessary to require that the entity's deductible payments be made in substantial part to such treaty country residents or their equivalents. For example, a third-country resident could lend funds to a German-owned German corporation to be reloaned to the United States. The U.S. source interest income of the German corporation would be exempt from U.S. withholding tax under Article 11 (Interest) of the Convention. While the German corporation would be subject to

German corporation income tax, its taxable income could be reduced to near zero by the deductible interest paid to the third-country resident. If, under a Convention between Germany and the third country, that interest is exempt from German tax, the U.S. treaty benefit with respect to the U.S. source interest income will have flowed to the third-country resident.

Subparagraph (f) provides that a not-for-profit organization which is a resident of a Contracting State is entitled to benefits from the other Contracting State if it satisfies two conditions:

(1) It must be generally exempt from tax in its State of residence by virtue of its not-forprofit status, and

(2) more than half of the beneficiaries, members or participants, if any, in the organization must be persons entitled, under this Article, to the benefits of the Convention.

Paragraph 28 of the protocol clarifies that the not-for-profit organizations dealt within subparagraph l(f) include pension funds, pension trusts, private foundations, trade unions, trade associations and similar organizations. A pension fund or trust or similar entity created for the purpose of providing retirement, disability or other employment benefits is entitled to the benefits of the Convention if the organization sponsoring the fund, trust or entity is entitled to the Convention's benefits under Article 28. Thus, one need not determine that more than half of the beneficiaries of a German pension plan are residents of Germany in deciding whether the plan is entitled to U.S. treaty benefits in respect of its income so long as the German corporation sponsoring the fund is entitled to benefits under Article 28, because, for example, it is publicly traded on the Frankfurt stock exchange. If, however, the sponsoring organization is not entitled to benefits, the tests of subparagraph 10 must be met. Under the provision of Article 27 (Exempt Organizations), a not- for-profit organization, otherwise dealt within subparagraph 1(f) of Article 28, which is operated exclusively for religious, charitable, scientific, educational or other public purposes, is eligible for the source exemption provided by Article 27, notwithstanding any provisions of Article 28. Thus, a German charitable organization receiving dividend income from the United States is exempt from U.S. withholding tax under Article 27, even if all of the beneficiaries of the charity are residents of a third country.

Subparagraph 1(c) of Article 28 provides a test for eligibility for benefits which looks not solely at objective characteristics of the person deriving the income, but at the nature of the activity engaged in by that person and the connection between the income and that activity. Under the subparagraph, a resident of a Contracting State deriving income from the other Contracting State is entitled to benefits if the person Is engaged in an active trade or business in his State of residence, and the item of income in question is derived in connection with, or is incidental to, that trade or business. Income which is derived in connection with, or is incidental to, the business of making or managing investments will not qualify for benefits under this provision, unless the business is a bank or insurance company engaged in banking or insurance activities.

In general, it is expected that if a person qualifies for benefits under the other subparagraphs of paragraph 1, no inquiry will be made into qualification for benefits tinder subparagraph l(c). Upon satisfaction of any of the other tests of paragraph 1, any income derived by the beneficial owner from the other Contracting State is entitled to treaty benefits. Under

subparagraph 1(c), however, the test is applied separately for each item of income.

It is intended that the provisions of subparagraph 1(c) will be self-executing. Unlike the provisions of paragraph 2, discussed below, claiming benefits under this subparagraph does not require advance competent authority ruling or approval. The tax authorities may, of course, on review, determine that the taxpayer has improperly interpreted the subparagraph and is not entitled to the benefits claimed.

A memorandum was exchanged at the time of the signing of the Convention which suggests, by means of examples, the understandings reached by the negotiators as to the intended scope of subparagraph 1(c). The examples, structured for purposes of exposition in terms of a German entity claiming U.S. treaty benefits, are reproduced in the following paragraphs. They are not intended to be exhaustive, but are merely illustrative of the kinds of considerations which are relevant in making a determination as to whether a particular case falls within the scope of the subparagraph 1(c).

Example I

Facts: A German resident company is owned by three persons, each resident in a different third country. The company is engaged in an active manufacturing business in Germany. It has a wholly-owned subsidiary in the United States which has been capitalized with debt and equity. The subsidiary is engaged in selling the output of the German parent. The active manufacturing business in Germany is substantial in relation to the activities of the U.S. subsidiary. Are the subsidiary's interest and dividend payments to its German parent eligible for treaty benefits in the United States?

Analysis: Treaty benefits would be allowed because the treaty requirement that the U.S. income is "derived in connection with or is incidental to" the German active business is satisfied. This conclusion is based on two elements in the fact pattern presented:

(1) the income is connected with the active German business in this example in the form of a "downstream" connection; and

(2) the active German business is substantial in relation to the business of the U.S. subsidiary.

Example II

Facts: The facts are the same as Example I except that while the income is derived by the German parent of the U.S. subsidiary, the relevant business activity in Germany is carried on by a German subsidiary corporation. The German subsidiary's activities meet the business relationship and substantiality tests of the business connection provision, as described in the preceding example. Are the U.S. subsidiary's dividends and interest payments to the German parent eligible for U.S. treaty benefits?

Analysis: Benefits are allowed because the two German entities (i.e., the one deriving the income and the one carrying on the substantial active business in Germany) are related. Benefits are not denied merely because the income is earned by a German holding company and the relevant activity is carried on in Germany by a German subsidiary. The existence of a similar holding company structure in the United States would not affect the right of the German parent to treaty benefits. Thus, if the German parent owns a subsidiary in the United States which is, itself, a holding company for the group's U.S. activities, which are related to the business activity in Germany, dividends paid by the U.S. holding company to the German parent holding company would be tested for eligibility for benefits in the same way as described above, ignoring the fact that the activities are carried on by one entity and the income in respect of which benefits are claimed is paid by another, related, entity.

Example III

Facts: A German resident company is owned by three persons, each resident in a different third country. The company is the worldwide headquarters and parent of an integrated international business carried on through subsidiaries in many countries. The company's wholly-owned U.S. and German subsidiaries manufacture, in their countries of residence, products which are part of the group's product line. The United States subsidiary has been capitalized with debt and equity. The active manufacturing business of the German subsidiary is substantial in relation to the activities of the U.S. subsidiary. The German parent manages the worldwide group and also performs research and development to improve the manufacture of the group's product line. Are the U.S. subsidiary's dividend and interest payments to its German parent eligible for treaty benefits in the United States?

Analysis: Treaty benefits would be allowed because the treaty requirement that the United States income is "derived in connection with or is incidental to" the German active business is satisfied. This conclusion is based on two elements in the fact pattern presented:

(1) the income is connected with the German active business because the United States subsidiary and the German subsidiary manufacture products which are part of the group's product line, the German parent manages the worldwide group, and the parent performs research and development that benefits both subsidiaries; and

(2) the active German business is substantial in relation to the business of the U.S. subsidiary.

Example IV

Facts: A third-country resident establishes a German corporation for the purpose of acquiring a large U.S. manufacturing company. The sole business activity of the German corporation (other than holding the stock of the U.S. corporation) is the

operation of a small retailing outlet which sells products manufactured by the U.S. company. Is the German corporation entitled to treaty benefits under subparagraph 1(c) with respect to dividends it receives from the U.S. manufacturer?

Analysis: The dividends would not be entitled to benefits. Although there is, arguably, a business connection between the U.S. and the German businesses, the "substantiality" test described in the preceding examples is not met.

Example V

Facts: German, French and Belgian corporations create a joint venture in the form of a partnership organized in Germany to manufacture a product in a developing country. The joint venture owns a U.S. sales corporation, which pays dividends to the joint venture. Are these dividends eligible for U.S.-German treaty benefits?

Analysis: Under Article 4, only the German partner is a resident of Germany for purposes of the treaty. The question arises under this treaty, therefore, only with respect to the German partner's share of the dividends. If the German partner meets the ownership and base erosion or the public trading tests of subparagraph 1(d) or (e), it is entitled to benefits without reference to subparagraph 1(c). If not, the analysis of the previous examples would be applied to determine eligibility for benefits under 1(c). The determination of treaty benefits available to the French and Belgian partners will be made under the United States treaties with France and Belgium.

Example VI

Facts: A German corporation, a French corporation and a Belgian corporation create a joint venture in the form of a German resident corporation in which they take equal shareholdings. The joint venture corporation engages in an active manufacturing business in Germany. Income derived from that business that is retained as working capital is invested in U.S. Government securities and other U.S. debt instruments until needed for use in the business. Is interest paid on these instruments eligible for U.S.- German treaty benefits?

Analysis: The interest would be eligible for treaty benefits. Interest income earned from short-term investment of working capital is incidental to the business in Germany of the German joint venture corporation.

Paragraph 2 of Article 28 provides that a resident of a Contracting State that derives income from the other Contracting State and is not entitled to the benefits of the Convention under any of the provisions of paragraph 1, may, nevertheless, be granted benefits at the discretion of the competent authority of the Contracting State in which the income arises.

The paragraph itself provides no guidance to competent authorities or taxpayers as to

how the discretionary authority is to be exercised. The memorandum of understanding does provide some discussion and guidance. Relevant portions of that memorandum are reproduced in the discussion which follows.

It is assumed that, for purposes of implementing paragraph 2, a taxpayer will be permitted to present his case to his competent authority for an advance determination based on the facts, and will not be required to wait until the tax authorities of one of the Contracting States have determined that benefits are denied. In these circumstances, it is also expected that if the competent authority determines that benefits are to be allowed, they will be allowed retroactively to the time of entry into force of the relevant treaty provision or the establishment of the structure in question, whichever is later.

In making determinations under paragraph 2, it is understood that the competent authorities will take into account all relevant facts and circumstances. The factual criteria which the competent authorities are expected to take into account include the existence of a clear business purpose for the structure and location of the income earning entity in question; the conduct of an active trade or business (as opposed to a mere investment activity) by such entity; and a valid business nexus between that entity and the activity giving rise to the income. The competent authorities will, furthermore, consider, for example, whether and to what extent a substantial headquarters operation conducted in a Contracting State by employees of a resident of that State contributes to such valid business nexus, and should not, therefore, be treated merely as the "making or managing [of] investments" within the meaning of subparagraph 1(c) of Article 28.

The discretionary authority granted to the competent authorities in paragraph 2 is thought to be particularly important in view of the developments in, and objectives of, international economic integration, such as that among the member countries of the European Communities and between the United States and Canada. It is expected that the authority will be exercised with particular cognizance of those factors.

The following example illustrates the application of these principles :

Facts: German, French and Belgian companies, each of which is engaged directly or through its affiliates in substantial active business operations in its country of residence, decide to cooperate in the development, production and marketing of an advanced passenger aircraft through a corporate joint venture with its statutory seat in Germany. The development, production and marketing aspects of the project are carried out by the individual joint ventures. The joint venture company, which is staffed with a significant number of managerial and financial personnel seconded by the joint ventures, acts as the general headquarters for the joint venture, responsible for the overall management of the project including coordination of the functions separately performed by the individual joint ventures on behalf of the joint venture company, the investment of working capital contributed by the joint ventures and the financing of the project's additional capital requirements through public and private borrowings. The joint venture company derives portfolio investment income from U.S. sources. Is this

income eligible for benefits under the U.S.-German treaty?

Analysis: If the joint venture corporations' activities constitute an active business and the income is connected to that business, benefits would be allowed under subparagraph 1(c). If not, it is expected that the U.S. competent authority would determine that treaty benefits should be allowed in accordance with paragraph (2) under the facts presented, particularly in view of

(1) the clear business purpose for the formation and location of the joint venture company;

(2) the significant headquarters functions performed by that company in addition to financial functions; and

(3) the fact that all of the joint ventures are corporations resident in EEC member countries in which they are engaged directly or through their affiliates in substantial active business operations.