Article 22 (Limitation on Benefits)

Purpose of Limitation on Benefits Provisions

The United States views an income tax treaty as a vehicle for providing treaty benefits to residents of the two Contracting States. The proper operation of a treaty requires that it apply to those that are bona fide residents of one of the Contracting States for the purpose of being granted treaty benefits. This principal has long been recognized. For example, the Commentaries to the OECD Model authorize a tax authority to deny treaty benefits, under substance-over-form principles, to a nominee in one Contracting State deriving income from the other on behalf of a third-country resident. In addition, although the text of the OECD Model does not contain express anti-abuse provisions, the Commentary to Article 1 contains an extensive discussion regarding the appropriateness of such provisions in tax treaties in order to limit the ability of third state residents to obtain treaty benefits. The United States holds strongly to the view that tax treaties should include provisions that specifically prevent misuse of treaties by residents of third countries. Consequently, all recent U.S. income tax treaties contain comprehensive Limitation on Benefits provisions.

A treaty that provides treaty benefits to any resident of a Contracting State permits “treaty shopping”: the use, by residents of third states, of legal entities established in a Contracting State with a principal purpose to obtain the benefits of a tax treaty between the United States and the other Contracting State. Treaty shopping does not encompass every case in which a third state resident establishes an entity in a U.S. treaty partner, and that entity enjoys treaty benefits to which the third state resident would not itself be entitled. If the third country resident had substantial reasons for establishing the structure that were unrelated to obtaining treaty benefits, the use of the entity in the U.S. treaty partner would not fall within this concept of treaty shopping.

An anti-treaty shopping approach that required the tax authority to investigate the taxpayer's motives in establishing an entity in a particular country would be difficult to administer. In order to avoid the necessity of making such a subjective determination, Article 22 sets forth a series of objective tests. The assumption underlying each of these tests is that a taxpayer that satisfies the requirements of the test likely has a real business purpose for the structure it has adopted, or has a sufficiently strong nexus to the other Contracting State ( e.g., a resident individual) to warrant benefits even in the absence of a business connection, and that this business purpose or connection is sufficient to justify the conclusion that obtaining the benefits of the treaty is not a principal purpose of establishing or maintaining residence in that other Contracting State.

For instance, the assumption underlying the active trade or business test under paragraph 2 is that a third country resident that establishes a “substantial” operation in Japan and that derives income from a similar activity in the United States would not do so primarily to avail itself of the benefits of the Convention; it is presumed in such a case that the investor had a valid business purpose for investing in Japan, and that the link between that trade or business and the U.S. activity that generates the treaty-benefited income manifests a business purpose for placing the U.S. investments in the entity in Japan. It is considered unlikely that the investor would incur

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the expense of establishing a substantial trade or business in Japan simply to obtain the benefits of the Convention. A similar rationale underlies other tests in Article 22.

While these tests provide useful surrogates for identifying actual intent, these mechanical tests cannot account for every case in which the taxpayer was not treaty shopping. Accordingly, Article 22 also includes a provision (paragraph 4) authorizing the competent authority of a Contracting State to grant benefits in situations where none of the other tests of Article 22 is met. While an analysis under paragraph 4 may well differ from that under one of the other tests of Article 22, its objective is the same: to identify investors whose residence in the other Contracting State can be justified by factors other than a purpose to derive treaty benefits.