Article IV of the Protocol — U.S. Income Tax Treaty

Article 10 provides rules for the taxation of dividends paid by a company that is a resident of one Contracting State to a beneficial owner that is a resident of the other Contracting State. The Article provides for full residence country taxation of such dividends and a limited source-State right to tax.

Paragraph 1

The right of a shareholder's country of residence to tax dividends arising in the source country is preserved by paragraph 1, which permits a Contracting State to tax its residents on dividends paid to them by a company that is a resident of the other Contracting State.

Paragraph 2

The State of source also may tax dividends beneficially owned by a resident of the other State, subject to the limitations of paragraphs 2 and 3. Paragraph 2 generally limits the tax in the State of source on the dividend paid by a company resident in that State to 15 percent of the gross amount of the dividend. If, however, the beneficial owner of the dividend is a company that is a resident of the other State and that directly owns shares representing at least 10 percent of the voting power of the company paying the dividend, then the withholding tax in the State of source is limited to 5 percent of the gross amount of the dividend. Shares are considered voting shares if they provide the power to elect, appoint or replace any person vested with the powers ordinarily exercised by the board of directors of a U.S. corporation.

The benefits of paragraph 2 may be granted at the time of payment by means of reduced withholding at source. It also is consistent with the paragraph for tax to be

withheld at the time of payment at full statutory rates, and the treaty benefit to be granted by means of a subsequent refund so long as refund procedures are applied in a reasonable manner.

The term "beneficial owner" is not defined in the Convention, and is, therefore, defined as under the internal law of the country imposing tax ( i.e., the source country). The beneficial owner of the dividend for purposes of Article 10 is the person to which the dividend income is attributable for tax purposes under the laws of the source State. Thus, if a dividend paid by a corporation that is a resident of one of the States (as determined under Article 4 (Residence)) is received by a nominee or agent that is a resident of the other State on behalf of a person that is not a resident of that other State, the dividend is not entitled to the benefits of this Article. However, a dividend received by a nominee on behalf of a resident of that other State would be entitled to benefits. These interpretations are confirmed by paragraph 12 of the Commentary to Article 10 of the OECD Model. See also paragraph 24 of the Commentary to Article 1 of the OECD Model.

Companies holding shares through fiscally transparent entities such as partnerships are considered for purposes of this paragraph to hold their proportionate interest in the shares held by the intermediate entity. As a result, companies holding shares through such entities may be able to claim the benefits of subparagraph (a) under certain circumstances. The lower rate applies when the company’s proportionate share of the shares held by the intermediate entity meets the 10 percent threshold. Whether this ownership threshold is satisfied may be difficult to determine and often will require an analysis of the partnership or trust agreement.

The determination of whether the ownership threshold for subparagraph 2(a) is met for purposes of the 5 percent maximum rate of withholding tax is made on the date on which entitlement to the dividend is determined. Thus, in the case of a dividend from a U.S. company, the determination of whether the ownership threshold is met generally would be made on the dividend record date.

Paragraph 3

Paragraph 3 provides exclusive residence-country taxation ( i.e., an elimination of withholding tax) with respect to certain dividends distributed by a company that is a resident of one Contracting State to a resident of the other Contracting State. As described further below, this elimination of withholding tax is available with respect to certain inter-company dividends and with respect to tax-exempt pension funds.

Subparagraph (a) of paragraph 3 provides for the elimination of withholding tax on dividends beneficially owned by a company that has owned 80 percent or more of the voting power of the company paying the dividend for the 12-month period ending on the date entitlement to the dividend is determined. The determination of whether the beneficial owner of the dividends owns at least 80 percent of the voting power of the paying company is made by taking into account stock owned both directly and stock owned indirectly through one or more residents of either Contracting State.

Eligibility for the elimination of withholding tax provided by subparagraph (a) is subject to additional restrictions based on, but supplementing, the rules of Article 17 (Limitation on Benefits). Accordingly, a company that meets the holding requirements described above will qualify for the benefits of paragraph 3 only if it also: (1) meets the “publicly traded” test of subparagraph 2(c) of Article 17 (Limitation of Benefits), (2) meets the “ownership base erosion” and “active trade or business” test described in subparagraph 2(e) and subparagraph 4 of Article 17 (Limitation of Benefits), (3) meets the “derivative benefits” test of paragraph 3 of Article 17 (Limitation of Benefits), or (4) is granted the benefits of subparagraph 3(a) of Article 10 by the competent authority of the source State pursuant to paragraph 6 of Article 17 (Limitation on Benefits).

These restrictions are necessary because of the increased pressure on the Limitation on Benefits tests resulting from the fact that the United States has relatively few treaties that provide for such elimination of withholding tax on inter-company dividends. The additional restrictions are intended to prevent companies from reorganizing in order to become eligible for the elimination of withholding tax in circumstances where the Limitation on Benefits provision does not provide sufficient protection against treaty-shopping.

For example, assume that ThirdCo is a company resident in a third country that does not have a tax treaty with the United States providing for the elimination of withholding tax on inter-company dividends. ThirdCo owns directly 100 percent of the issued and outstanding voting stock of USCo, a U.S. company, and of SCo, a Swedish company. SCo is a substantial company that manufactures widgets; USCo distributes those widgets in the United States. If ThirdCo contributes to SCo all the stock of USCo, dividends paid by USCo to SCo would qualify for treaty benefits under the active trade or business test of paragraph 4 of Article 17. However, allowing ThirdCo to qualify for the elimination of withholding tax, which is not available to it under the third state’s treaty with the United States (if any), would encourage treaty-shopping.

In order to prevent this type of treaty-shopping, paragraph 3 requires SCo to meet the ownership-base erosion requirements of subparagraph 2(e) of Article 17 in addition to the active trade or business test of paragraph 4 of Article 17. Thus, SCo would not qualify for the exemption from withholding tax unless (i) on at least half the days of the taxable year, at least 50 percent of each class of its shares was owned by persons that are residents of Sweden and eligible for treaty benefits under certain specified tests and (ii) less than 50 percent of SCo’s gross income is paid in deductible payments to persons that are not residents of either Contracting State. Because SCo is wholly owned by a third country resident, SCo could not qualify for the elimination of withholding tax on dividends from USCo under the ownership-base erosion test and the active trade or business test. Consequently, SCo would need to qualify under another test or obtain discretionary relief from the competent authority under Article 17(6). For purpose of Article 3(a)(ii), it is not sufficient for a company to qualify for treaty benefits generally under the active trade or business test or the ownership-base erosion test unless it qualifies for treaty benefits under both.

Alternatively, companies that are publicly traded or subsidiaries of publiclytraded companies will generally qualify for the elimination of withholding tax. Thus, a company that is a resident of Sweden and that meets the requirements of Article 17(2)(i) or (ii) will be entitled to the elimination of withholding tax, subject to the 12-month holding period requirement of Article 10(3)(a).

In addition, under Article 10(3)(a)(iii), a company that is a resident of a Contracting State may also qualify for the elimination of withholding tax on dividends if it satisfies the derivative benefits test of paragraph 3 of Article 17. Thus, a Swedish company that owns all of the stock of a U.S. corporation may qualify for the elimination of withholding tax if it is wholly-owned, for example, by a U.K., Dutch, or a Mexican publicly-traded company and the other requirements of the derivative benefits test are met. At this time, ownership by companies that are residents of other European Union, European Economic Area or North American Free Trade Agreement countries or that are resident in Switzerland would not qualify the Swedish company for benefits under this provision, as the United States does not have treaties that eliminate the withholding tax on inter-company dividends with any other of those countries. If the United States were to negotiate such treaties with more of those countries, residents of those countries could then qualify as equivalent beneficiaries for purposes of this provision.

The derivative benefits test may also provide benefits to U.S. companies receiving dividends from Swedish subsidiaries, because of the effect of the Parent-Subsidiary Directive in the European Union. Under that directive, inter-company dividends paid within the European Union are free of withholding tax. Under subparagraph (h) of paragraph 7 of Article 17, that directive will also be taken into account in determining whether the owner of a U.S. company receiving dividends from a Swedish company is an “equivalent beneficiary.” Thus, a company that is a resident of a member state of the European Union will, by definition, meet the requirements regarding equivalent benefits with respect to any dividends received by its U.S. subsidiary from a Swedish company. For example, assume USCo is a wholly-owned subsidiary of ICo, an Italian publiclytraded company. USCo owns all of the shares of SCo, a Swedish company. If SCo were to pay dividends directly to ICo, those dividends would be exempt from withholding tax in Sweden by reason of the Parent-Subsidiary Directive, even though the tax treaty between Italy and Sweden otherwise would allow Sweden to impose a withholding tax at the rate of 5 percent. If ICo meets the other conditions of subparagraph 7(g) of Article 17, it will be treated as an equivalent beneficiary by reason of subparagraph 7(h) of that article.

A company also may qualify for the elimination of withholding tax pursuant to Article 10(3)(a)(iii) if it is owned by seven or fewer U.S. or Swedish residents who qualify as an “equivalent beneficiary” and meet the other requirements of the derivative benefits provision. This rule may apply, for example, to certain Swedish corporate joint venture vehicles that are closely-held by a few Swedish resident individuals.