ARTICLE 17

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. This statement begs the question of who is to be treated as a resident of a Contracting State for the purpose of being granted treaty benefits. The Commentaries to the OECD Model authorize a tax authority to deny benefits, under substanceover-form principles, to a nominee in one 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 Commentaries to Article 1 contain an extensive discussion approving the use of such provisions in tax treaties in order to limit the ability of third-country 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 benefits to any resident of a Contracting State creates possibilities for "treaty shopping": the use, by residents of third countries, of legal entities established in a Contracting State with a principal purpose of obtaining the benefits of a tax treaty between the United States and the other Contracting State. It is important to note that this definition of treaty shopping does not encompass every case in which a third-country resident establishes an entity in a U.S. treaty partner, and that entity enjoys treaty benefits to which the third-country 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 structure would not fall within the definition of treaty shopping set forth above.

Of course, the fundamental problem presented by this approach is that it is based on the taxpayer's intent, which a tax administrator is normally ill-equipped to identify. In order to avoid the necessity of making this subjective determination, Article 17 sets forth a series of objective

tests. The assumption underlying each of these tests is that a taxpayer that satisfies the requirements of any of the tests probably 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.

For instance, the assumption underlying the active trade or business test under paragraph 1 (d) is that a third-country resident that establishes a "substantial" operation in Venezuela and that derives income from a related activity in the United States would not do so primarily to avail itself of the benefits of the treaty; it is presumed in such a case that the investor had a valid business purpose for investing in Venezuela, 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 Venezuela. It is considered unlikely that the investor would incur the expense of establishing a substantial trade or business in Venezuela simply to obtain the benefits of the Convention. A similar rationale underlies other tests in Article 17.

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 17 also includes a provision (paragraph 4) authorizing the competent authority of a Contracting State to grant benefits. While an analysis under paragraph 4 may well differ from that under one of the other tests of Article 17, its objective is the same: to identify investors whose residence in the other State can be justified by factors other than a purpose to derive treaty benefits.