Anti-treaty shopping restrictions in the new U.S.-Netherlands tax treaty.

Introduction

The recently negotiated income tax treaty between the United States and the Netherlands [hereinafter Netherlands-2 Treaty] (1*) and accompanying protocol [hereinafter Netherlands-2 Protocol](2) contain a series of detailed anti-treaty shopping rules that have hitherto been absent in U.S. bilateral tax treaties. Intended primarily to update the antiquated U.S.Netherlands Treaty of 1948 [hereinafter Netherlands-l Treaty],(3) the new treaty represents the U.S. Treasury Department's most successful effort at extending into actual treaty formation extant U.S. statutory and regulatory restrictions on the use of a treaty by residents of a third nation.

Long stymied in its attempts to effectively combat this pervasive treaty-related abuse, the Treasury has increasingly insisted on including stringent anti-treaty shopping articles in tax treaties, as well as limiting the application of existing treaties through restrictive statutes, regulations, and revenue rulings. Nevertheless, the myriad treaty limitations in the Netherlands-2 Treaty are so comprehensive and complex that this treaty can only be regarded as a radical reorganization of the anti-treaty shopping regime.

The Treasury has long realized the critical need to amend its treaty with the Netherlands. Owing to its liberal tax regime governing foreign-source income earned by holding companies, an investor's easy access to its extensive tax treaty network, and the absence of any anti-treaty shopping article in the Netherlands-1 Treaty, few nations offer a better location for treaty shopping than the Netherlands. The Netherlands has become such a favored center for holding investment in the United States that many multinational corporations resident in U.S. treaty partners (such as France and Germany) hold their U.S. subsidiaries through Dutch holding companies.

The United States, on the other hand, provides a poor conduit for third-country investment in the Netherlands since the U.S. tax rules on foreign-source income are far less advantageous, and the United States has far fewer tax treaties in force. Accordingly, the limitations mandated in the Netherlands-2 Treaty can properly be viewed solely as an effort to deny treaty benefits on investment in the United States by non-Dutch residents. Because only foreign investment in the United States will be affected, the restrictions in the new treaty effectively represent a one-way street. The Dutch negotiators were only able to secure specific rules extending the definition of Dutch residency to the entire European Community (EC).(4)

Although the Netherlands-2 Treaty will not enter into effect before the end of 1993, multinational corporations operating through Dutch corporations in the United States should begin to reorganize their investments to meet the new rules. Failure to recognize the implications imposed by the new restrictions may cause the loss of treaty coverage altogether. This article delineates the effect of the Netherlands2 Treaty upon investment in the United States by Dutch corporations. More specifically, it considers the tax benefits offered by the Netherlands-2 Treaty upon such investments and the extensive provisions limiting the treaty's application. Current U.S. policy concerning anti-treaty shopping maneuvers is also discussed.

Treaty-Related Benefits Specific to the Netherlands-2 Treaty

Standard treaty-imposed inducements to foreign investment are provided in the Netherlands-2 treaty. Business profits,(5) interest,(6) royalties,(7) and other income not specifically mentioned in the treaty(8) are not taxed by the source nation unless a permanent establishment or fixed based has been established in the source nation? Dividends may be taxed by both nations, though source nation withholding rates on dividends are set at 5 percent in the case of subsidiaries where the parent holds at least 10 percent of the voting power of the subsidiary and 10 percent otherwise.(10) In the absence of the treaty, U.S. with-holding rates of 30 percent would apply to each category of passive income.(11) The source nation is precluded from taxing shipping and air transport income altogether.(12) The Netherlands-1 Treaty contains similar inducements. Business profits,(13) interest,(14) royalties,(15) and transportation income(16) are also exempt from taxation in the source nation. Dividends are taxed at 5 percent in the case of a 25 percent subsidiary corporation and 15 percent otherwise.(17)

The Operation of Treaty Shopping

Treaty shopping is the utilization of a tax treaty by third-country nationals. The intent is to achieve treatyimposed exemptions and withholding rates upon the repatriation of income to non-treaty nations. This practice is ordinarily achieved when a national of neither treaty nation establishes a company in one of the treaty countries. For example, a resident of Malaysia holds several investments in the United States. Since the United States has no tax treaty with Malaysia, it would be impossible to achieve treaty benefits. The United States does have a treaty, however, with Indonesia, and the Malaysian investor can establish a company in Indonesia and repatriate profits to that company under highly favorable treaty terms. Since both Malaysia and Indonesia follow the territorial approach to taxation (whereby only income arising from within its borders is taxed), income arising from within the United States would be exempt from taxation upon subsequent repatriation to both nations.

Treaties may also be linked together. Since the Netherlands has a tax treaty with Malaysia, the investor may establish an intermediary company in the Netherlands and use its treaty with the United States to realize treaty benefits upon repatriation of profits to the Dutch company. Treaty-related benefits can then be achieved upon the repatriation of profits to Malaysia. In both cases, a resident of a nation with which the United States has no tax treaty is able to use a U.S. treaty, though the application of each treaty is intended solely for legitimate residents of the nations that negotiated the treaty.

U.S. Tax Policy Restricting Treaty Shopping

The Treasury Department has employed several techniques to curb treaty shopping. Treaties negotiated over the past two decades have contained specific anti-treaty shopping provisions, although the results actually achieved have been limited in scope especially when compared with the Netherlands-2 Treaty. The primary measure has been to limit the percentage of corporate ownership held by third-country nationals. The 1977 U.S. Model Tax Treaty, for instance, states that a corporation will not be considered a resident of either treaty nation unless at least 25 percent of its shares are owned by bona fide residents of either country and it is not a mere conduit to pass profits to a third nation.(18) The proposed 1981 U.S. Model Tax Treaty increased the level of ownership to 75 percent.(19)

Faced with its inability to negotiate effective anti-treaty shopping restrictions, the Treasury has increasingly relied upon unilateral anti-treaty shopping restrictions, which have in turn become the focal points of anti-treaty shopping language in treaty negotiation. The Tax Reform Act of 1986 provided for two independent scenarios allowing a foreign corporation to qualify as a resident of a treaty partner under the branch profits tax regime of section 884 of the Internal Revenue Code.

A. Publicly Traded Corporations

Effective treaty shopping will normally be achieved only through a closely-held corporation. In light of this, a publicly traded foreign corporation automatically qualifies for treaty coverage if its stock is primarily and regularly traded on an established stock exchange in either the United States or the treaty partner.(20) In the case of a subsidiary corporation, this test is met if at least 90 percent of the subsidiary's stock is owned by another corporation that is incorporated in the treaty partner and whose stock is publicly traded there or in the United States.(21)

B. Shareholder and Base Erosion Tests

A privately held foreign corporation must satisfy both a shareholder test and a base erosion test. The former test requires that more than half of the value of all stock be beneficially owned, as determined under U.S. look-through and attribution rules, by bona fide residents of the treaty partner or the United States.

The base erosion test requires that no more than half of a corporation's total income be used to liquidate liabilities owed to persons who are not qualified residents of the treaty partner or the United States.(22) This measure is intended to operate in the following situation:

Assume a Malaysian investor merely lends capital to a resident of Indonesia, who forms a corporation there. The Indonesian corporation operates a trade or business in the United States. Substantially all of the income earned from the U.S. operation is repatriated to the Indonesian corporation and then paid out as interest to the Malaysian investor. Because the corporation functions only as a conduit between a U.S. trade or business and a nonresident lender, the latter would be the principal beneficiary of any treaty benefits arising on U.S.source income. Accordingly, the base erosion test precludes the treaty benefits from flowing to the nonresident lender.

C. Active Trade Or Business Rule

To ameliorate the inflexibility of both scenarios, Treasury Regulations have added the active business test that extends treaty coverage to foreign corporations failing the statutory tests of section 884. This test requires that (1) a foreign corporation be actively engaged in a trade or business in the treaty partner and has a substantial presence there, and (2) U.S.-source income qualifying for treaty coverage be derived from activities within the United States that form an integral component of the corporation's active business in the treaty partner.(23) This exception is intended to allow commonly controlled corporations that carry on operations in the United States through intermediaries to qualify for treaty coverage.

For example, a Dutch manufacturing subsidiary of a privately held German corporation that licenses patents and manufacturing expertise to a related manufacturing company in the United States that is in the same line of business as the Dutch company would fail the shareholder test, even though the legitimate beneficiary of any treaty benefit would be the parent corporation in Germany, a nation having a treaty with the United States. The active business test permits the Dutch corporation to qualify under the Netherlands-l Treaty.

The following three ratios are used to determine substantial presence in the treaty partner:

* the value of assets used or held in the treaty partner to worldwide assets employed;

* gross income arising in the treaty partner to worldwide gross income; and

* payroll expense in the treaty partner to worldwide payroll expense.

A substantial presence is deemed to exist if each ratio exceeds 20 percent and the average of the three ratios exceeds 25 percent.(24)

Example 1

FORCo, a company incorporated in nation F (a U.S. tax treaty partner), is the wholly owned subsidiary of USCe, a U.S. corporation. USCo is not publicly traded, and has no operations in F. USCo receives dividends and interest from FORCo and utilizes more than half of this income to pay off its debts te third-nation bankers in violation of the base erosion test. Treaty benefits can therefore be secured only under the active business test.

Financial data relating to USCo's worldwide operations are, as follows:

  FORCo Operations
           FORCo        Worldwide    as Percentage of
           Operations   Operations   Worldwide Operations
Assets     $500         $2,300       21.74%
Income     170          555          30.63%
Payroll    400          1,400        28.57%

Since each financial ratio exceeds 20 percent and the average of all three factors of 26.98 percent exceeds 25 percent, the interest and royalty payments are covered under the U.S. treaty with F.

Significantly, these provisions override conflicting treaty provisions that existed before passage of the Tax Reform Act of 1986. Section 7852(d) of the Code imposes a last-in-time standard in cases of conflict between statutory and tax treaty provisions. The most recent provision then takes precedence. Since the Netherlands-l Treaty went into force in 1948, the Tax Reform Act of 1986's provisions govern treaty limitations. Once the Netherlands-2 Treaty goes into effect, its burdensome provisions will govern treaty limitations.

The Treasury Department clearly intended these anti-treaty shopping provisions to act as a model for future treaty formulation. The Treasury quickly realized that unilateral measures could only curtail flagrant cases of treaty shopping. In reality, it only restricts third-country nationals to minority corporate status. Treaty limitations language in the Netherlands-2 Treaty thus represents Treasury's attempt to expand these maneuvers to further curb anti-treaty shopping.

Treaty Limitations in Netherlands-2 Treaty

The corpus of treaty limitations in the Netherlands-2 Treaty is organized into the following four basic tests, only one of which need be passed by a resident corporation to qualify for treaty coverage:

* Stock exchange test;

* Shareholder test;

* Active trade or business test; and

* Headquarters test.

Although each test is rooted in U.S. statutory or regulatory provisions, the Netherlands-2 Treaty provides objective standards relating to connection and local substance that dramatically exceed either U.S. law or restrictions imposed in prior treaties.

The stock exchange and shareholder tests are complicated by the imposition of three separate conduit tests-- the conduit company test, the base reduction test, and the conduit base reduction test. Not only is each of these tests entwined in substantive detail, but application of each test varies with the basic test involved. Each conduit test is customized to prevent particular abuses in particular circumstances, even though one of the basic tests has already been satisfied. The conduit tests will be discussed in further detail as they relate to the underlying basic tests.

A. Stock Exchange Test

Full treaty benefits are granted to any corporation operating in either treaty nation if its principal class of shares is regularly and substantially traded on any recognized stock exchange.(25) The treaty defines a recognized stock exchange as any stock exchange operating in the United States (including any exchange registered with the Securities and Exchange Commission(26) and the NASDAQ trading system(27) or in the Netherlands (albeit only with respect to the Amsterdam exchange and parallel markets(28), and any exchange agreed upon by the competent authorities.(29) This provision clearly mirrors U.S. statutory language. The Netherlands-2 Protocol, however, expands the list of recognized exchanges to include those in Paris, Frankfurt, and London.(30) This expanded list probably reflects the desire on the part of the Dutch Ministry of Finance to extend the list of qualifying exchanges to all those in the EC.

Treaty benefits are also extended to the subsidiaries of listed corporations if more than 50 percent of the aggregate vote and value of their shares are directly or indirectly owned by five or fewer companies that qualify as residents of either treaty nation. A Dutch subsidiary also qualifies if:

* at least 30 percent of the aggregate vote and value of its shares is owned by five or fewer Dutch companies that trade on a recognized stock exchange, and

* at least 70 percent of the aggregate vote and value of its shares is owned by five or fewer companies resident in the United States or EC countries whose shares are also regularly traded.(31)

Unlike publicly traded parent corporations (which are not subject to any conduit test), qualifying subsidiaries must meet both the conduit company and the conduit base reduction tests.(32) The former test disallows treaty status to any company that immediately distributes in the form of deductible payments of interest and royalties at least 90 percent of its aggregate receipts of interest and royalties.(33) A conduit company, therefore, would normally operate solely to traffic in treaty withholding rates. U.S. treaty negotiators have long sought to limit the use of conduits especially in cases of back-to-back loan and royalty arrangements where the resident corporation is unrelated to the payor or payee of the passive income.(34)

Conduit companies can still qualify under the treaty if they satisfy the conduit base reduction test. This test is actually a liberalization of the stringent base reduction test. The base reduction test requires that no less than half of a corporation's gross income can be utilized, directly or indirectly, to make deductible payments, such as interest and royalties, in the current tax year to non-residents of either treaty partner.(35) Although this test directly resembles the base erosion test of section 884, critical restrictions have been added to the treaty. Gross income is calculated as that income earned in the first year preceding the current taxable year. This amount cannot, however, exceed the average gross income over the four taxable years preceding the current taxable year, thereby disallowing increased payment of liabilities during years of significantly increased revenues.(36) The definition of deductible payments is also constrained by precluding payments for rents and services.(37)

Dutch companies failing this test may elect to include the gross income of EC affiliates, though at least 30 percent of combined gross income must be paid out in interest and royalties to Dutch residents and at least 70 percent of such income must be paid out to persons who are residents of either the Netherlands or other EC countries.(38)

The conduit base reduction test is identical to the base reduction test except that interest and royalty payments are considered only if they are made to associated enterprises in whose hands they will be taxed at a rate less than 50 percent of the Dutch tax rate.(39) Therefore, only minimal payments to related parties are covered.

B. Shareholder Test

Under the shareholder test, a privately held corporation qualifies for treaty benefits if more than 50 percent of its shares are owned, directly or indirectly, by qualified residents.(40) Although similar to the shareholder test of section 884, the treaty imposes additional restrictions. Stock ownership is defined as direct or indirect ownership of the aggregate vote and value of all classes of shares, rather than just the principal classes of stock. The treaty's definition also includes "disproportionate classes of shares." This term denotes any class of shares of a corporation resident in either treaty nation that allows the shareholder disproportionately higher participation, through such means as dividends or redemption payments, in earnings generated in the treaty partner by particular assets or activities of the corporation.(41)

Corporations satisfying the shareholder test must also meet the base reduction test.(42)

C. Active Trade or Business

A corporation failing the first two tests can qualify for treaty benefits if it is engaged in the active conduct of a trade or business in the nation of residence and either --

* it satisfies the requirement of substantiality in that income arising from within the source nation must be derived in connection with a trade or business within the nation of residence and is substantial in relation to the trade or business in the source nation, or

* it satisfies the requirement of incidental income in that income derived within the source nation need only qualify as an incidental component of a trade or business carried on within the nation of residence.(43)

In either event, operations in both nations must be in the same line of business. Source nation operations must constitute a component of, or be complementary to, the trade or business in the nation of residence(44) and cannot consist of making or managing investments except in the case of banking or insurance companies.(45)

1. Substantiality Test

Substantiality is determined by reference to three financial ratios. During the preceding taxable year, the average of the following three ratios must exceed 10 percent with each exceeding 7.5 percent:

* the value of assets used or held in the resident country to the assets in the source country;

* gross income arising in the resident country to that in the source country; and

* payroll expense in the resident country to that in the source country.(46)

Example 2

USCo, a U.S. corporation, is the wholly owned subsidiary of DUTCo, a Dutch corporation. Neither corporation is traded on a recognized stock exchange. Both corporations actively conduct a trade or business within their respective nations, and neither carries on any other operation. DUTCo fails the base reduction test. Financial data attributable to the companies are, as follows:

  USCo as
          DUTCo     USCo      Percentage of DUTCo
Assets    $300      $50       16.67%
Income    50        10        20.00%
Payroll   60        10        16.67%

DUTCo receives dividends and interest from USCo. Since each financial ratio exceeds 7.5 percent and the overall average of all three factors of 17.78 percent exceeds 10 percent, the dividends and interest are covered under the treaty.

Serious complications arise in the case of multiple ownership of an investment in the source nation. The ownership of operations in the source nation must be determined as a proportionate share of activities that qualify as a component part of or are directly related to the trade or business in the source nation. Multiple ownership is permitted under any of the following scenarios:

* a controlling beneficial interest(47) is held by a group of five or fewer owners each engaging in a trade or business in the nation of residence;

* stock is held by a corporation that qualifies as a member of a consolidated group under the tax laws of the nation of residence;

* a controlling beneficial interest is held by a group of five or fewer persons that are residents of an EC nation or a nation with which either the United States or the Netherlands has an effective information sharing agreement(48) and carry on a trade or business in the nation of residence; or

* the source nation operation is under the common control(49) of five or fewer persons who qualify under any of the aforementioned conditions?

Application of the factors relating to substantiality in the case of ownership by a group of qualifying investors will also result in instances where less than 100 percent participation exists in the trade or business in the source nation.

Example 3

Assume that NSCo (a Dutch corporation) and AMCo (a U.S. corporation) are both controlled by five Dutch investment companies. Both corporations carry on a trade or businesses in their home nations. One of the investors (A) owns a 50 percent interest in AMCo and the other four investors (B, C, D, and E) each own a 12.5 percent interest in the same corporation. Dutch investor (E) owns a 50percent interest in the NSCo while the other four investors (A, B, C, and D) each own a 12.5 percent interest in NSCo.

Relevant financial data relating to trade or business within the two nations are, as follows:

  NSCo       AMCo
    Assets   $1,000     $6,000
    Income   10,000     40,000
    Payroll   1,000      5,000

AMCo pays dividends to each of its five Dutch owners. Each of the three factors must be multiplied by the investor's percentage share in NSCo as the corporation operating a trade or business in the nation of residence by the investor's percentage share in AMCo or the trade or business in the source nation. Dividends paid to B,C, D, and E would pass the substantiality test since the three ratios as applied to them would be 16.7 percent, 25 percent, and 20 percent, respectively. The three ratios when applied to E would be 66.7 percent, 100 percent, and 80 percent. Dividends paid to A fail the substantiality test since the ratios are 4.2 percent, 6.25 percent, and 5 percent.(51)

Example 4

Assume the same facts present in example 2, except that DUTCo has transferred its active trade or business to DUTSub, a Dutch corporation in which DUTCo owns 50 percent. IRLCo, an Irish corporation with no active trade or business, owns the remaining interest in DUTSub. Pertinent financial data are, as follows:

  USCo as Percentage
          DUTSub     USCo      of DUTSub
Assets    $300       $50       16.67%
Income    50         10        20.00%
Payroll   60         10        16.67%

USCo makes annual interest and dividend payments to DUTCo. These payments cannot qualify for treaty benefits unless DUTCo can be considered as engaging in the active conduct of a substantial trade or business in the Netherlands. Therefore, the three factors of DUTSub are related to a qualifying trade or business and may be attributed to DUTCo since DUTCo and IRLCo have a controlling beneficial interest in DUTSub and Ireland is a member of the EC. Half of DUTSub's assets, income, and payroll are attributable to DUTCo. The amounts so attributed to DUTCo after taking into account its percentage ownership of USCo are, as follows:

  DUTCo          DUTCo as Percentage of DUTSub
Assets   $25            8.33%
Income   5             10.00%
Payroll  5              8.33%

Since the average of the three ratios is under 10 percent, DUTCo does not qualify as a trade or business and cannot claim treaty benefits on interest and dividends received. The unfavorable situation facing the Dutch corporation can be corrected by adjusting its ownership interest in its operations in the source nation.

Example 5

Assume the same facts as in Example 4, except that DUTCo owns only 80 percent of USCo. USCo's assets, income, and payroll must be multiplied by DUTCo's percentage of ownership. The critical ratios are restated after taking into account DUTCo's percentage of ownership of USCo and DUTSub, as follows:

  USCo as
          DUTSub       USCo      Percentage of DUTSub
Assets    $240         $25       10.42%
Income    40           5         12.50%
Payroll   48           5         10.42%

DUTCo thus qualifies for treaty coverage on the interest and dividend payments since each ratio exceeds 10 percent.

Dutch corporations can elect to base these ratios on operations in the entire EC. In this case, the average of the three ratios must be at least 60 percent and each ratio must be at least 50 percent-(52) To qualify, the Dutch share must be at least 15 percent of the EC total.(53)

Example 6

Gilder Co., a Dutch corporation, owns 100 percent of Yankee, Inc., a U.S. corporation. Financial data are, as follows:

                                Gilder as
         Yankee     Gilder      Percentage of Yankee
Assets   $1,000     $110        11.00%
Income    5,000      500        10.00%
Payroll   6,000      480         8.00%

Under the general test of substantiality, treaty benefits are denied since the average ratio of 9.67 percent is below the required 10 percent threshold, though each ratio is above the 7.5 percent level.

DUTCO, however, has operations that qualify as a trade or business in Germany, Italy, and Austria. In this case, Gilder can include its operations in Germany and Italy because both are members of the EC, though Austria is not. Financial data stated in terms of the operations within each EC nation are, as follows:

                         EC Combined
                                  EC    as Percentage
          Dutch    German  Italy  Combined  of Yankee
 Assets   $110     $ 400   $160   $ 670     67.00%
 Income   500      2,500   1,150  3,150     63.00%
 Payroll  480      1,100   1,270  3,050     50.83%

If the election to include EC operations is made, affected payments to Yankee qualify for treaty benefits since the average ratio exceeds 60 percent while each ratio exceeds 50 percent. The Dutch share of the EC total in each financial category--16.42 percent, 15.87 percent, and 15.74 percent, respectively--exceeds the required 15-percent level.

2. Incidental Test

The trade or business test can also be met if the income derived from within the source nation is only incidental to a trade or business carried on within the nation of residence. Operations within the source nation need only facilitate or supplement the conduct of the trade or business in the nation of residence. The source of the incidental income need not be a related party. Unfortunately, the treaty provides no firm statistical test to define incidental income. The treaty does mention the investment of working capital of a trade or business. Thus, the temporary investment of surplus funds in the United States by the Dutch subsidiary of a German multinational corporation qualifies as incidental to the Dutch trade or business.

The EC-wide test would permit Dutch corporations to include U.S.-source incidental income earned by its EC affiliates. The amount so earned by the EC corporations, however, cannot exceed four times the amount of incidental income actually earned by the Dutch corporation-(54)

D. Headquarters Test

The headquarter company of a multinational corporate group qualifies for treaty benefits if it meets each of the following conditions:

(1) It provides a substantial portion of the supervision and administration of the group, which can include, but not be principally, group financing;

(2) The corporate group consists of at least five corporations operating in at least five different nations, each of which earns at least 10 percent of the group's combined gross income;

(3) No more than 50 percent of the group's combined gross income arises from within any single country other than the nation of residence;

(4) No more than 25 percent of the group's combined gross income arises from within the treaty party;

(5) The headquarter corporation exercises independent discretionary authority;

(6) The headquarter corporation is subject to the same income tax rules that apply to companies engaged in a trade or business in the resident country of the headquarter company; and

(7) The source nation income is derived from or is incidental to the trade or business of the group.

If the gross income requirements listed under (2), (3), or (4) are not met, they will be deemed to be satisfied if the required ratios are met when averaging the gross income over the preceding four years.(55)

Shipping and Air Income

In order to qualify for treaty exemptions on shipping and air transport income(56) more than half of the value of a corporation's stock must be owned by either:

* bona fide residents of either the United States or the Netherlands or citizens of the United States, or

* publicly traded corporations resident in any nation that exempts shipping and air transport income either under domestic tax law or through a tax treaty with the United States or the Netherlands containing similar shipping and air transport provisions.(57)

Thus, a Dutch company owned by residents of a third nation qualifies if that nation's tax code provides for such an exemption or if it has a tax treaty with the United States that exempts shipping and air transport income.

Not-For-Profit Organizations

Income earned by organizations engaged on a not-for-profit basis in the country of residence, such as governmental units, pensions funds, pension trusts and private charities, is exempt by the source nation if more than half of its beneficiaries, members, or participants are residents of either the United States or the Netherlands or citizens of the United States.(58)

Competent Authority Override

Taxpayers failing all tests restricting treaty benefits can still be granted treaty coverage via a direct appeal to the competent authority of the source nation.(59) For example, a U.S. resident with an investment in the Netherlands could apply directly to the Dutch Ministry of Finance, which needs to consult with the U.S. Treasury only when denying the petition. The Netherlands-2 Protocol provides that the competent authority shall consider factors relating to the age of the corporation, continuity of ownership, business strategies, extent of treaty benefits, capitalization, and tax treaty position of the nation of actual ownership.(60) Since most cases of treaty shopping occur on investments in the United States, however, appeal must be made to U.S. tax authorities. It is doubtful that the Treasury Department will grant exceptions in any but the most extreme cases.

Treaty Entry into Force

The Netherlands-2 Treaty is currently before the U.S. Senate for ratification. Since Senate concerns over treaty shopping that have dominated the ratification process over the past two decades have been more than effectively addressed in the new treaty, ratification should be achieved by the end of this year. The treaty will then enter into force 30 days following ratification by both nations, although the new withholding rates are not effective until January of the year following the date of entry into force.(61) Affected taxpayers may elect to apply the Netherlands-l Treaty for one year after the new treaty enters into force, although in such case the old treaty must be applied in toto in order to avoid cherry picking.(62) Since the new treaty provides no grandlathering mechanism, this may be the sole remedy for third-country nationals who use the old treaty to shelter their U.S. investments.

Conclusion

It is imperative that multinational corporations using the Netherlands-1 Treaty as a conduit for their investments in the United States examine the effects of the Netherlands-2 Treaty to maintain optimal tax strategies. Scenarios allowing third-country investment are limited. Affected corporations will only have until one year after the new treaty goes into force to realign these holdings. For other third-country owned multinationals, traditional avenues for U.S. bound investments are totally blocked. These corporations are faced with a brief window of opportunity to grab whatever benefit they can under the Netherlands-l Treaty.

It is too early to tell if the Netherlands-2 Treaty sets a dangerous precedent by denying tax advantages on foreign investment in the United States. No longer content with established anti-treaty shopping norms and the statutory language of section 884, Treasury may have signalled its future direction in the treaty limitations article of the Netherlands-2 Treaty. There remains the very serious danger that the restrictions so imposed may destroy the very intention of tax treaties. The resulting tax-related barriers could seriously retard the United States' ability to attract foreign investment.

-Notes - (1) Convention Between the United States of America and the Kingdom of the Netherlands for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, quoted in CCH Tax Treaties [paragraph] 6103.

(2) Understanding Regarding Income Tax Treaty Between the Netherlands and the United States, quoted in CCH Tax Treaties [paragraph] 6113. Both the Netherlands-2 Treaty and the Protocol were signed on December 18, 1992.

(3) Convention Between the United States of America and the Kingdom of the Netherlands with Respect to Taxes on Income and Certain Other Taxes, 1950-1 C,B, 93. The treaty was amended by supplemental protocol of December 30, 1965, 1967-2 C.B. 472.

(4) Netherlands-2 Treaty, Art. 26(8)(h) defines EC nations as the Netherlands and any other member of the EC that has a comprehensive income tax treaty with both the United States and the Netherlands. The other eleven members of the EC have such an agreement with the Netherlands. The United States has similar treaties with all members of the EC except Portugal. Thus, the list of EC nations under the treaty would include Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Spain, and the United Kingdom.

(5) Netherlands-2 Treaty, Art. 7(1).

(6) Netherlands-2 Treaty, Art. 12(1).

(7) Netherlands-2 Treaty, Art. 13(1).

(8) Netherlands-2 Treaty, Art. 23(1).

(9) Netherlands-2 Treaty, Art. 25(4). The permanent establishment article in the Netherlands-2 Treaty follows standard treaty language. A permanent establishment is a fixed base of operations within the source nation. The term normally includes a place of management, office, branch, factory, mine, workshop, oil or gas well, and quarry. The use of an agent also gives rise to a permanent establishment if the agent has the right to bind the principal to a contract.

(10) Netherlands-2 Treaty, Arts. 10(1) and (2).

(11) R.C. [section][section] 871(a)(1) and 881(a).

(12) Netherlands-2 Treaty, Art. 8(1).

(13) Netherlands-1 Treaty, Art. III.

(14) Netherlands-1 Treaty, Art. VIII.

(15) Netherlands-1 Treaty, Art. IX.

(16) Netherlands-1 Treaty, Art. VI.

(17) Netherlands-1 Treaty, Art. VII.

(18) 1977 U.S. Model Income Tax Treaty, Art. 16, quoted in Rhoades & Langer, Income Taxation of Foreign Related Transactions [paragraph 92.

(19) 1981 U.S. Model Income Tax Treaty, Art. 16, quoted in Rhoades & Langer, Income Taxation of Foreign Related Transactions [paragraph] 93.

(20) I.R.C. [section] 884(e)(4)(B).

(21) Temp. Reg. [section] 1.884-5T(d)(5).

(22) I.R.C. [section] 884(e)(4)(A).

(23) Temp. Reg. [section] 1.884-5T(e).

(24) Temp. Reg. [section] 1.884-5T(e)(3).

(25) Netherlands-2 Treaty, Art. 26(1)(c)(i).

(26) Netherlands-2 Treaty, Art. 8(d)(i).

(27) Netherlands-2 Treaty, Art. 8(d)(iii).

(28) Netherlands-2 Treaty, Art. 8(d)(ii).

(29) Netherlands-2 Treaty, Art. 8(d)(iv). Article 3(1)(i) defines the competent authorities to be the Dutch Minister of Finance and the U.S. Secretary of the Treasury.

(30) Netherlands-2 Protocol, Art. XXII.

(31) Netherlands-2 Treaty, Arts. 26(1)(c)(iii)(A) and (B).

(32) Netherlands-2 Treaty, Art. 26(1)(c)(ii).

(33) Netherlands-2 Treaty, Art. 26(8)(m).

(34) U.S. policy regarding conduit companies is most clearly elucidated in Rev. Rul. 84-153, 1984-2 C.B. 383, requiring intermediary companies to exercise dominion and control over payments of passive income passing through them.

(35) Netherlands-2 Treaty, Art. 26(5)(a)(i).

(36) Netherlands-2 Treaty, Art. 26(5)(b).

(37) Netherlands-2 Treaty, Art. 26(5)(c).

(38) Netherlands-2 Treaty, Art. 26(4)(a).

(39) Netherlands-2 Treaty, Art. 26(5)(d). Dutch corporate tax rates are currently 40 percent on taxable income up to Dfl 250,000 ($135,000) and 35 percent thereafter. Associated enterprises are defined in Netherlands-2 Treaty, Art. 9 as two or more corporations directly or indirectly controlled by identical interests. No objective tests governing control are mentioned in the treaty.

(40) Netherlands-2 Treaty, Art. 26(1)(d)(i).

(41) Netherlands-2 Treaty, Art. 26(8)(c).

(42) Netherlands-2 Treaty, Art. 26(5)(d)(ii).

(43) Netherlands-2 Treaty, Arts. 26(2)(a)(i) and (ii).

(44) Netherlands-2 Treaty, Art. 26(2)(b).

(45) Netherlands-2 Treaty, Art. 26(2)(a).

(46) Netherlands-2 Treaty, Arts. 26(2)(c)(i), (ii), and (iii).

(47) A person or group is deemed to hold a controlling beneficial interest in a corporation if it owns, directly or indirectly, more than 50 percent of the aggregate value and voting power of the corporation. Each member of the group must own at least 10 percent of the corporation. Netherlands-2 Treaty, Art. 26(2)(f).

(48) Netherlands-2 Protocol, Art. XVI identifies the states, as follows: Australia, Austria, Barbados, Belgium, Bermuda, Canada, Costa Rica, Cyprus, Denmark, Dominica, Dominican Republic, Egypt, Finland, France, Germany, Grenada, Honduras, Iceland, Ireland, Jamaica, South Korea, Malta, Marshall Islands, Mexico, Morocco, New Zealand, Norway, Pakistan, Philippines, St. Lucia, Sweden and Trinidad and Tobago and with regards to the Netherlands: Aruba, Australia, Austria, Belgium, Brazil, Bulgaria, Canada, China, Czechoslovakia, Denmark, Finland, France, Germany, Greece, Hungary, India, Ireland, Indonesia, Israel, Italy, South Korea, Luxembourg, Malaysia, Maltal Morocco, Netherlands Antilles, New Zealand, Norway, Pakistan, Philippines, Poland, Romania, Singapore, South Africa, Spain, Sri Lanka, Surinam, Sweden, Thailand, Turkey, United Kingdom, Zambia, and Zirnbabwe.

(49) Common control of two or more corporations is deemed to exist whenever a single owner holds a controlling beneficial interest in each corporation. Netherlands-2 Treaty, Art 26(2)(g).

(50) Netherlands-2 Treaty, Arts. 26(2)(e)(iv), (v), (vi), and (vii).

(51) The use of subsidiaries within a controlling group may also be included in the computation of the ratios defining substantiality.

(52) Netherlands-2 Treaty, Art. 26(2)(c).

(53) Netherlands-2 Treaty, Art. 26(2)(h).

(54) Netherlands-2 Treaty, Art. 26(2)(d).

(55) Netherlands-2 Treaty, Art. 26(3).

(56) Netherlands-2 Treaty, Art. 8.

(57) Netherlands-2 Treaty, Art. 26(6).

(58) Netherlands-2 Treaty, Art. 26(1)(e). Eligible persons are defined in Article 26(8)(g).

(59) Netherlands-2 Treaty, Art. 26(7).

(60) Netherlands-2 Protocol, Art. XIX.

(61) Netherlands-2 Treaty, Art. 37(1).

(62) Netherlands-2 Treaty, Art. 37(2).

RAYMOND WACKER is an Assistant Professor of Accountancy at Southern Illinois University's College of Business and Administration. He holds a Ph.D. from the University of Houston and is a certified public accountant. Before entering academia, Mr. Wacker worked both in public accounting and in industry. Mr. Wacker is the author of numerous aricles on tax-related issues.