New U.S.-Netherlands treaty may adversely affect Netherlands holding company structures.

Historically, the Netherlands has been an attractive place to locate a holding company, due to the combination of its extensive treaty network and its internal tax laws that minimize the amount of potential double taxation on earnings repatriated from other countries. in addition, the Netherlands does not tax capital gains from the sale of subsidiary stock.

Foreign multinational corporations frequently use Netherlands holding companies for various business reasons, as well as foreign tax reasons. One widespread use of such holding companies is to obtain U.K. foreign tax credit (FTC) benefits. In the United Kingdom, FTCs are generally computed on a source-by-source basis, so that taxes associated with dividends from a subsidiary subject to a high rate of foreign tax cannot be used to offset U.K. tax on dividends from a subsidiary subject to a low rate of foreign tax. To avoid this result, U.K. companies often put all of their non-U.K. subsidiaries under a Netherlands holding company. This allows dividends from different sources to flow into the Netherlands holding company, so that the U.K. parent receives dividends from a single, foreign source. The Netherlands company serves as a "mixer" to effectively cross-credit taxes incurred by different subsidiaries.

However, the "Limitations on Benefits" article contained in the new U.S.-Netherlands Income Tax Treaty may make it costly for U.K. companies to continue to hold their U.S. operations through a Netherlands mixer company. The treaty was signed in December 1992 and will become effective for tax years beginning (or with respect to payments subject to withholding tax that are paid) on or after the first day of January of the year following ratification. Taxpayers may elect to extend the application of the current treaty for an additional 12 months.

The principal purpose of the Limitations on Benefits article is to prevent persons who are residents of countries that do not have a favorable treaty with the United States from using a Netherlands corporation as an investment vehicle merely to obtain treary benefits. Accordingly, these provisions are commonly referred to as "anti-treaty shopping" provisions. The current U.S.-Netherlands treaty does not contain such provisions. Therefore, nonresidents of the Netherlands may generally avail themselves of the current U.S.-Netherlands treaty through the use of a Netherlands holding company.

The anti-treaty shopping provisions in the new treaty, which are to some extent more liberal than the provisions contained in other recent U.S. treaties, generally allow a company resident in either the United States or the Netherlands to obtain treaty benefits if it meets one of four objective tests, or if the competent authority of the source country determines that the company satisfies a subjective test. Special rules allow Netherlands corporations to take into account activities or ownership in other European Community countries to some extent. Briefly, the tests contained in the treaty are:

1. Stock exchange test: Under this test, a corporation will generally qualify for treaty benefits if it is (1) listed on a recognized exchange in either the Netherlands or the United States and (2) regularly traded on one or more recognized exchanges (including exchanges in other countries). A company that is not itself publicly traded may qualify under a "lookthrough" test if more than 50% of its shares are owned by five or fewer companies, each of which meets the stock listing and trading requirements.

2. Shareholder test: This test is satisfied by a company if more than 50% of its shares are owned, directly or indirectly, by qualified persons. A "qualified person" is generally a person that would itself qualify for benefits under the treaty. The company must also meet a base reduction test, which requires that less than 50% of the company's gross income be used, directly or indirectly, to make deductible payments to nonqualified persons.

3. Active trade or business test: This test is satisfied by a company engaged in the active conduct of a trade or business in its country of residence, and the income earned in the source country is derived in connection with, or is incidental to, such trade or business. Furthermore, the trade or business in the residence country must be substantial relative to the income-producing activity in the source country. This is generally determined by various ratios involving the assets, gross income and payroll expense in both countries.

4. Headquarters test: To qualify as a headquarters company, a company must provide a substantial portion of the supervision and administration of group companies. This may include, but cannot be principally, group financing. In addition, there are very detailed rules that prescribe the minimum numbers of companies in and countries with which the group must be engaged in business, and the minimum and maximum amounts of activity that may be conducted in any given country by the group.

5. Subjective test: If the taxpayer does not meet any of the objective tests, the treaty provides a subjective test, under which the taxpayer may be granted treaty benefits if the competent authority of the source country so determines. In making this determination, the competent authority will take into account as its guideline whether one of the principal purposes for the establishment, acquisition or maintenance of the company was the obtaining of treaty benefits.

In the case of a Netherlands mixer company, it seems unlikely that any of the objective tests would be met. One possibility is the headquarters company test. However, this test contains very strict requirements that are difficult to satisfy. Accordingly, such a company would have to rely on the subjective test to qualify for treaty benefits, and the extent to which this test will be applied is uncertain.

First of all, the language of the provision appears to be discretionary. It only states that the company may receive the benefits of the treaty if the competent authority so determines, and the competent authority shall take into account as a guideline whether one of the principal purposes for establishment of the company was obtaining treaty benefits. The provision does further state that the competent authority of the residence country shall be consulted before denying benefits. However, the treaty language seems to give the source country much discretion in determining whether to grant benefits.

Secondly, it is not certain how the principal purpose guideline will be applied. Because the obtaining of benefits need only be one of the principal purposes, the fact that the ultimate parent company had a legitimate business or foreign tax reason for forming the holding company may not be enough to satisfy the competent authority. The competent authority could always claim that the holding company was formed in the Netherlands in order to obtain the benefits of the treaty.

The Memorandum of Understanding to the treaty gives some guidance, by listing factors that may be taken into account in applying the principal purpose test. One factor looks to the extent to which the corporation would be entitled to benefits comparable to those granted by this treaty if the corporation had been incorporated in the country where the majority of the shareholders reside. In the case of a Netherlands mixer company, if the U.K. parent had instead used a U.K. subsidiary, the same withholding rate would apply to dividends from a U.S. subsidiary. Accordingly, this factor would weigh towards the granting of benefits in this case. However, this is only one of six factors listed, and the list is not meant to be exclusive. Therefore, this factor would not necessarily be dispositive of the issue.

In addition, because there are four objective tests in the treaty that contain very specific requirements and that are described in great detail, the competent authorities may be hesitant to grant benefits under the subjective test. Therefore, there is a great deal of uncertainty as to whether Netherlands mixer companies will continue to qualify for treaty benefits. The potential cost of not qualifying is very high, as dividends will be subject to the statutory withholding tax rate of 30%. By contrast, under both the Netherlands and U.K. treaties, dividends from a U.S. subsidiary would be subject to only 5% withholding.

Accordingly, it is hoped that the IRS will give some guidance on this matter before the treaty goes into effect, in the form of a revenue ruling or procedure. in the absence of such guidance, U.K. companies with Netherlands mixer subsidiaries should consider requesting a letter ruling. However, if guidance is not forthcoming before the new treaty becomes effective, a company in this position may have to consider restructuring the ownership of its U.S. subsidiary.