The noose tightens: Netherlands-2 Treaty enters into force but with revisions.

Introduction

The Netherlands-2 Treaty(1)(*) was ratified by the U.S. Senate on November 20,

1993, and was signed by President Clinton on December 1, 1993. Since the Dutch ratification process was also completed by December 1, the new treaty-known for its extensive limitation on benefits article preventing treaty shopping or the utilization of a treaty by third-country nationals(2)--entered into force for tax years beginning after January 1, 1994. The new treaty, however, became effective subject to the provisions of an October 13, 1993, explanatory protocol [hereinafter referred to "Protocol"],(3) as well as diplomatic notes [hereinafter referred to as "Notes"] exchanged simultaneously by the two governments. The Notes are considered integral components of the Protocol.(4)

In its attempt to clarify certain ambiguities in the treaty and the accompanying understanding,(5) the Protocol and Notes modify certain aspects of the stock exchange, active-trade-or-business, and headquarters tests that operate to restrict treaty benefits. The Protocol also places a new U.S. withholding tax on any interest and royalties remitted to a Dutch company that are in turn allocated by the Dutch company to a branch operating as a permanent establishment in a low-tax third-country. This article explains the new restrictions and summarizes their effects on the ability of Dutch companies with investments in the United States to qualify for treaty benefits.

Stock Exchange Test

The Protocol modifies the residency test applicable to the subsidiaries of a qualifying publicly traded corporation. Under the Netherlands-2 Treaty, any such subsidiary (other than a conduit company)(6) is allowed treaty benefits if it resides within the Netherlands or the United States and more than 50 percent of the aggregate vote and value of all shares outstanding is directly or indirectly owned by five or fewer publicly traded companies residing in either treaty nation. In the case of Dutch corporations, only 30 percent must be owned by five or fewer Dutch corporations as long as 70 percent is owned by five or fewer corporations residing within the European Community.(7)

The treaty imposes one critical restriction: each corporation in the ownership chain used to satisfy the relevant ownership test must itself meet the residence requirement.(8) The Protocol relaxes this requirement to provide that each intermediate corporation in the chain need only be a resident of either treaty nation or any EC member.(9) Therefore, a Dutch corporation may make greater use of EC-based intermediate corporations that have substantial non-Dutch ownership.

Active-Trade-or-Business Test

The Notes address three separate issues relating to the active-trade-or-business test. Under the Netherlands-2 Treaty, a Dutch company carrying on an active trade or business in the Netherlands can claim treaty benefits for operations within the United States if--

(1) its U.S.-source income is derived in connection with its Dutch trade or business and is substantial in relation to its U.S. operations, or

(2) such income is incidental to the Dutch trade or business.(10)

Substantiality in turn is determined by reference to required financial ratios relating to the interrelationship between operations within the United States and the Netherlands.(11)

The Notes provide that the substantiality requirements are ignored with respect to the receipt of U.S.-source income by a Dutch corporation from an unrelated party.(12) The Netherlands-2 Treaty states all tests determining substantiality in terms of income received from a related party. The Notes would then allow for treaty benefits in cases of unrelated party income. Although this concession will provide increased flexibility, the ambiguity of the new rules may exacerbate uncertainty. An affected Dutch corporation must still qualify under the active-trade-or-business test; it is only excused from the financial tests determining substantiality. Thus, a Dutch corporation must still prove that any U.S.-source income received from unrelated parties is derived in connection with its Dutch active trade or business or is incidental to that trade or business. In contrast to the rigid tests determining substantiality, the new standards are quite subjective.

The Notes also add Japan and Portugal to the list of identified states. This inclusion may prove an effective planning tool since a Dutch corporation will qualify as carrying on a trade or business within the Netherlands if, as a member of a group of residents of any identified state, it owns a controlling beneficial interest in that trade or business.(13) A Dutch corporation would have an easier time establishing a Dutch trade or business through a joint venture with Japanese firms.

Finally, the Notes further restrict the treaty benefits available to investment management companies. The Netherlands-2 Treaty provides that companies other than banks and insurance companies that regularly make or manage investments do not qualify under the active-trade-or-business test.(14) The Notes also provide that interest derived from group financing or portfolio investments is considered a component of making or managing investments and therefore does not qualify for treaty benefits.(15)

Headquarters Test

In the case of a privately held diverse multinational group, the headquarters test will often prove to be the easiest test to satisfy under the Netherlands-2 Treaty. A group operating in several nations could use this test to bypass the allocation problems inherent in the shareholder test(16) and the statistical requirements of the active-trade-or-business test.(17)

The treaty itself requires that the headquarters corporation administer a group of at least five subsidiaries operating as active trades or businesses in at least five nations. Quantitative requirements define the level of business activity operated by the corporate group.(18) The treaty, however, does not stipulate the situs of the headquarters activities. An effective tax planning strategy would seemingly be to perform the majority of headquarters activities through a branch in a low-tax nation such as a Belgian coordination center. The Notes prevent this maneuver by requiring that headquarters activities must be performed within either treaty nation.(19) Unfortunately, the Notes do not specify any minimum percentage of headquarters activities that must be carried on within the treaty nations, but presumably only marginal headquarters activities at best can be performed in a third nation. The Dutch negotiators were unable to extend the right to perform any reasonable portion of headquarters activities in other EC nations. This is surprising in light of their general success in extending treaty benefits to operations of Dutch corporations in other EC countries. It would be prudent for a multinational group using a Dutch headquarters corporation to supervise or administer its U.S. investments to carry on the vast majority, if not all, of its headquarters activities within the Netherlands.

Treaty Coverage of Dutch Intermediate Holding Companies

The Dutch Finance Ministry has served notice that it intends to petition the U.S. Treasury Department under the competent authority override mechanism(20) to extend treaty coverage to certain Dutch intermediate holding companies. Affected corporations, also known as mixer companies, are third-nation parent corporations that hold their operating subsidiaries in the United States and elsewhere through Dutch holding companies. The Dutch companies would achieve lower withholding rates through the Netherlands's extensive treaty system, but would be denied favorable withholding rates provided under the Netherlands-2 Treaty through the application of anti-treaty shopping rules. The Dutch Memorandum of Answers clearly states the position that the United States should grant treaty coverage to these corporations.(21) The Treasury Department has yet to publicly state an official position on this question.

New U.S. Withholding Tax on Remittance to Branches Operating in Low-Tax Countries

Although not a component of the limitation-on-benefits article, an additional U.S. withholding tax on remittances to branches(22) of Dutch corporations operating in low-tax jurisdictions is imposed by the Protocol. Under the treaty, this "triangular case" would allow U.S.-source profits earned by branches of Dutch corporations located in third-nation permanent establishments(23) to be subject solely to the aggregate of minimal Dutch and third-nation income taxes.

A critical concession granted to Dutch investors under the Netherlands-2 Treaty is the exemption of interest and royalties paid by a U.S. subsidiary to a Dutch parent from U.S. taxation.(24) Under the new Protocol, the United States

will impose a withholding tax of 15 percent on all interest and royalty payments rendered to a Dutch parent if the income of the Dutch company is allocated to a branch with a permanent establishment(25) in a low-tax third country. The determination of a low-tax third country is set as the aggregate of corporate taxes imposed by the Netherlands and the third nation. The low-tax withholding rate will apply if this aggregate is less than 50 percent of the Dutch general company tax prior to January 1, 1998, and 60 percent thereafter.(26) Since the current maximum Dutch rate is 35 percent, the aggregat e rate must be at least 17.5 percent to avoid the new 15-percent withholding rate.

Date of Entry into Force

The new Protocol entered into force concurrently with the Netherlands-2 Treaty on January 1, 1994.(27) The new withholding rates on interest and royalties allocable to low-tax branches will not affect payments made prior to January 30, 1994.(28) Affected taxpayers can still elect to apply the Netherlands-1 Treaty for one full year, in which case the terms of the new Protocol are also delayed.(29)

Conclusion

The Protocol and Notes have probably plugged the last remaining major opportunities for treaty shopping. The terms of the new agreements are especially significant since the U.S. Treasury Department apparently regards the Netherlands-2 Treaty as its test case in taking an increasingly hard line against suspected treaty shopping. If successful, future U.S. income tax treaties will probably contain similar restrictions.

-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, reprinted in CCH Tax Treaties [paragraph] 6103.

2 Netherlands-2 Treaty, Art. 26. For a detailed analysis of anti-treaty shopping restrictions in the new treaty and the first protocol, see Raymond F. Wacker, Anti-Treaty Shopping Restrictions in the New U.S.-Netherlands Tax Treaty, 45 Tax Executive 383-90 (Sept.Oct. 1993).

3 Protocol Amending the Convention between the Kingdom of the Netherlands and the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, reprinted in CCH Tax Treaties [paragraph] 6116. The Protocol was ratified by the Dutch government on November 25, 1993.

The Protocol was mandated by a provision in the Netherlands-2 Treaty that a clarifying protocol must be published if the Dutch government did not enact legislation preventing any amendments to the treaty prior to U.S. Senate Foreign Relations Committee hearings on the new treaty. Since such legislation was not promulgated before the Senate's hearings of October 27, 1993, the Protocol was necessary for the Senate to consider ratification.

4 The Notes are summarized in CCH Tax Treaties [paragraph] 6119. The governments had initially published Agreed Minutes to the negotiations that became the basis of the official text of the diplomatic notes. The Dutch government also published its Memorandum of Answers, which provides assistance in predicting Dutch policy regarding the limitations-on-benefits article. Neither the Agreed Minutes nor the Memorandum of Answers were included in the Protocol or Notes. Dutch Memorandum of Answers, reprinted in LEXIS Doc. 38549030.

5 Understanding Regarding Income Tax Treaty Between the Netherlands and the United States, reprinted in CCH Tax Treaties [paragraph] 6113. This understanding was described as a protocol in the article cited in note 2. The U.S. Senate, however, did not ratify this earlier understanding as a separate protocol. Care must be taken not to confuse the October 13 Protocol, which is the subject of this article, with the earlier understanding.

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

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

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

9 Protocol, Art. 5.

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

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

12 See note 4 supra.

13 Netherlands-2 Treaty, Art. 26(2)(e)(vi).

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

15 See note 4 supra.

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

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

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

19 See note 4 supra.

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

21 See note 4 supra.

22 A branch is an unincorporated operation in a foreign nation. Nations commonly tax foreign branches in a discriminatory manner. See, e.g., I.R.C. [section] 884. Netherlands-2 Treaty, Art. 11 discusses branch taxes.

23 A permanent establishment is a fixed base of operations. Netherlands-2 Treaty, Art. 5.

24 Netherlands-2 Treaty, Arts. 12(1) and 13(1).

25 The Notes fail to stipulate whether the definition of a permanent establishment under the Netherlands-2 Treaty or the definition under the Dutch treaty specific to each third nation involved will apply.

26 Protocol, Arts. 1 and 2.

27 Protocol, Art. 7(1).

28 Protocol, Art. 7(2).

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