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U.S. policy against treaty shopping - from Aiken Industries to anti-conduit regs: critical view of current double-step approach in light of tax treaties' objectives and purposes.

The scope of this article is to analyze the evolution of the mechanisms to fight treaty shopping in the U.S. Model Treaty and the role and efficiency regarding the application of domestic anti-conduit rules by the United States on its double tax treaties, in light of international tax principles and purposes.

For that, this article will address the history and leading cases involved in the enactment of those domestic measures to fight tax treaty abuse. Additionally, the article will examine the structure and impact of U.S. Model Treaty existing provisions, notably Article 22 (Limitation on Benefits) to avoid the improper use of treaty benefits between the United States and the other Contracting State.

In this sense, the leading and notorious precedent about treaty shopping, Aiken Industries, will be duly analyzed, as well as the following domestic measures used by Treasury and the Service to prevent the abuse of treaty benefits entitlement by third countries, until the enactment of the anti-conduit regulations, domestically.

Lastly, this study will conclude by stating my opinion regarding the U.S. experience on this matter, the problems arising from such an approach, and suggest possible solutions to improve the fight against treaty shopping based on the current and the new proposed anti-conduit rules as well as in the Limitation on Benefits (LOB) clause, pointing out the sensible issues that might be more explored and reviewed in consideration of U.S. tax treaty partners.

I.     INTRODUCTION                     298








IX.    CONCLUSION                       328


This article analyzes the evolution of the mechanisms to fight treaty shopping in the United States. It also scrutinizes the role and efficiency of the dual application of domestic anti-conduit rules and the United States's Limitation on Benefits treaty provision, in light of the objectives and purposes of tax treaties, i.e., their applicable principles.

Because treaty shopping is considered an abusive practice that falls outside the general objectives of double tax treaties, countries have been increasing measures to stop this undesired international practice, both domestically and internationally. Thus far, however, there has not been a satisfactory worldwide response to this practice.

The relevance of the international tax scenario for the United States lies not only in the country's economic importance in cross-board investment flow, but also in the fact that United States has one of the strictest domestic rules regarding limits on the improper and abusive use of conduit companies in international transactions. These rules are known as "anti-conduit rules" (referred to in section 7701 (l) of the Internal Revenue Code (Code) and Regulations 1.881-3 and 1.881-4). Additionally, the United States pioneered the "limitation of benefits" (LOB) clause in its Model Treaty (U.S. Model Treaty), (1) and it has very strict and well-developed LOB clauses in its current tax treaties.

In this sense, this article will address the normative history leading to the enactment of those domestic measures to fight tax treaty abuse. Moreover, the structure and impact of the U.S. Model Treaty's existing provisions--notably Article 22 (Limitation on Benefits)--that avoid improper distribution of treaty benefits between the United States and other Contracting States will be examined.

Next, the article will survey, from a historical perspective, how the United States domestically fought treaty shopping. To accomplish that purpose, the rulings, judicial doctrines, cases, and legislation in the United States that dealt with such issues will be analyzed, ranging from the classic Aiken Industries case to the anti-conduit regulations currently in force.

Lastly, the article will conclude my opinion regarding the United States's current "double-step approach" to this matter, i.e., the application of both domestic and treaty provisions to prevent abuse of tax treaties. This approach is reviewed in light of international tax treaty principles such as good faith, pacta sunt servanda, and the main purposes and objectives of tax treaties.


The United States's federal income tax regulations for taxing foreign persons are different than those for taxing U.S. residents. (2) This difference occurs in two different categories: (1) income effectively connected to U.S. trade or business (taxed on a net basis at the progressive rates generally applicable to U.S. residents), or (2) U.S. sourced income known as FDAP, (3) which normally includes royalties, dividends, interest, rents, and others (subject to a thirty percent withholding tax on gross income). If the nonresident receiving FDAP income is a resident of a country with which the United States has entered into a tax treaty, (4) however, he or she might be entitled to treaty benefits (provided some requirements in the treaty are met).

Usually, treaty benefits include a reduction in the withholding tax rate applicable to the income derived from the source country (sometimes even eliminating the tax burden by granting an exemption), nontaxation of an item of income in the source country (an effect similar to an exemption), or entitlement to use of tax credits (including additional ones granted as matching credits). Consequently, persons who are not residents of countries that entered into tax treaties with the United States often incorporate entities in countries that have entered into tax treaties with the United States so those benefits can be accessed indirectly. This practice is known as "treaty shopping."

It is said the term "treaty shopping" originated in the United States. (5) The concept has been traced back to the U.S. Congressional Hearings on Offshore Tax Havens in the early 1970s. (6) Some have analogized this term with "forum shopping," a phenomenon in U.S. civil procedure whereby a litigant attempts to "shop" between jurisdictions in which he or she expects a more favorable decision. (7) In the case of "treaty shopping," a taxpayer "shops" (i.e., searches) for the jurisdiction that has the best tax treaty with the country in which such taxpayer intends to invest (the host country), normally aiming for an exemption or reduction of tax rates in the host country because of the treaty with the "shopped" jurisdiction.

H. David Rosenbloom defines treaty shopping as "the practice of some investors of 'borrowing' a tax treaty by forming an entity (usually a corporation) in a country having a favorable tax treaty with the country of source--[that is,] the country where the investment is to be made and the income in question is to be earned." (8) According to Charles H. Gustafson, et al., it occurs when "tax planners [ ] establish corporate vehicles in third countries to take advantage of the benefits of a treaty between the third country and the country in which income would be earned." (9)

For decades, treaty-shopping arrangements have been well-known and widely practiced. The reason is quite simple (and obvious): treaties generate treaty shopping (10) as a natural response to a primitive stimulus (i.e., advantages generate opportunities).

According to Avi-Yonah and Panayi, there are three basic markers identifying a treaty-shopping structure:

(1) the beneficial owner ... of the treaty-shopping entity ... does not reside in the country where the entity is created;

(2) the interposed company ... has minimal economic activity in the jurisdiction in which it is located; and

(3) the income is subject to minimal (if any) tax in the country of residence of the interposed company. (11)

Although it might seem simple in theory, it is extremely difficult in some international structures to determine when a taxpayer is abusing a tax treaty. So far, successive models and commentaries have done little to clarify the limit between artificial arrangements and legitimate ones. (12) In the majority of cases, it is hard to distinguish a sham intermediary company from one with the required economic substance.

It has been disputed for years that treaty shopping is bad for countries because, among other factors, (13) (1) it "breaches the reciprocity of a treaty and alters the balance of concessions attained therein between the two contracting States," (14) (2) it allows "the third country to gain revenue power, [even in the] absen[ce] of any (substantial) claim to economic allegiance," (15) (3) it "creates a disincentive for countries to negotiate tax treaties," (16) (4) the "lack of fiscal co-operation enhances opportunities for international tax evasion," (17) and (5) it ultimately leads to revenue loss.

Curiously, in the recent case Union of India v. Azadi Bachao Andolan, the Indian Supreme Court refused to imply an anti-treaty-shopping clause in the India-Mauritius tax treaty. (18) In the judgment, the Supreme Court emphasized that in developing countries, treaty shopping was often regarded as a tax incentive to attract scarce foreign capital or technology. Such a decision demonstrated that, depending on the case (and, more importantly, on the country), treaty shopping may be a necessary evil, tolerated in a developing economy by some countries that wish to encourage economic growth derived from foreign investments.

This precedent represents a detour in the long fight against treaty shopping, especially since OECD has increasingly taken measures based in the United States's experience to continue discouraging such practice. Firstly, it recommended that Contracting States also include "specific provisions to ensure that treaty benefits will be granted in bona fide cases." Secondly, the 2003 OECD Commentary included, for the first time, the LOB clause, (19) which is the same one present in the U.S. Model Treaty (Article 22). This can surely be considered an improvement on the battle against treaty shopping, especially since 1977.


The United States was the first country to advance objections to treaty shopping. The U.S. Model Treaty promulgated in 1981 included a provision that only allowed treaty benefits to an entity resident in one of the Contracting States if seventy-five percent of the beneficial interest in such entity were owned by individual residents in that Contracting State, and no substantial part of its income was paid out as deductible income (interest, royalties, and others). (20)

The 1981 anti-abusive provision, however, proved to be "too blunt an instrument," (21) which explains why, during the late 1980s and early 1990s, it became increasingly improved and refined. Precisely for this reason, in the U.S. Model Treaty of 1996, the Treasury included the Article 22 draft, justifying the need and concern for a phrasing change of the LOB article by affirming the necessity to prevent residents of third countries, who establish legal entities in one of the Contracting States, with a principal purpose of obtaining the benefits of the treaty between the United States and the other Contracting State from doing so.

The issue of taxpayer's intent to configure treaty shopping was also mentioned in the U.S. Technical Explanation as a concern, and the solution for such difficult burden of proof (attributable to the tax administration) was to include in Article 22 a series of objective tests (22)According to the Treasury, the assumption underlying each of the objective tests is that a taxpayer who satisfies the requirements of any of such tests probably has a real "business purpose" for the structure it has adopted, or has a sufficiently strong nexus to the other Contracting State that validates the obtainment of treaty benefits even in the absence of a business connection to the Contracting State. (23)

It is important to remember the historical background in which the LOB provision was created. Before 1981, the United States had no systematic limitation on treaty shopping, although certain cases limited the use of treaties in abusive situations. The United States began to incorporate LOB provisions initially by administrative rulings and then into treaties. The U.S.-German treaty from 1989 was the first to include an LOB provision, and all subsequent U.S. treaties include LOB provisions, so that now there are virtually no U.S. treaties without such provision. (24) Particularly regarding U.S. international tax policy, Rosenbloom points to what he called "an element of disingenuousness" to defend his thought that it was time for a country like the United States to include a LOB article in its Model Treaty, since it was easier to remove relevant provisions from a model than to add it in the course of negotiations of a specific treaty. (25)

Recent wording of U.S. tax treaties (with the UK (26) and Switzerland (27)) includes elaborated LOB provisions that are much more complex than the provision in the 2006 U.S. Model Treaty, which was considered insufficient to prevent treaty shopping through inverted structures. (28)

The structure of the LOB clause set forth in Article 22 of the 2006 U.S. Model Treaty is divided into five paragraphs. The first paragraph states the general rule that'residents are entitled to benefits only if such person is a "qualified resident" under the terms defined in Article 22. (29)

Paragraph 2 lists a series of required attributes of a qualified resident in order to claim treaty benefits, referred to from (a) to (e). The presence of any one of the listed requirements allows the person to have access to all the benefits of the treaty. Essentially, individuals, (30) governments, publicly traded companies or their subsidiaries, or any form of legal entities (companies, trusts, or estates) that meet the "ownership/base erosion test" will be regarded as "qualified residents" under Article 22(2). (31)

Paragraph 3 provides an alternative test for a person who is not a qualified resident. In this sense, even when a person is not entitled to benefits under Paragraph 2, treaty entitlement may still be granted to that person if some requirements are met, which, in this case is "an active conduct of a trade or business" in the Residence State. (32)

Paragraph 4 contains a discretionary granting of treaty benefits by competent authorities, in the case that, even though a person who is not a qualified person (because this person does not meet the requirements of active conduct of a trade nor business), he or she would, at the sole discretion of that Contracting State, be entitled to the treaty provisions. In other words, if the competent authority of the state from which benefits are being claimed determines that it is appropriate to provide those benefits in the specific case of that person, treaty entitlement will still exist. (33)

Lastly, Paragraph Five contains the definition of the terms previously used in the article, such as "recognized stock exchange," "principal class of shares," and "primary place of management and control." (34)

The LOB provision is, unquestionably, an advance from the beneficial owner concept, due to its wide range of objective tests to verify treaty entitlement (rather than a vague and unclear concept--which is precisely what happens with the beneficial owner concept). (35) However, Congress still considered it too general, since the paragraphs do not address complex international financing transactions with hybrid financial instruments and hybrid entities, and practitioners often criticize its requirements and point out relevant flaws. One of the criticisms from practitioners is that the existing LOB provision does not solve important qualification problems for purposes of its own application, such as the competent country to apply the base erosion test or to disregard the intermediary entity for treaty entitlement purposes, (36) which still generates considerable controversy and may even lead to disputes between the Contracting States.

Additionally, in the "Facebook business era" of well-developed e-commerce and constant and rapid movement of capital, services, and persons, LOB requirements such as minimum physical presence tests are absolutely incongruent with current economy and technology and shall be reviewed.

Historically, although the United States attempted to apply domestic measures to prevent abusive treaty practices, the development of such internal provisions, standing alone, also proved to have considerable flaws, contributing to several modification and even termination of tax treaties entered into by the United States, examined as follows. (37)


The United States's fight against treaty shopping did not start, as some might believe, with the Aiken Industries case (38) Before that, the Internal Revenue Service (Service) attempted to apply judicial doctrines to treaty shopping cases but has historically failed. In Gustafson's opinion, (39) the historical failure is mainly due to the test that originated in 1943 with Moline Properties, Inc., v. Commissioner, in which the Court held that taxpayer only needed to prove that the corporation was either (1) formed for a business purpose or (2) carried on business activity in order to be respected as a separate entity for tax purposes. (40) " In Johansson v. United States, a Swedish boxer incorporated a company in Switzerland and purportedly worked for a Swiss paper corporation, in order to claim the exemption of compensation income under U.S.-Swiss tax treaties, (41) which were applicable to employees of Swiss corporations for services performed while temporarily in the United States. (42) The court did not accept the line of thought and did not consider that Mr. Johansson was, in fact, an employee of the Swiss company, but instead its sole shareholder. Therefore, the income was not qualified as employee's compensation and subject to the beneficial treatment under the treaty. (43)

Four years later, in another case involving application of judicial doctrines, Bass v. Commissioner, the Tax Court rejected the denial of treaty benefits to a Swiss corporation under a U.S.-Swiss tax treaty, holding that, due to documentary evidence and testimony, the taxpayer demonstrated that the "corporation was managed as a viable concern, and not as simply a lifeless facade." (44)

Despite all prior attempts, Aiken Industries, Inc. v. Commissioner in 1971 was the first important case the Service won that specifically related to treaty shopping. (45) In Aiken Industries, a United States corporation (debtor) and a Bahamian corporation (creditor) used a Honduran corporation as an intermediary to obtain the benefits of the U.S.-Honduras treaty. At the time, such treaty provided an exemptionon interests paid from U.S. sources to Honduran residents. The decision by the Tax Court was to deny the treaty benefits. The court determined that the Honduran corporation was a mere conduit company through which the interest flowed to the Bahamian corporation, which was not, itself, eligible for the exemption based in any tax treaty. (46)

This case involved an Ecuadorian corporation ("Ecuadorian"), a resident of the Bahamas, that owned 99.99% of the stock of Aiken Industries, Inc. ("Aiken"), a resident of the United States. In addition, Aiken was the sole shareholder of Mechanical Products Inc. ("MPI"), also a resident of the United States. In 1963, MPI borrowed US $2.3 million from Ecuadorian in exchange for a four percent promissory note. In 1964, Industrias Hondurenhas S.A. ("Industrias") was incorporated in Honduras. Ecuadorian, which owned through a subsidiary all shares of Industrias, transferred the four percent promissory note issued by MPI to Industrias, in exchange for nine promissory notes issued by Industrias in the same overall amount. The principal and the interest of such notes were the same of those previously issued by MPI. (47)

There was no tax treaty between the United States and Bahamas at the time, but there was a tax treaty in force between the United States and Honduras. Under the U.S.-Honduras treaty, the United States had to exempt any interest "received by" a corporation resident in Honduras, originated in the United States. MPI did not apply the thirty percent domestic withholding income tax on interest paid to Industrias, due to the U.S.-Honduras tax treaty provision. However, U.S. tax authorities argued that Aiken--the MPI legal successor after its incorporation--should have levied the thirty percent tax rate, since Ecuadorian had to be considered as the recipient of the interest. As a consequence, the U.S.-Honduras tax treaty was not applicable. (48)

The U.S. Tax Court confirmed the position of the U.S. tax authorities. (49) The decision was based on Article 2(2) of the treaty which stated that any terms not defined thereof should be given, unless the context otherwise required, the meaning they had under the laws of the state applying the treaty. (50) In this sense, the interest could not be considered as "received by" Industrias, since the latter was under a legal obligation to transfer the same amount of interest received to a related corporation resident in a third state (i.e., no margin of profits was kept in Honduras). It was stated that the term "received by" was not just the obtaining of temporary physical possession of values, but contemplated complete dominion and control over those funds. (51) Thus, Industrias were a mere collection agent acting as a conduit company for the interest payments between MPI and Ecuadorian.


After Aiken Industries, the approach chosen by the Service to fight treaty shopping was based on invoking administrative authority in light of Aiken Industries. In Revenue Ruling 80-362, 1980-2 C.B. 208, a resident of a nontreaty jurisdiction licensed a patent to a Dutch corporation, which in turn sublicensed the patent to a U.S. corporation for use in the United States. The royalties paid from the United States to the Netherlands were exempt from withholding tax under the Netherlands-U.S. income tax treaty. The Service ruled, however, that the royalties paid from the Netherlands to the nontreaty jurisdiction were U.S.-source royalties under section 861(a)(4) because they were paid in consideration for the privilege of using a patent in the United States. (52) Therefore, those royalties were subject to a thirty percent withholding tax in the United States, i.e., cascading royalties were subject to U.S. income tax without the application of treaty provisions. (53)

Before 1984, the United States faced numerous international tax structures using the Netherlands Antilles jurisdiction, which became known as the "Dutch Sandwich," especially regarding interest, dividend, and royalty income derived from U.S. sources. (54) The classic "Dutch Sandwich" structure was characterized either by a Netherlands corporation inserted between a U.S. corporation and a foreign lender, or a Netherlands Antilles corporation owned by a Netherlands corporation that was owned by a Netherland Antilles corporation. (55) A variation known as "open faced Dutch sandwich," occurred when a Netherlands Antilles corporation owned a Netherlands corporation that, in turn, owned a U.S. subsidiary. (56)

The immediate reaction to such abusive practices was the issuance of Revenue Ruling 84-152 by the Service. (57) In this Ruling, it was held that interest payments by a U.S. corporation are not exempted from taxation by the United States under Article VIII(l) of the U.S. Netherlands Convention (extended to the Antilles) if received by a Netherlands Antilles company that is wholly owned by a Swiss entity that also owns 100 % of the voting power of the U.S. corporation. (58) It was basically the same understanding found in Aiken Industries, but applicable to the Netherlands (and Antilles) tax treaty. In Revenue Ruling 84-153, 1984-2 C.B. 383, the issue was the same, but with the use of a Netherlands Antilles finance subsidiary. The holding was that the U.S.-Netherlands Antilles Treaty benefits were not applicable when a U.S. parent uses an Antilles subsidiary to issue bonds to foreign parties and then lends the proceeds to a U.S. subsidiary. (59)

The issuance of these two rulings caused a huge impact among holders of debt that was financed through Netherlands Antilles financed companies. As stated by Gustafson, at the time there was an implicit acknowledgment by the Service that those rulings went beyond the holding in Aiken Industries, precisely why the effects derived by such rulings were prospective and not retroactive. (60)

On June 29, 1987, due to the increasingly abusive practices with U.S.-Netherland Antilles structures, the United States gave notice that the tax treaty with Netherlands Antilles would be terminated effective as of January 1, 1988. (61) For that reason, Revenue Ruling 89-110, 1989-2 C.B. 275, was released to explain the effect of partial termination of the Netherlands Antilles treaty on both Revenue Ruling 84-152 and 84-153.

At the time, the Service also issued Revenue Ruling 87-89, aimed at back-to-back loans involving an intermediary financial institution. That Ruling held that the loans should be recharacterized as a loan directly from the nontreaty parent because the intermediary would not have made the loan substantially on the same terms but for the deposit or loan of funds by the parent. Fox and Kennedy (62) point out that such holding was based on the substance over form judicial doctrine originated by the notorious case of Gregory v. Helvering. (63)

Further, in 1995, in Northern Indiana Public Service Co. v. Commissioner, once again financing structures were challenged. (64) This time the issue was whether interest payments on a note made by a domestic corporation to its wholly owned Netherlands Antilles subsidiary were exempt from United States withholding tax, under the United States-Netherlands Income Tax Convention. The Service claimed that, under Aiken Industries, a financing arrangement involving a borrowing by a Netherlands Antilles finance subsidiary was "interposed to exploit" the United States-Netherlands Antilles Tax Treaty. (65) The court held that the finance subsidiary could be recognized as the borrower because the arrangement had been established to borrow money from unrelated lenders for relending to the taxpayer. (66)

Additionally, the court also distinguished Northern Indiana from Aiken Industries by noting that significant earnings were generated by the finance subsidiary's financing activity. (67) The Court of Appeals rejected the Service's argument that the finance subsidiary was inadequately capitalized. The Court of Appeals rejected the Service's attempt to apply substance over form or economic substance analysis to a Netherlands Antilles finance subsidiary; thus, the Tax Court decision was affirmed. (68)

In SDI Netherlands B.V. v. Commissioner, the issue revolved around cascading royalties. SDI Bermuda (a company that had the worldwide rights to use a certain computer software) licensed these rights to SDI Netherlands (licensee). (69) SDI Netherlands, by its turn, sublicensed the rights to use the software in the United States to a U.S. corporation (SDI USA). Therefore, SDI USA paid royalties to SDI Netherlands, and SDI Netherlands paid royalties to SDI Bermuda. The Service argued that the Code provisions required a thirty percent tax on royalty payments that SDI Netherlands made to SDI Bermuda, which represented the royalties it received from SDI USA. The rejected argument (present in Revenue Ruling 80-362) was that royalties paid by SDI USA to SDI Netherlands were United States-source income, and that the royalties retained the same character when SDI Netherlands transferred a portion of such royalties to SDI Bermuda. (70) The decision expressly mentioned that the facts on SDI Netherlands fell under the case of Northern Indiana, and not under Aiken Industries, thus, ruling in favor of the taxpayer. (71)

In 1999, a curious change of position was made in Del Commercial Properties, Inc. v. Commissioner, in which an unrelated Canadian bank made a loan to a member of the taxpayer's affiliated group, and the proceeds of the loan were passed among the members of the group, winding up with the Dutch member who loaned them to the taxpayer. (72) The Court of Appeals applied the "step transaction doctrine" under which "a particular step in the transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly, but instead included the step for no other purpose than to avoid U.S. taxes." (73) For that reason, it held that, although interest payments are exempt from the withholding income tax under U.S.-Netherlands Treaty, by applying the step transaction doctrine, the relationship was, in fact, between a U.S. company and a Canadian company. Thus, the U.S.-Canada Treaty that allowed a fifteen percent withholding tax rate to interest payments should have been applied. (74) At the time, the application of a judicial doctrine came as a surprise.

As it can be verified from the history in the case law, administrative rulings, and judicial doctrines, the U.S. domestic mechanisms against treaty shopping since Aiken Industries (1971)--and even before it--were very confusing, incongruent, and heterogeneous. No general rule or principal could be clearly drawn from all the U.S. cases, and the judicial doctrines such as substance over form and step transaction were sometimes denied, and sometimes accepted, by courts. There was no reliable legal guidance for residents of a treaty country to clarify the conditions for the entitlement of treaty benefits with the United States.

From that time on, domestic measures proved to be insufficient to duly fight treaty shopping, and the international community was already working on a bilateral (or multilateral) alternative, specifically applicable to tax treaties and Treaty Models.


In 1993, Congress strengthened the Service's position in cases involving treaty shopping that was experienced in all previous cases cited, and also avoided abuse of portfolio interest exemption, (75) when it enacted section 7701(l), which authorized regulations "recharacterizing any multiple-party financing transaction ... as appropriate to prevent avoidance of any tax law." (76) The regulations authorized by section 7701 (l), notably Regulation 1.881-3, were issued in 1995 and permitted the Service to disregard the participation of one or more intermediate entities in a financing arrangement for purposes of sections 871, 881,1441, and 1442. (77)

The relevance of anti-conduit regulations is that, if a conduit entity is disregarded, such financing arrangement is recharacterized (in total or in part) (78) as occurring directly between the other remaining parties involved in the transaction (i.e., the financing and the financed entities). (79) For that purpose, there is no treaty entitlement for the disregarded entity (treated as an agent), which means no treaty benefits such as exemption or rate reduction of withholding taxes existing in a tax treaty entered into by United States and the country in which the disregarded entity is resident will be available.

Based upon examination of such regulations, the necessary elements that would trigger the application of such anti-conduit rules are, essentially:
  [1] the existence of a financing transaction; [2] [participation of
  an intermediate entity in that transaction; [3] [a]n actual reduction
  of taxes on nonresidents as a result of that participation; [4] [t]he
  existence, or deemed existence, of a tax-avoidance plan; [and] [5]
  [a]n intermediary that either (1) is related to the borrower or
  lender or (2) would not have given the same loan terms to its
  borrower but for the terms from its lender[.] (80)

A financing arrangement is defined as:
  [a] series of transactions by which one person (the financing entity)
  advances money or other property, or grants rights to use property,
  and another person (the financed entity) receives money or other
  property, or rights to use property, if the advance and receipt are
  effected through one or more other persons (intermediate
  entities). ... (81)

It should be noted that the financed and financing entities do not need to be related persons. (82) The Service is also allowed to treat two or more related persons as a single intermediary entity, even without any transaction linking/connecting the entities themselves, if the structure's main purpose is to prevent the characterization of such structure as a financing arrangement. (83)

The definition of "financing transaction" comprises transactions with debt instruments, leases, or license agreements. (84) Guarantees are not included in this definition. (85) There is also the possibility that corporate stock and interest in partnerships and trusts could be considered a financing transaction, if some requirements are met. (86)

Under the regulations, the "conduit company" is defined as "an intermediate entity whose participation in a financing arrangement may be disregarded in whole or in part" (87) and a "conduit financing arrangement" is defined as a financing arrangement effectuated through one or more conduit entities. (88)The final relevant, legally defined concept is the "related" meaning. The persons are related if they fit the concept of related under section 267(b) (89) or 707(b)(1) (90) of the Code, or if they are considered commonly controlled for purposes of section 482. It should be noted that the rules dealing with constructive ownership of section 318 are applicable when determining if the persons are related, and the attribution rules of section 267(c) apply if their effects are broader than section 318 rules. (91)

As to the characterization of a "conduit entity," the intermediary company will be considered as a conduit if the participation in the financing arrangement reduces taxes under section 881 and is "pursuant to a tax avoidance plan." (92) According to Bittker and Lokken, the Service believes that its application of this rule "generally will be reviewed by the court under an abuse of discretion standard." (93)

Moreover, the Service is entitled to treat (and thus, disregard the transaction between) two or more related intermediate entities as one conduit if "one of the principal purposes for using multiple intermediate entities is to circumvent the conduit rules by, for example, preventing the characterization of an intermediate entity as a conduit or reducing the portion of a payment that is subject to withholding tax," (94) which makes the anti-conduit regulations even broader in light of prevention of international tax abusive schemes.

In order qualify as a conduit, there must be a reduction of U.S. withholding income tax (95) by comparing the withholding tax between the financed entity with the intermediary, the financed entity, and financing entities. (96) The reduction must be done in accordance with a "tax avoidance plan," defined as "a plan one of the principal purposes of which is the avoidance of [withholding] tax," and can be formal or informal, written or oral, to be inferred by facts and circumstances. (97) The significance of tax avoidance is measured by the effective amount of withholding tax saved by using the intermediary entity in the transaction, and not the nominal tax rate. (98)

Further evidence of a tax avoidance plan is shown when the intermediate entity lacks "sufficient available money or other property of its own" to make the advance to financed entity without the advance of money or other property to it by the financing entity in a short period of time between the financing entity's advance to the intermediate entity and the latter's advance to the financed entity. (99) There are, nonetheless, two exceptions to that classification: (1) when the financing transaction occurs in the ordinary course of the "active conduct of complementary or integrated trades or business," (100) and (2) if the entity carries on "significant financing activities" in the financing arrangement. (101) The regulations also have a bonafide exception to withholding tax liability that protects taxpayers acting in good faith as long as the financing entity making payments is unrelated to other participants in the financing arrangement and only if the intermediate entity is actively engaged in a substantial trade or business. (102) Nevertheless, the financed entity still might have withholding tax liability as an agent. (103)

In order to avoid any discussion on treaty overriding (104) due to theadoption of the "later in time" (105) policy, the Treasury stated that the anti-conduit regulations do not conflict with the limitation on benefits clause used in the U.S. Model Treaty and in practically all tax treaties entered into by the United States. (106) It is said that the anti-conduit regulations "supplement, but do not conflict, with the limitation on benefits articles in tax treaties," and they are intended to determine who is the beneficial owner of the income with respect to a certain financing arrangement. (107) Thus, the Treasury tried to harmonize the anti-conduit regulations with the U.S. Model Treaty provisions. (108)

In the same vein, the Technical Explanation on Article 22 states that domestic anti-abusive provisions, such as anti-conduit regulations, complement the LOB clause on tax treaties entered into by the United States. Especially since, even though Article 22 establishes the sufficient nexus for a taxpayer to be considered a resident for at least one of the Contracting States for treaty benefits entitlement, the internal provisions determine whether the transaction shall be disregarded and recharacterized in accordance with its true substance. (109) The OECD Commentary on Article 1 (110) manifests a similar position. (111)

For that reason, Bittker and Lokken seem to defend a double-step application of anti-abusive provisions to treaty shopping, i.e., a domestic and international approach to avoid the unintended treaty entitlement. (112) First, internal law principles and rules of the source State apply in order to identify the beneficial owner of the income in question. Subsequently, Article 22 of the treaty shall apply to verify if the beneficial owner is entitled to the benefits of such treaty.

According to this "double-step" approach, the United States is basically combining its domestic anti-conduit regulations (and applicable judicial doctrines and Revenue Rulings) with the provisions included in its double tax treaties entered into with other States (essentially the LOB clause) to prevent treaty shopping under U.S. double tax treaties.

Although this anti-abusive policy might seem reasonable from an efficiency perspective, it gives rise to some important issues under international treaty principles and international customs by challenging relevant diplomatic discussions on cooperation, reliability, and interpretation of bilateral treaties.


It is common sense in the international law community that the interpretation of double tax treaties, as well as any other international treaty, should be construed in light of and according to the provisions of the Vienna Convention on the Laws of Treaties (VOLT). (113) This convention from 1969 establishes the general principles applicable to the interpretation of international treaties, and it has been considered as the common standard for Contracting States. (114)

Articles 26 (Pacta sunt servanda) and 27 (Internal law andobservance of treaties) of the VCLT provide important guidelines on applying international treaties. According to Article 26, "every treaty in force is binding upon the parties to it and must be performed by them in good faith. (115) That means a Contracting State is obliged to duly perform and apply the provisions negotiated and inserted in the text of the treaty. Actually, the "good faith" principle is also mentioned in Article 31(1) of the VCLT, which provides the General Rule of Interpretation, electing the required elements to be used when interpreting a treaty: (1) good faith and (2) the ordinary meaning of the term. (116)

In this sense, good faith in interpreting and applying tax treaties requires not only the search for the ordinary meaning of a term used in the treaty but also interpreting all treaty provisions in good faith, according to what was negotiated and agreed at the time the treaty was signed by both parties.

Article 27 also plays an important role in the application of international treaties, by prescribing that "a party may not invoke the provisions of its internal law as justification for its failure to perform a treaty." (117) In this sense, future modifications under domestic law that affect treaty provisions and terms shall not, as a general rule, be automatically applied to the treaty, since at the time of the negotiation they were not discussed or known by the other party. That does not mean they cannot be included in the treaty; however, there is a special procedure: entering into a Protocol.

The role of a Protocol is to amend the treaty and guarantee that its provisions are updated and in line with the current internal policy and legislation of one or both countries. Precisely for this reason, the Protocol is a bilateral instrument and, thus, must be agreed to and signed by both Contracting States.

Lastly, Article 31 clearly mentions that a treaty must be interpreted and applied in accordance with its object and purpose. (118) Since the object and purpose of a tax treaty is to allocate taxing power between two states, in order to promote economic and business development and avoid double legal taxation and tax evasion, it is difficult to reconcile these objectives when one party unilaterally applies its own domestic legislation to override a treaty provision, instead of using the Protocol instrument.

Even though this is the well-known position adopted by the United States for a long time, according to its "later in time" policy, the international tax community and the other Contracting States, as well as the United States's treaty partners, do not share this view. Actually, when the issue relates to treaty shopping, the mere application of domestic law to avoid treaty shopping does not fairly solve the problem. The country of residence of the entity or person claiming the treaty entitlement is the one that can actually provide the proper evidence of economic substance, factual presence, certificate of residence, and all other relevant proof required by the country paying the income (in this case, the United States).

Therefore, the need for cooperation and exchange of information and other evidence between the two countries involved in the transaction (i.e., the Contracting States) is vital for the proper fight against and prevention of treaty shopping. In order to avoid tax treaty abuse, from a domestic legal perspective, the relationship with the other Contracting State has to be transparent and in good faith with the treaty provisions. Otherwise, internal rules will either extend their scope (attacking unintended legitimate transactions) or be limited to obviously abusive transactions (which are easy to spot and, for that reason, already normally repealed, since they completely lack economic or business substance).

In the first case, the excessive anti-treaty-shopping measures will damage genuine lawful foreign investments, harming the economy of the host country applying such domestic rules--which goes completely against the double tax treaties' scope and purposes (i.e., to stimulate economic growth, international cooperation, and exchange of information between treaty partners). In the second case, the domestic rules will have no additional effect, since the classic abusive structures using mailbox companies are already known by most developed and developing countries and, thus, will not prevent new abusive international schemes. Consequently, the double-step approach against treaty shopping will be viewed in light of the treaty provisions in place between the two countries. Otherwise, the country receiving the income will not cooperate and provide the necessary evidence to the payor country, leading to one of the aforementioned results.

Subsequently, this vicious circle of treaty overriding, leading to no cooperation or exchange of information, too broad or too narrow application of domestic anti-treaty-shopping rules, and the opposite effect of the treaty objectives and purposes (stimulating foreign investment and economic growth internationally) will, ultimately, lead to the termination of the tax treaty by one of the Contracting States.

If a tax treaty is terminated, countries are not restricted by the treaty provisions, and may apply their own domestic tax laws without any constraint, due to tax sovereignty. Thus, as can be inferred from this analysis, the United States's "later in time" policy to tax treaties, when applied to treaty-shopping provisions, might actually (1) stimulate more treaty shopping, since countries that terminated or have not have entered a tax treaty with the United States will, due to excessively strict domestic rules, use another country that still has a treaty with the United States to set up their conduit entity and, thus, have access to the treaty benefits of this other treaty, and (2) disincentivize legitimate foreign investments, since it might lead the investment shifting to another similar country that does not apply incredibly unreasonable anti-abusive measures to cross board investments, but has similar economic/business conditions.

Thus, the manner in which the double-step approach is currently applied by the United States might, eventually, represent revenue lost for the United States on foreign investments, contributing to negative economic consequences, in addition to eventual political and diplomatic tension between the United States and the Contracting States that may terminate the treaty, or that may not enter into a tax treaty with the United States (like Brazil, for example).

Considering that with or without a treaty, the United States will apply its own domestic provisions to fight treaty shopping, i.e., in the case of financing arrangements it means the application of anti-conduit regulations, from the sole treaty-shopping perspective, the treaty itself (even with the LOB clauses) will not matter. This is due to the fact that it will not work as a limitation of the domestic legislation of both countries in that matter. It is evident that both provisions (LOB clauses and anti-conduit regulations) are not identical and, although they overlap in some issues, they tackle different points of abusive structures.

For that reason, knowing that the United States will certainly apply both provisions - even in the case of an existence of a treaty without any reference to domestic laws on the abuse or treaty-shopping subject - a treaty partner may consider, strictly from the treaty-shopping point, terminating the tax treaty with the United States, thereby ending any additional limitation derived from the LOB clause, and just invest in the United States directly, without a tax treaty in force, since the anti-conduit rules will apply in any case (with or without a treaty).

Countries, when entering into tax treaties, are restricting the scope and assessment of their domestic rules by applying the rules under the treaty. From a treaty-shopping perspective, states are exchanging existing anti-abusive provisions in domestic law for a LOB clause under the treaty. If no reference to domestic law is made to this issue within the treaty, the Contracting States are actually exchanging a domestic anti-abusive provision (unilaterally made) for another one, mutually negotiated. In other cases, instead of a substitution the Contracting State may be creating an international anti-abusive provision (provided that its domestic law permits it) if they do not already have a domestic one, since the state accepted a LOB clause in the treaty with the other state with which it just entered into a treaty.

This conclusion may lead to other adverse collateral damages, since termination of a tax treaty also puts an end to the international cooperation, exchange of information, extraterritorial enforcement of tax claims, investors' legal certainty and reliability, and the existence of measures to solve bilateral controversies on tax matters (like mutual agreement procedure and arbitration) between these two countries.

It can be observed that the violation of international treaty principles through the use of domestic law (i.e., treaty override), when related to treaty-shopping measures, can produce other undesirable consequences for the countries that have or would have entered into a tax treaty. With that in mind, in the current international scenario, most countries either allow the use of foreign credit or exempt the income already taxed at the host country by unilateral measures, the importance of tax treaties in the current economy is not just the avoidance of double or multi taxation which, in most cases, does not occur anymore, but the other indirect or secondary advantages of having a tax treaty, mentioned previously.

In the same sense, those other advantages may disappear if the U.S. policy on treaty shopping does not change to adopt the international customs and the international principles stated in the VCLT. Hence, the collateral damage is, precisely, the triggering of the vicious circle and the problems brought by such chain of events. No country can effectively exist in the international economy without the interaction and cooperation of other partners, and the United States is not exempt from this rule. Even though there is no legal remedy to punish or stop treaty override in international public law, the political, diplomatic, economic, and even social consequences of such treaty violation could be much worse than potential punitive damages, if such existed. The commercial prohibitions and retaliation, the reduction of foreign investments, the end of extradition and international criminal agreements, and even the hate and prejudice generated among the citizens and residents of the other country who suffer from the override can create numerous negative consequences for the overriding country, despite the lack of judicial or legal measures to correct that behavior. In difficult times, such as the post-worldwide crises, and the eminence of several other economic collapses and downturns, a good international relationship can never be taken for granted, especially when state financial aid and political help for refugees, political prisoners, and expatriates are added to this equation. Tax treaties involve more than just tax matters, and, since they have a high political and economic value, they have to be carefully and correctly analyzed, interpreted, and applied by countries.


The possible solution to the double-step approach in its current format is to grant more interaction and harmonization between the tax treaty provisions against treaty shopping (notably the LOB clause, since the beneficial owner concept does not solve the problem) and the extensive anti-conduit regulations, which are more specific and adopt a more transactional (objective) approach, rather than the entity (subjective) approach given by the LOB provision.

For instance, in the near future, one possible approach on this subject might be to adapt LOB ownership and base erosion tests (Article 22(2)(e) of 2006 U.S. Model Treaty) to test for regulatory conduit status, extending some of the requirements and developments included in the anti-conduit regulations to tax treaties. (119) The problem with this approach is whether imposing a second set of ownership and base erosion rules, by domestic regulation, is a necessary or administrable solution to the problem of hybrid instruments in light of treaty shopping.

One alternative suggested by the Treasury and the Service is to include the transactions involving financial instruments between a financing entity and an intermediate entity as financing transactions not only for purposes of the conduit financing regulations but for treaty purposes as well. (120) Another possibility is to add other factors to be considered when determining in which cases stock in a corporation (or interest in a partnership or trust) may constitute a financing transaction for treaty purposes. (121)

In any case, this integration between domestic rules and treaty provisions must be made in accordance with Articles 26, 27 and 31 of the VCLT, which means that it is mandatory (also under international customs) for the United States to include a reference in the wording of the LOB clause to the domestic rules that are intended to apply to the transactions with the other country negotiating the tax treaty. The use of vague and general references to "anti-abusive rules in force in domestic legislation at the time" shall be avoided as much as possible, due to the considerable uncertainty that they might bring upon application, and the confusion they might bring to what can be considered as an internal anti-avoidance rule at the time of the event and within the scope of such provision (indirect violations, analogies, etc.). For clearer reference, it is preferable that the treaty wording explicitly mention the specific domestic law or legislation.

Hence, the express mention of the anti-conduit regulations in a specific treaty provision or in one of the paragraphs of the LOB clause, composing the wording of the treaty, seems to be the best method to apply domestic anti-treaty-shopping rules without incurring treaty overriding or preventing economic growth in the United States through foreign direct investments.

Nevertheless, the treaty mention of domestic rules is not the only measure to help solve the treaty-shopping problem. There is a clear need for both domestic and treaty provisions to be in relative harmony, completing and interacting, at least in essence, with each other. As it was briefly demonstrated herein, the anti-conduit regulations and the LOB clauses both have flaws and have to be improved to effectively prevent the true illegitimate treaty-shopping practices. If those two rules are not in sync, the application of those anti-abusive rules to cross-board transactions may - and most definitely will - backfire, creating the vicious circle previously mentioned, leading to negative economic consequences in the United States by reducing foreign investments, development of cross-board business, international cooperation, and exchange of information (which are precisely the purposes for which tax treaties exist).

For that reason, it is understood that a part of the international tax reform addressed by the U.S. government shall touch upon this delicate issue, to effectively improve the prevention of treaty shopping, in cases in which it is considered bad for the host country, as it is for the United States as a known developed capital exporter.


In the current domestic and international scenario, the fight against treaty shopping is similar to a witch-hunt, in which governments are extremely suspicious when granting treaty entitlement. Since Aiken Industries, the Service and taxpayers have become more aware of the consequences treaty shopping can generate. Several internal measures were used by the Service, including Revenue Rulings, administrative procedures, and judicial doctrines, but none of them alone proved to be the ultimate solution to the treaty-shopping issue. After decades of study and analysis on foreigners' abusive practices, the anti-conduit rules were enacted and are certainly considered as an evolution to domestic mechanisms to eliminate or reduce treaty-shopping practices, especially after the Service's failed attempts to apply those judicial doctrines and administrative authority in Revenue Rulings.

From an international and treaty perspective, the adoption and improvement of a LOB article in the U.S. Model Treaty demonstrated that more mechanisms could still be used, and their immediate effect on treaty shopping tended to be more satisfactory. However they are still considered to be too generic and not as specific and transactionally oriented as the domestic anti-conduit rules.

The double-step approach used by the United States to prevent treaty shopping, characterized by the mutual application of the domestic rules under the anti-conduit regulations and the international measures under the tax treaty (LOB clause) for situations involving a treaty partner, in its current format, does not satisfactorily solve the problem. Furthermore, as demonstrated herein, that approach might lead to the opposite of the treaty's intended effect: the reduction of foreign investments, a negative overall economic effect on the U.S. domestic economy, and even the termination of existing treaties.

These unintended results might be reached because the Treasury and the Service, by applying two different approaches to a conduit transaction, might be surpassing the battle against abusive practices and starting to disincentivize legitimate business structures carried through transparent entities and holdings that, in fact, have economic substance. It seems the excessive unilateral pressure brought by the government may, from an economic perspective, induce investors' contrary behavior, due to its lack of reasonable criteria under international treaty principles such as good faith, pacta sunt servanda, as well as tax treaties' objectives and purposes.

Thus, in a time of expansion of international tax and banking cooperation in light of the recent UBS Settlement, (122) and constantly promoted by Article 26 of Double Tax Treaties and Tax Information Exchange Agreements (TIEAs) entered into with tax havens jurisdictions, developed countries like the United States shall work to harmonize both domestic and international measures against treaty shopping, relying on the information and evidence provided by the other Contracting State, and receiving the income from the United States, instead of unilaterally trying to solve a complex matter that demands bilateral cooperation.

As demonstrated in the course of this study, the United States acts as a role model when it implements measures against treaty shopping, both from a domestic and an international perspective. The anti-conduit regulations are an example of the high level of development on internal rules aimed to avoid abusive practices in international tax planning. Additionally, the LOB clauses used by the United States have already served as a standard for several other countries and have even been recognized by the OECD as a useful mechanism against such practices.

In conclusion, I believe that, although the double-step approach used by the United States to fight treaty shopping might be considered the most effective method, the way that the United States applies suchan approach is not ideal, since the approach not only fails to address important treaty issues that arise from LOBs, but also contributes to a vicious circle that may lead to the opposing objective and purpose of tax treaties: to stimulate foreign investment and the economic growth of the Contracting States. As mentioned, the negative effects are not only related to tax issues, but migrate further to politics, diplomacy, economics, third sector, etc. As President Obama has already stated that this is a time for change, (123) it certainly includes changes in U.S. treaty-shopping policy.

(1) U.S. MODEL INCOME TAX CONVENTION OF NOV. 15,2(K)6 art. 22 (2006). 2 U.S. residents are subject to the worldwide taxation, currently taxed at a progressive rate up to thirty-five percent both for companies and individuals, on the net income.

(2) U.S. residents are subject lo the worldwide taxation, currently taxed at a progressive rate up to thirty-five percent both for companies and individuals, on the net income.

(3) I.R.C. [section][section] 871 (a); 881 (a).

(4) According to Article 4, paragraph 1, of the 2006 U.S. Model Income Tax Convention, a person is a "resident of a Contracting State" if he "is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature." U.S. MODEL INCOME TAX CONVENTION OF Nov. 15,2006 art. 4 (2006).

(5) Reuven Avi-Yonah & Christiana HJI Panayi, Rethinking Treaty Shopping: Lessons for the European Union 2 (Pub. Law and Legal Theory Working Paper Series, Working Paper No. 182, Jan. 2010).

(6) See The Use of Offshore Tax Havens for the Purpose of Evading Income Taxes: Hearing before the Subcomm. on Oversight of the II. Comm. on Ways and Means, 96th Cong. 284 (1979) (statement of H. David Rosenbloom, Int. Tax Counsel, Dep't of the Treasury); H. David Rosenbloom, Tax Treaty Abuse: Policies and Issues, 15 LAW & POL'Y INT'L BUS. 763, 766 (1983) [hereinafter Rosenbloom, Tax Treaty Abuse].

(7) Becker Helmut & Felix J. Wurm, Survey, in TREATY SHOPPING: AN EMERGING TAX ISSUE AND ITS PRESENT STATUS IN VARIOUS COUNTRIES 1, 2 (Becker Helmut & Felix J. Wurm, 1988).

(8) H. David Rosenbloom, Derivative Benefits: Emerging US Treaty Policy, INTERTAX, Jan. 1994, at 83.


(10) John F. Avery Jones, The David R. Tillinghast Lecture: Are Tax Treaties Necessary?, 53 TAX L. REV. 1, 3-8 (1999).

(11) Avi-Yonah & Panayi, supra note 5, at 5.


(13) [See] Avi-Yonah & Panayi, supra note 5, at 5-7.


(15) Avi-Yonah & Panayi, supra note 5, at 6 (citing H. David Rosenbloom & Stanley I. Langbein, United States Tax Treaty Policy: An Overview, 19 COLUM. J. TRANSNAT'L L. 359,397-98 (1981)).

(16) See I.R.S. News Release IR-1694 (June 27, 1979) (relating to the U.S. treaty with the Netherlands Antilles).

(17) Avi-Yonah & Panayi, supra note 5, at 7 (citing H. David Rosenbloom & Stanley I. Langbein, United States Tax Treaty Policy: An Overview, 19 COLUM. J. TRANSNAT'LL. 359, 396-97 (1981)).

(18) Union of India v. Azadi Bachao Andolan, (2004) 10 S.C.C. 1 (India) ("Developing countries need foreign investments, and the treaty shopping opportunilies can be an additional factor to attract them.").

(19) MODEL TAX CONVENTION ON INCOME AND ON CAPITAL art. 1 cmt. [paragraph] 20 (OECD 2003).


(21) Id.

(22) The current wording of the 2006 U.S. Model and its Technical Explanation are both very clear that Article 22 is an anti-lreaty-shopping provision and that the intent or motivation of the resident in the Contracting State is not important; the resident's intent is only relevant to fulfill one of the requirements of the objective tests prescribed in such an article. See U.S. MODEL INCOME TAX CONVENTION OF NOV. 15,2006 art. 22 (2006); U.S. MODEL TECHNICAL EXPLANATION ACCOMPANYING THE U.S. MODEL INCOME TAX CONVENTION OF NOV. 15,2006 art. 22, [paragraph] 1 (2006) ("In general, the provision does not rely on a determination of purpose or intention but instead sets forth a series of objective tests.").


(24) BITTKER & LOKKEN,supra note20.

(25) Rosenbloom, Tax Treaty Abuse, supra note 6, at 830.

(26) See Mohammed Amin, The Anti-Conduit Provisions of the New UK/US Treaty, FIN. INSTRUMENTS: TAX AND Acer. REV., Sept. 2003.

(27) See Peter Reinarz, Swiss/US Pact Sets Strict Limitation on Benefits, INT'L TAX REP., Dec. 1996, at 1-6.

(28) Avi-Yonah & Panayi stress that:

[B]etween 1997 and 2001 many public US corporations engaged in 'inversion' transactions in which they became subsidiaries of new public corporations in Bermuda. Bermuda does not have a treaty with the US so for treaty purposes the new parent corporations qualified as residents of Barbados. Subsequently, the new parent would lend funds to the US subsidiary which would deduct the interest and pay no withholding tax under the Barbados treaty. The LOB provision in the treaty proved ineffective because it does not apply to public corporations (even though the corporation was traded in New York, not in Barbados) Avi-Yonah & Panayi, supra note 5, at 22.


(30) Article 22(2)(a) of the 2006 U.S. Model Convention does not contain a restriction for "individuals" claiming the treaty benefits, other than that they are residents of at least one of the Contracting States. U.S. MODEL TECHNICAL EXPLANATION ACCOMPANYING THE U.S. MODEL INCOME TAX CONVENTION OF NOV. 15,2006 art. 22, [paragraph] 2(a) (2006). Nonetheless, the treaty entitlement may be challenged by competent authority of the source country if the individual is used as a conduit (nominee of agent) to obtain treaty benefits for items of income that are beneficially owned by a resident of a third country (2006 Technical Explanation, paragraph 290). Id.

(31) The first test (the "ownership test") prescribes that a qualified resident has to own at least fifty percent of each class of the company's shares during half of the days (or more) of the taxable year. U.S. MODEL TECHNICAL EXPLANATION ACCOMPANYING THE U.S. MODEL INCOME TAX CONVENTION OF NOV. 15,2006 art. 22, [paragraph] 2(e) (2006). The ownership may be direct or indirect, i.e., through other persons, each of whom are, themselves, entitled to benefits under paragraph two. Id. The second test (the "base erosion test") requires that "less than fifty percent of the person's gross income for the taxable year ... is paid or accrued," directly or indirectly, to persons who are not qualified residents of the state or U.S. citizens in the form of payments that are deductible for tax purposes in the entity's state of residence. Id.

(32) The term "trade or business" is not defined in the 2006 U.S. Model Convention. U.S. MODEL TECHNICAL EXPLANATION ACCOMPANYING THE U.S. MODEL INCOME TAX CONVENTION OF NOV. 15, 2006 art. 22, [paragraph] 3 (2006). Thus, a United States competent authority will refer to the regulations issued under section 367(a) for the definition of the term "trade or business," i.e., "a specific unified group of activities that constitute or could constitute an independent economic enterprise carried on for profit." Id.

(33) U.S. MODEL TECHNICAL EXPLANATION ACCOMPANYING THE U.S. MODEL INCOME TAX CONVENTION OF NOV. 15, 2006 art. 22, [paragraph] 4 (2006). The 2006 Model Convention includes this discretionary provision because of the increasing scope and diversity of international economic relations. This provision recognizes that there may be cases where significant participation by third country residents in a Contracting State's enterprise is warranted by sound business practice or long-standing business structures and do not necessarily indicate a motive of attempting to derive unintended Convention benefits.

(34) Although the U.S. Model Convention does not contain a sixth paragraph, in some treaties entered into by the United States such paragraphs exist. Normally, the additional Paragraph six gives the competent authorities power (in addition to that of Article 26 - "Mutual Agreement Procedure") to consult each other and develop a common application of the provisions of Article 22, including the publication of regulations or other public guidance. Such application would be done in accordance with the provisions of Article 27 - "Exchange of Information and Administrative Assistance." Id. This additional paragraph exists in the U.S.-Lithuania tax treaty, for example. Convention Between the Government of the Republic of Lithuania and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, U.S.-Lith., art. 23, Jan. 15, 1998,2358 U.N.T.S. 51.

(35) For a complete article about the beneficial owner concept as well as history and cases in international tax law, see generally Leonardo Freitas de Moraes e Castro, The Influence of Beneficial Owner Clauses in the Prevention of International Tax Treaty Abuse. "Diritto e Pratica Tributaria Internazionale". Vol. VII - N. 1. Milano, CEDAM, p. 121-52 (2010).

(36) Kenneth J. Krupsky, The Conduit Regulations Redux, Hybrid Instruments, and LOBs, INTT, J. (June 25,2009), available at id=3940.

(37) For example, the United States's treaty with the Netherlands Antilles terminated in 1987.

(38) Aiken Indus., Inc. v. Commissioner, 56 T.C. 925 (1971).

(39) GUSTAFSON, PERONI & PUGII, supra note 9, at 222.

(40) Moline Props., Inc. v. Commissioner, 319 U.S. 436,438-39 (1943).

(41) Johansson v. United States, 336 F.2d 809, 811-13 (5th Cir. 1964). The decision in this case was based on the judicial doctrine of substance over form; it was confirmed by the lack of documentation proving that Mr. Johansson was, in fact, a true employee of a Swiss corporation. Id.

(42) See Rev. Rul. 74-330, 1974-2 C.B. 278 (treating as employment contracts in applying tax treaty with United Kingdom single loan-out arrangements between foreign entertainers and foreign corporations); Rev. Rul. 74-331, 1974-2 C.B. 281 (same as to double loan-out arrangement involving two foreign corporations).

(43) BUTKF.R & LOKKEN, supra note 20.

(44) Bass v. Commissioner, 50 T.C. 595, 602 (1968).

(45) 56 T.C. 925 (1971).

(46) Id.

(47) Castro, supra note 35, at 140.

(48) Id.

(49) Aiken Industries, Inc. v. Commissioner, 56 T.C. 925,933 (1971).

(50) GUSTAFSON, PERONI & PUGH, supra note 9, at 225.

(51) Id. at 226.

(52) Jeffrey Rubinger, Proposed Conduit Financing Regulations Treat Disregarded Entities as Regarded Entities, WEALTH STRATEGIES J. Mar. 2, 2009, at 3, available at

(53) Peter H. Blessing, Foreign Income: Source of Income Rules, 905 TAX MGMT.PORT. (BNA) A-49 (1993) (citing Rev. Rul. 60-226,1960-1 C.B. 26).

(54) GUSTAFSON, PERONI & PUGH, supra note 9, at 227.

(55) Id.

(56) Id. Gustafson, Peroni, and Pugh believe the U.S. Treasury's exemption for portfolio debt investments from withholding tax on interests was also a response to the "Dutch sandwich" structures. Id.

(57) Rev. Rul. 84-152, 1984-2 C.B. 381. This was modified and clarified in Rev. Rul. 85-163, 1985-2 C.B. 349 and Rev. Rul. 89-110, 1989-2 C.B. 275 (applying to the Netherland Antilles).

(58) Rev. Rul. 84-152 was later declared obsolete. Rev. Rul. 95-56,1995-2 C.B. 322 (following Aiken Industries, where a foreign parent loaned funds to a Netherlands Antilles subsidiary at ten percent interest and the subsidiary re-loaned funds to a domestic sister subsidiary at eleven percent interest).

(59) Rev. Rul. 94-153,1984-2 C.B. 383.

(60) GUSTAFSON, PERONI & PUGH, supra note 9, at 227.

(61) For a more profound study on the implications of such termination for U.S. and Netherlands Antilles tax policies, see Mark B. Schoeller, Note, The Termination of the United States-Netherlands Antilles Income Tax Convention: A Failure of U.S. Tax Policy, 10 U. PA. J. INT'I. Bus. L. 493 (1988).

(62) Stephen C. Fox & John P. Kennedy, Anti-Conduit Proposed Regulations Could Result in Unexpected Withholding, 12 J. TAX'N INVESTMENTS 275,277.

(63) 293 U.S. 465 (1935).

(64) 105 T.C. 341 (1995).

(65) BITTKER & LOKKEN, supra note 20, at 46-67.

(66) GUSTAFSON, PERONI & PUGH, supra note 9, at 230-31.

(67) According to scholars, the main differences between Northern Indiana and Aiken Industries were that: (1) in Aiken Industries, all parties to the transaction were related, whereas the subsidiary's debt in Northern Indiana was owed to unrelated persons and (2) the subsidiary in Northern Indiana realized significant earnings from the transactions because the interest rate on the Euronotes was one percentage point less than the interest paid by the taxpayer to the subsidiary, whereas the transactions in Aiken Industries were a wash. Bittker & lokken, supra note 20, at 46-67; see also Gustafson, Phroni & Pugh, supra note 9, at 230.

(68) N. Indiana Pub. Serv. Co. v. Commissioner, 115 F.3d 506 (7th Cir. 1997).

(69) SDI Netherlands B.V. v. Commissioner, 107 T.C. 161 (1996) (involving a tax year that preceded an LOB provision in the Netherlands treaty).

(70) International Taxation of Low-Tax Transactions 2006: High-Tax Jurisdictions 563 (Dennis Campbell ed., 2006).

(71) SDI Netherlands, 107 T.C. at 175.

(72) Del Commercial Props., Inc. v. Commissioner, 78T.C.M. (CCH) 1183 (1999).

(73) Del Commercial Props., Inc. v. Commissioner, 251 F.3d 210, 213 (D.C. Cir. 2001).

(74) Id at 214.

(75) Michael Cooper & Arthur Dichter, Proposed New Anti-Conduit Regulations, 26 TAX ADVISER (Mar.l, 1995).

(76) I.R.C. [section]7701(l).

(77) I.R.C. [section] 7701(1). "Regulations" refers to section 881, but it also includes, "except as otherwise provided and as the context may require, ... taxes imposed under sections 871 or 884(f(1(A)" or taxes withheld under sections 1441 or 1442. Treas. Reg. [section] 1.881-3(a(1) (1998); see also BITTKER & LOKKEN, supra note 20, at 47-67.

(78) BITTKER & LOKKEN, supra note 20, at 58-67.

(79) Treas. Reg. [section] 1.881-3(a(3(ii(A) (1998).

(80) Fox & Kennedy, supra note 62, at 278-79.

(81) Treas. Reg. [section] 1.881-3(a(2(i(A) (1998) According to Treasury Directive 8611, 1995-2 C.B. 286, 289, this test is applied by taking a "snapshot" after all the transactions are in place.

(82) Treas. Reg. [section] 1.881-3(e), ex. 3 (1998).

(83) Treas. Reg. [section] 1.881-3(e), ex. 8 (1998).

(84) Treas. Reg. [section] 1.881-3(a(2(ii(A) (1998).

(85) Id.

(86) Basically, (1) the issuer is required to redeem the stock or interest at a specific time, (2) the issuer has the right to redeem the stock or interest and such redemption is more likely to occur than to not, (3) the holder may require the issuer to redeem or pay back, and (4) the holder may require that the stock or interest be acquired by a person related to the issuer or acting in his position. BlTTKER & LOKKEN, supra note 20, at 50-67.

(87) Treas. Reg. [section] 1.881-3(a(2(iii) (1998).

(88) Treas. Reg. [section] l.881-3(a(2(iv) (1998).

(89) Section 267 refers to "[l]osses, expenses, and interest with respect to transactions between related taxpayers." I.R.C. [section] 267. Related taxpayers for the purposes of section 267 are defined as follows:

(1) Members of a family, as defined in subsection (c)(4);

(2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual:

(3) Two corporations which are members of the same controlled group (as defined in subsection (f));

(4) A grantor and a fiduciary of any trust;

(5) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;

(6) A fiduciary of a trust and a beneficiary of such trust;

(7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

(8) A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

(9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which arc exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

(10) A corporation and a partnership if the same persons own

(A) more than 50 percent in value of the outstanding stock of the corporation, and

(B) more than 50 percent of the capital interest, or the profits interest, in the partnership;

(11) An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation;

(12)An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or

(13) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate. I.R.C. [section] 267(b).

(90). Section 707 transactions between a partner and a partnership include the following:

(b) Certain sales or exchanges of property with respect to controlled partnerships

(1) Losses disallowed

No deduction shall be allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between -

(A) a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or

(B) two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests

In the case of a subsequent sale or exchange by a transferee described in this paragraph, section 267 (d) shall be applicable as if the loss were disallowed under section 267 (a)(1). For purposes of section 267 (a)(2), partnerships described in subparagraph (B) of this paragraph shall be treated as persons specified in section 267 (b).

I.R.C. [section] 707(b)(1).

(91) In the author's opinion, this shows a clear intent to make the related persons definition as wide as possible, as it occurs with transfer pricing rules stated at section 482 (for example, effective economic control by acting in concert is sufficient to demonstrate ownership in determining related parties).

(92) Treas. Reg. [section] 1.881-3(a)(4)(i) (1998).

(93) BITTKER & LOKKEN, supra note 20, at 52-67 (citing T.D. 8611m, 1995-2 C.B. 286, 289).

(94) Treas. Reg. [section] 1.881-3(a)(4)(ii)(B) (1998).

(95) Treas. Reg. [section] 1.881-3(a)(4)(i) (1998).

(96) According to Treasury Regulation 1.881-3(e), ex. 18 (1998), however, if the withholding tax applicable to the transaction with the intermediary results in an exemption by domestic law (such as portfolio interest), there would also be an exemption without the use of such entity, since there is no tax reduction. Therefore, this is not an abusive transaction.

(97) Treas. Reg. $ 1.881 -3(b)( 1) (1998).

(98) Example 8 of Treasury Regulation 1.881-3(e) categorically states that the mere use of a treaty to reduce the withholding tax on a payment made from the financed entity to an intermediary entity does not conclusively determine whether a significant reduction has occurred for purposes of a tax avoidance plan.

(99) BITTKER & LOKKEN, supra note 20, at 52-67. The "short period of time" can include periods of even twelve months but it is not a fixed rule, as mentioned in Treasury Regulation 1.881-3(e), ex. 16.

(100) Treas. Reg. [section] 1.881-3(b)(2)(iv) (1998).

(101) This is only applicable in two cases. First, the situation could arise in lease or license transactions. Treas. Reg. [section] 1.881-3(b)(3)(ii)(A). Second, the situation could arise in financing activity when "officers and employees of the intermediate entity participate actively and materially in arranging the intermediate entity's participation in such financing transactions ... and perform the business activity and risk management activities;" or the "financing transactions produces (or reasonably can be expected to produce) efficiency savings by reducing transaction costs and overhead and other fixed costs." Treas. Reg. 1.881-3(b)(3)(ii)(B)(l) (1998).

(102) Treas. Reg [section] 1.881-3(a)(3)(ii)(E)(2)(1998). According to current regulations, the financing entity will not be liable for the withholding tax derived from a recharacterization in two cases: (1) if is not related to the financed entity nor the disregarded conduit, and (2) if it does not know or has reason to know that the transaction is a part of a conduit arrangement, which will occur based on sufficient facts to establish that the participation of the intermediate entity in the financing arrangement was not pursuant to a tax avoidance plan. Id.

(103) Treas. Reg. [section] 1.1442-3(g)(l) (1998).

(104) For a defense of the theory that anti-conduit regulations create treaty override, see Avi-Yonah & Panayi, supra note 5, at 22 ("[I]n 1993 Congress authorized the [Service] to adopt regulation involving 'conduit arrangements' in multiple-party financing transactions. The regulations adopted by the [Service] follow the 1984 rulings and apply to a wide range of financing transactions, and they also constitute a treaty override."); GUSTAFSON, PERONI & PUGH, supra note 9, at 233 ("See Reg. 1.881-3(a)(3)(i)(c). Would their application violate the obligations of the United States under the U.S. Model Treaty? If so, does Section 7701(1) represent another treaty override?").

(105) I.R.C. [section] 785(2)(d).

(106) For a discussion of treaty overriding, see Timothy S. Guenthcr, Tax Treaties and Overrides: The Multiple-Party Financing Dilemma, 16 VA.TAX REV. 645 (1997).

(107) Treas. Reg. 1.881-3(a)(3)(ii)(C) (1998).

(108) See Articles 10, 11, and 12 (Beneficial Owner) and Article 22 (LOB) of 2006 U.S. Model Convention as an example. U.S. MODEL INCOME TAX CONVENTION OF Nov. 15,2006 (2006).


(110) See MODEL TAX CONVENTION ON INCOME & ON CAPITAL art. 1 cmt. 1 9.5 (OECD 2003) ("It is important to note, however, that it should not be lightly assumed that a taxpayer is entering into the type of abusive transactions referred to above. A guiding principle is that the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favorable tax treatment in these circumstances would be contrary to the object and purpose of the relevant provisions.").

(111) DAVID A. WARD, ADVISORY PANEL ON CANADA'S SYS. OF INT'L TAXATION, ACCESS TO TAX TREATY BENEFITS 24 (2008) ("[T]he abuse of a tax treaty can also be characterized as an abuse of domestic law so that to the extent that anti-abuse rules in domestic law create the basis for determining the facts giving rise to tax liability, these rules are not affected by tax treaties themselves so that the facts as determined by domestic anti-avoidance rules in tax cases can also be applied to determine the facts for the purposes of the application of a tax treaty.").

(112) BITTKER & LOKKEN, supra note 20, at 67-68.

(113) Vienna Convention on the Law of Treaties, May 23,1969,1155 U.N.T.S. 331.

(114) Castro, supra note 35, at 131.

(115) Vienna Convention on the Law of Treaties, supra note 113, art. 26, 1155 U.N.T.S. at 339.

(116) Id. art. 31, 1 1, 1155 U.N.T.S. at 340 ("A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose.").

(117) Id. art. 27,1155 U.N.T.S. at 339.

(118) Id. art. 31,1155 U.N.T.S. at 340.

(119) Krupsky, supra note 36.


(121) Id. at 5-6 (stating that such factors might include "(1) intent of the parties to pay all or substantially all payments received by the intermediate entity to the financing entity; (2) [t]he history of payment of amounts received by the intermediate entity to the financing entity; and (3) [t]he precedence of the obligees over other creditors regarding the payment of interest and principal, currently or in bankruptcy").

(122) See Agreement between the United States of America and the Swiss Confederation on the Request for Information from the Internal Revenue Service of the United States of America Regarding UBS AG, a Corporation Established Under the Laws of the Swiss Confederation, U.S.-Switz., Aug. 19, 2009, available at; see also Kevin McCoy, UBS Must Release Data on 4,500 Suspected Tax Cheats, USA TODAY, Aug. 20,2009, at 1B; Ashby Jones, In UBS Deal, Is the U.S. Hoping to Use Secrecy to Its Advantage?, WALL ST. J. BLOG, Aug. 19,2009,

(123) Charlotte Erdmann, A Time for Change, a Time for Hope: The AMT's Adverse Effects on Large Families and Congress' Season to Change It, (last visited Jan. 1, 2011) (discussing Barack Obama's 2008 presidential campaign slogan).

* LL.M. in Taxation, Georgetown University Law Center (recipient of the Graduate Tax Scholarship and Dean's Certificate). International Associate at Milbank, Tweed, Hadley and McCloy in New York. Email:

Leonardo F.M. Castro *
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Author:Castro, Leonardo F.M.
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Date:Sep 22, 2011
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