if the misstatement of profits which gave rise to the original adjustment was the result of fraud, gross negligence, or willful default. Article 10. Dividends Internal dividend rules United States The United States generally imposes a 30-percent tax on the gross amount of U.S. source dividends (other than dividends paid by an "80/20 company" described in Code section 861(c)) paid to nonresident alien individuals and foreign corporations. The 30-percent tax does not apply if the foreign recipient is engaged in a trade or business in the United States and the dividends are effectively connected with that trade or business. In such a case, the foreign recipient is subject to U.S. tax, like a U.S. person, at the standard graduated rates, on a net basis. The United States imposes a branch profits tax on the deemed repatriation of U.S. earnings and profits of a U.S. branch of a foreign corporation (see detailed discussion below under Article 11A (Branch Tax)). Under U.S. law, the term dividend generally means any distribution of property made by a corporation to its shareholders, either from accumulated earnings and profits or current year earnings and profits. Liquidating distributions, however, generally are treated as payments in exchange for stock, and thus are not subject to the 30-percent withholding tax described above (see discussion of capital gains in connection with Article 13, below). Moreover, amounts paid on debt obligations carrying the right to participate in profits typically are treated as interest under U.S. law, and as a result, such amounts may in some cases be exempt under the Code from U.S. withholding tax (see discussion of interest in connection with Article 11, below). U.S. source dividends generally are dividends paid by a U.S. corporation. Also treated as U.S. source dividends for this purpose are portions of certain dividends paid by a foreign corporation, 25 percent or more of whose gross income over a three-year testing period consists of income that is treated as effectively connected with the conduct of a U.S. trade or business. The U.S. source portion of such a dividend generally is equal to the total amount of the dividend, multiplied by the ratio over the testing period of the foreign corporation's U.S. effectively connected gross income to its total gross income. No tax is imposed, however, on a foreign recipient to the extent of such U.S. source portion unless a treaty prevents application of the statutory branch profits tax. The tax imposed on dividends paid by a foreign corporation is often referred to as the "second-level" withholding tax. Under proposed regulations, certain other payments that substitute for dividends in a securities lending transaction are treated as dividends for tax purposes.56 These regulations cover cases where, for example, a foreign person owns dividend-paying stock in a U.S. corporation and "lends" the stock to a second person in exchange for a promise by the second person to make payments to 56 INTL-106-89, 1992-1 C.B. 1196. The proposed regulations would amend sections 1.861-2, 1.861-3, 1.871-2, 1.871-7, 1.881-2, 1.894-1, and 1.1441-2 of the Treasury regulations. the lender. The "borrower" collects the dividends paid with respect to the stock, and is required to make equivalent payments to the lender during the term of the "loan." This equivalent payment is referred to in the proposed regulations as a substitute dividend payment. In general, corporations do not receive deductions for dividends paid under U.S. law. Thus, the withholding and branch taxes often represent imposition of a second level of tax on corporate taxable income. Treaty reductions of these taxes reflect the view that where, for example, the United States already imposes corporate level tax on the earnings of a U.S. corporation, a 30-percent withholding rate may represent an excessive level of source country taxation. Moreover, the 5-percent rate on dividends paid to direct investors which is found in many U.S. income tax treaties reflects the view that the source country tax on payments of profits to a substantial foreign corporate shareholder may properly be reduced further to avoid double corporate-level taxation and to facilitate international investment. A real estate investment trust (REIT) is a corporation, trust, or association that is subject to the regular corporate income tax, but that receives a deduction for dividends paid to its shareholders if certain conditions are met (Code sec. 857(b)). In order to qualify for the deduction for dividends paid, a REIT must distribute most of its income. Thus, a REIT is treated, in essence, as a conduit for federal income tax purposes. A REIT is organized to allow persons to diversify ownership in primarily passive real estate investments. Often, the principal income of a REIT is rentals from real estate holdings. Because a REIT is taxable as a U.S. corporation, a distribution of earnings is treated as a dividend, rather than income of the same type as the underlying earnings. Distributions of rental income, for example, are not themselves considered rental income. This is true even though the REIT generally is not taxable at the entity level on the earnings it distributes. Because a REIT cannot be engaged in an active trade or business, its distributions are U.S. source and thus are subject to U.S. withholding tax of 30 percent when paid to foreign owners. Like dividends, U.S. source rental income of foreign persons generally is subject to U.S. withholding tax at a statutory rate of 30 percent (unless, in the case of rental income, the recipient elects to have it taxed in the United States on a net basis at the regular income tax rates). Unlike the tax on dividends, however, the withholding tax on real property rental income generally is not reduced in U.S. income tax treaties. The Code also generally treats regulated investment companies (RICS) as both corporations and conduits for income tax purposes. The purpose of a RIC is to allow investors to hold a diversified portfolio of securities. Thus, the holder of stock in a RIC may be characterized as a portfolio investor in the stock held by the RIC, regardless of the proportion of the RIC's stock owned by the dividend recipient. Mexico Mexican corporations generally are subject to corporate income tax at a 35-percent rate.57 At present, under Mexico's integration system, no tax is imposed on dividends paid (to either residents or nonresidents) by Mexican corporations out of previously taxed net earnings. In cases where the corporate tax has been reduced by tax preferences, a 35-percent compensatory tax is imposed on the distributing corporation at the time of the distribution to recapture those preferences. Treaty reduction of dividend taxes Under the proposed treaty, each country could tax dividends paid by its resident companies, but the rate of tax would be limited by the treaty if the beneficial owner of the dividends is a resident of the other country.58 Source country taxation generally would be limited to 5 percent of the gross amount of the dividend if the beneficial owner of the dividend is a company which holds directly at least 10 percent of the voting shares of the payor corporation. Subject to a transition rule, the tax generally would be limited to 10 percent of the gross amount of the dividends in other cases involving dividends paid to residents of the other country. Under the transition rule, for a period of five years from the date on which the provisions of Article 10 of the proposed treaty take effect, the withholding rate of 15 percent would be permitted.59 The limitation of the tax at source to 10 percent on portfolio dividends would be more restrictive than most other existing U.S. income tax treaties and more restrictive than the U.S. model, which prescribes a maximum rate of 15 percent. Pursuant to the proposed protocol (paragraph 8(a)), the prohibition on source country tax in excess of 5 percent on direct investment dividends would not apply to a dividend from a RIC or REIT. Thus, the proposed protocol would allow the United States to impose the portfolio dividend rate of tax (generally 10 percent, subject to the transition rule) on a U.S. source dividend paid by a RIČ to a Mexican company owning 10 percent or more of the voting shares of the RIC. In addition, there would be no limitation under the proposed protocol on the tax that could be imposed by the United States on a dividend paid by a REIT to a Mexican resident, if the recipient is either an individual holding a 10 percent or greater interest in the REIT, or a company. Such a dividend would thus be taxable by the United States, assuming no change in present internal law, at the full 30-percent rate. The portfolio dividend rate would apply to REIT dividends paid to Mexican individuals who hold a less than 10-percent interest in the REIT. Paragraph 8(b) of the proposed protocol contains a special provision which would reduce the 5-percent rate of withholding tax on direct investment dividends under the proposed treaty if the United States agrees in a treaty with another country to impose a lower 57 The staff understands that there is a current proposal in Mexico to reduce the corporate income tax rate to 34 percent. 58 The proposed treaty would not limit Mexico's ability to levy its 35-percent compensatory tax on Mexican corporations that distribute non-previously-taxed earnings. 59 See the discussion of Article 29 (Entry Into Force) below for details on when the provisions of Article 10 will take effect. 73-304 0 - 93 - 3 rate on such dividends. If such an agreement were to ever come about, the applicable rate for purposes of the U.S.-Mexico treaty would be the rate agreed to for purposes of the other treaty. The staff understands that it is intended that such reduction would take effect at the same time as it takes effect in the U.S. treaty with the third country. The limitations on source country taxation of dividends would not affect the corporate-level taxation of the profits out of which the dividends are paid. Definition of dividends The proposed treaty provides a definition of dividend that is similar to the definition in the U.S. model treaty and some U.S. treaties. The proposed treaty generally defines "dividends" as income from shares or other rights which participate in profits and which are not debt claims. The term also includes income from other corporate rights that is subjected to the same tax treatment by the country in which the distributing corporation is resident as income from shares. Special rules and exceptions The proposed protocol (paragraph 9) provides that where the internal law of one of the countries characterizes a payment in whole or in part as a dividend, or limits the deductibility of such payment because of thin capitalization rules or because the relevant debt instrument includes an equity interest, that country could treat the payment in accordance with such law. The proposed treaty's reduced rates of tax on dividends would not apply if the dividend recipient carries on (or has carried on) business through a permanent establishment (or fixed base in the case of an individual performing independent personal services) in the source country and dividends are attributable to the permanent establishment (or fixed base). Dividends attributable to a permanent establishment would be taxed as business profits (Article 7); dividends attributable to a fixed base would be taxed as income from the performance of independent personal services (Article 14). The proposed treaty contains a general limitation on the taxation by a treaty country of income of a resident of the other treaty country from dividends paid by a corporation which is not a resident of that country (a so-called "second-level withholding tax"). Under this provision, Mexico could not impose any taxes on dividends paid by a non-Mexican corporation except where the dividends are paid to Mexican residents or are attributable to a permanent establishment or fixed base in Mexico. Similarly, the United States could not impose any tax on dividends paid by a non-U.S. corporation except where the dividends are paid to a resident of the United States or where the dividends are attributable to a permanent establishment or fixed base in the United States. Article 11. Interest Internal interest rules United States Subject to numerous exceptions (such as those for portfolio interest, bank deposit interest, and short-term original issue discount), the United States imposes a 30-percent tax, collected by withholding, on U.S. source interest paid to foreign persons under the same rules that apply to dividends. U.S. source interest, for purposes of the 30-percent tax, generally is interest on the debt obligations of a U.S. person, other than a U.S. person that meets the foreign business requirements of Code section 861(c) (a so-called "80/20 company"). Also subject to the 30-percent tax is interest paid by the U.S. trade or business of a foreign corporation. A foreign corporation is also subject to a branch-level excess interest tax, which is the tax it would have paid had a wholly-owned domestic subsidiary paid the foreign corporation the portion of the interest it deducted (under the rules of Treas. Reg. sec. 1.882-5) in computing its U.S. effectively connected income that is in excess of the interest actually paid by the U.S. trade or business (sec. 884(f)). Portfolio interest generally is defined as any U.S. source interest that is not effectively connected with the conduct of a trade or business and (1) is paid on an obligation that satisfies certain registration requirements or specified exceptions thereto, and (2) is not received by a 10-percent owner of the issuer of the obligation, taking into account shares owned by attribution.60 Under a provision enacted in the Omnibus Budget Reconciliation Act of 1993, the portfolio interest exemption is inapplicable to certain contingent interest income. For this purpose, contingent interest generally includes interest determined by reference to any of the following attributes of the debtor or any related person: receipts, sales, or other cash flow; income or profits; or changes in the value of property. In addition, contingent interest generally includes interest determined by reference to changes in the value of, or yields on, certain actively traded property. In the case of an instrument on which a foreign holder earns both contingent and noncontingent interest, denial of the portfolio interest exemption applies only to the portion of the interest which is contingent interest. If an investor holds an interest in a fixed pool of real estate mortgages that is a real estate mortgage interest conduit (REMIC), the REMIC generally is treated for U.S. tax purposes as a passthrough entity and the investor is subject to U.S. tax on some portion of the REMIC's income (which, in turn, generally is interest income). If the investor holds a so-called "residual interest" in the REMIC, the Code provides that a portion of the net income of the REMIC that is taxed in the hands of the investor-referred to as the investor's "excess inclusion"-may not be offset by any net operating losses of the investor, must be treated as unrelated business income if the investor is an organization subject to the unre 60 Certain additional exceptions to this general rule apply only in the case of a corporate recipient of interest. In such a case, the term portfolio interest generally excludes (1) interest received by a bank on a loan extended in the ordinary course of its business (except in the case of interest paid on an obligation of the United States), and (2) interest received by a controlled foreign corporation from a related person. |