stantial 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 U.S. 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. Slovakia Under Slovak law, it is understood that a gross-basis tax of 25 percent generally is imposed on dividends paid by Slovak companies. The tax applies to dividends received by both resident and nonresident shareholders. It is collected by withholding. Treaty reduction of dividend taxes Under the proposed treaty, dividends paid by a company that is a resident of one country to a resident of the other country would be taxable by both countries. The proposed treaty would limit, however, the rate of tax that the country of which the payor corporation is a resident (the "source country") may impose on dividends paid to a beneficial owner in the other country. None of the limitations on taxation of dividends would apply to taxation of the company in respect of the profits out of which the dividends are paid. The limitation would be 15 percent or 5 percent, depending on the relationship between the payor and the payee. With one exception discussed below, the rate of source-country tax could never exceed 15 percent of the gross amount of the dividends. The 5-percent rate of source-country tax generally would apply to dividends if the beneficial owner is a company which owns at least 10 percent of the voting stock of the company paying the dividends. The 15-percent rate would apply to dividends in all other cases. Notwithstanding the rules just described, the proposed treaty would permit imposition of the 15-percent tax rate on certain dividends paid to companies regardless of their level of ownership in the payor, and permit full operation of internal law on dividends paid to certain investors by REITs. A tax of up to 15 percent would be permitted to be imposed on all dividends paid by a RIC, and on dividends paid by a REIT to individuals that own less than 10-percent interests in the REIT. In the case of REIT distributions to other interest holders, the rate of withholding tax applicable under domestic law (currently 30 percent) would apply, rather than any reduced rate prescribed by the treaty. Definition of dividends The proposed treaty would define dividends to mean income from shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subject to the same tax treatment as income from shares by the laws of the source country. The term dividends, under the proposed treaty, also would include income from arrangements, including debt obligations, carrying the right to participate in profits, to the extent so characterized under the domestic law of the country in which the income arises. This definition of dividend would allow the United States to apply its domestic rules for determining whether an interest is debt or equity. Branch profits tax The proposed treaty would expressly permit the United States to collect the branch profits tax from a Slovak company.18 The United States would be allowed to impose the branch profits tax on a Slovak corporation that either has a permanent establishment in the United States, or is subject to tax on a net basis in the United States on income from real property or gains from the disposition of interests in real property. The proposed treaty, however, would permit at most a 5-percent branch profits tax rate, and, in cases where a Slovak corporation conducts a trade or business in the United States but not through a permanent establishment, the proposed treaty would completely eliminate the branch profits tax that the Code would otherwise impose on such corporation (unless the corporation earned income from real property as described above). According to the Technical Explanation, it is understood that the U.S. branch profits tax imposed under the proposed treaty on a Slovak company would be based on the company's dividend equivalent amount (as that term is defined under U.S. internal law). None of the restrictions on the operation of the U.S. internal law branch profit tax provisions would apply, however, unless the cor 18 It would also permit Slovakia to reciprocally impose a branch profits tax on U.S. companies if, under its internal laws, it imposes such a tax on all permanent establishments within its borders that are maintained by nonresident companies. poration seeking treaty protection meets the conditions of the proposed treaty's limitation on benefits article (Article 17). As described in the discussion of Article 17 below, the limitation on benefits requirements of the proposed treaty are similar, but not identical, to the corresponding provisions of the branch profits tax provisions of the Code (sec. 884(e)). Other rules The reduced rates of tax on dividends would apply unless the beneficial owner of the dividends 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 the dividends are attributable to the permanent establishment (or fixed base). Dividends attributable to a permanent establishment would be taxed on a net basis as business profits (Article 7). Dividends attributable to a fixed base would be taxed on a net basis as income from the performance of independent personal services (Article 14). A treaty country may tax dividends paid by a company resident in the other country, only in two cases: first, where its own resident receives the dividends; and second, where the holding in respect of which the dividends are paid forms part of the business property of a permanent establishment (or fixed base) situated in that country (even if the dividends paid consist wholly or partly of profits or income arising in that country). The article on dividends would be subject to the provisions of the saving clause (Article 1, paragraph 3). Therefore, as a general rule, the United States could tax its citizens and residents on dividend income without regard to the provisions contained in the proposed treaty. Specifically, in the case of dividends paid by a U.S. company to a U.S. citizen resident in Slovakia, the U.S. tax would not be limited by the source country withholding limits contained in Article 10. 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"). Álso 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 corporation paid the foreign corporation the interest deducted by the foreign corporation in computing its U.S. effectively connected income, but not 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.19 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 unrelated business income tax under section 511, and is not eligible for any reduction in the 30-percent rate of withholding tax (by treaty or otherwise) that would apply if the investor were otherwise eligible for such a rate reduction. Slovakia It is understood nonresident persons generally are subject to a gross-basis tax at a rate of 25 percent on interest arising from sources within Slovakia. The tax is collected by withholding. Treaty elimination of interest taxes Under the proposed treaty, interest arising in a treaty country and beneficially owned by a resident of the other country generally would be taxable only by that other country. In this respect, the proposed treaty is consistent with the U.S. model treaty position of eliminating source country withholding tax on interest. The reduced rate established by the proposed treaty would apply only if the interest is beneficially owned by a resident of the other country. Accordingly, it would not apply if the recipient is a nominee for a nonresident. 19 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. Notwithstanding the general rule prohibiting source country withholding taxes on interest, the proposed treaty would grant no reduction of U.S. withholding tax in the case of an excess inclusion with respect to a residual interest in a REMIC. Definition of interest The proposed treaty would define interest to mean income from debt-claims of every kind, whether or not secured by mortgage and, subject to the definition of the term "dividends" provided the article on dividends (Article 10, paragraph 4), whether or not carrying a right to participate in the debtor's profits. The term interest also would include, in particular, income from government securities and income from bonds or debentures (including premiums or prizes attaching to such securities, bonds, or debentures). It would also include all other income treated as interest by the tax law of the country in which the interest arises. Thus, the United States would be permitted to apply its domestic rules for determining whether an interest is debt or equity. Branch-level interest tax Because the proposed treaty would exempt from source country tax interest derived by a resident of the other treaty country, the United States would not impose the branch-level interest tax under Code section 884 on excess interest of a U.S. branch of a Slovak company. Source rule for interest The proposed treaty provides a source rule for interest (which, it is understood, would not be relevant to Article 24 (Relief from Double Taxation) for foreign tax credit purposes). Interest would be deemed to arise within a country if the payor is a resident of that country. If, however, the interest expense is borne by (i.e., for purposes of computing taxable income, deductible by) a permanent establishment (or fixed base) that the payor has in Slovakia or the United States and the indebtedness was incurred with respect to that permanent establishment (or fixed base), then the interest would have as its source that country, regardless of the residence of the payor. Generally, this is consistent with U.S. source rules (secs. 861-862) which provide as a general rule that interest income is sourced in the country in which the payor is resident. Thus, for example, if a Swiss resident has a permanent establishment in Slovakia and that Swiss resident incurs indebtedness to a U.S. person for that Slovak permanent establishment, and the permanent establishment bears the interest, then the interest would have its source in Slovakia. Other rules The elimination of source country tax would not apply if the recipient carries on or has carried on business through a permanent establishment, or performs or has performed services from a fixed base in the source country, and the interest is attributable to that permanent establishment or fixed base. In that event, the interest would be taxed as business profits (Article 7) or income from the performance of independent personal services (Article 14). |