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Could New US/Spain DTT Make Spain Hub for LATAM & European investment?
Consistent with the latest US policy, the new treaty provides for exclusive residence country taxation with regard to dividends, interest, capital gains, and royalties and expands the existing limitation on benefits clause to mitigate treaty shopping. Taxand Spain and Taxand US summarise some of the key provisions of the new Protocol, and thoughts on what companies should be considering in light of this new development.
The Protocol generally reduces in-country withholding tax on interest from 10% to zero. Contingent interest that does not qualify as portfolio interest under US domestic law will remain subject to 10% withholding. As a result, US lenders may now enjoy the same withholding treatment afforded to EU lenders on loans to Spanish borrowers. These changes are a positive development for US financial institutions seeking to increase their Spanish loan portfolio and for Spanish companies financing into the US market.
Royalty payments are generally exempt from withholding under the Protocol, which eliminates the 5% to 10% withholding tax under the existing treaty. The definition of a "royalty" is also revised to, among other things, exclude payments for technical assistance performed in connection with intangible property, as well as the gain on the disposition of intangible property that is contingent on the productivity, use, or disposition of the property. The new definition is a welcomed change and should reduce controversies between Spanish tax authorities and US companies in connection with the characterisation of technical assistance and other types of payments related to intangible property or services that are covered by the royalty article.
As with interest payments, the Protocol also creates greater parity with the EU Interest-Royalties directive by eliminating the withholding tax on royalty payments. However, the Protocol does not have a minimum ownership requirement for the withholding exemption, whereas the EU directive requires a 25% minimum ownership. This will make the new treaty more favorable than the EU directive in terms of royalty payments.
The Protocol significantly reduces withholding taxes on dividend payments and completely eliminates them in the case of certain intercompany dividends. Under the Protocol, dividends are generally subject to withholding tax at 15%. The withholding rate comes down to 5% if the beneficial owner is a company that owns directly at least 10% of the voting stock of the company paying the dividend. Withholding tax is eliminated when the beneficial owner is a company that owns directly shares representing 80% or more of the voting stock of the company paying the dividend, and has held those shares for the 12 month period ending on the ex-dividend date. The 80% ownership may also be met "indirectly" if the beneficial owner owns the shares through intermediary entities. Nevertheless, in both cases (directly or indirectly) the beneficial owner and/or the intermediaries must consider the provisions of the limitation on benefits clause, (discussed below) to ensure that the lower rates will be available. Under the Protocol, dividends paid to certain tax-exempt pension funds or similar entities may be exempt from withholding taxes.
The elimination of withholding tax can present interesting results in the context of the EU Parent-Subsidiary Directive. Generally, Spain can deny the benefits of the EU Parent-Subsidiary Directive where the ultimate shareholder of a Spanish company is not an EU resident (eg a US entity). However, in cases where the ultimate US shareholder meets the requisite ownership requirement, it could be argued that Spanish tax authorities should not apply the anti-abuse rule, given that a withholding tax would not apply under the new treaty if the dividend payment was made directly to the US parent. This is something to consider when reviewing Spanish holding structures.
The Protocol generally exempts from tax capital gains derived from the sale of personal property (including stock or similar rights). In contrast, the existing treaty subjects US tax residents to tax in Spain on the sale of stock or similar interests. The tax is applied in Spain where the company is a Spanish resident, and the transferee holds directly or indirectly at least a 25% interest in the capital of the company during the 12-month period, ending on date of disposition. The treaty will eliminate this provision and therefore, for the most part equates the taxation of capital gains in the US and Spain.
Under US domestic tax law, non-resident Spanish investors are generally not subject to US taxation on the disposition of stock, unless such shares are effectively connected with a trade or business or entity being sold holds significant US property interests. In this regard, the Protocol aligns the treatment of US and Spanish investors by exempting in Spain most stock sales, and retaining the taxing jurisdiction for capital gains (including stock and similar rights) from the disposition of personal property attributable to a permanent establishment and from the disposition of stock or similar interest in a company that holds real property in Spain.
Limitations on Benefits ("LOB")
The new Protocol contains a robust LOB consistent with recent US income tax treaties with other European countries. The new LOB clause modernises the publicly traded ownership-base erosion test, and the active trade or business test contained in the current treaty. The Protocol also adds a derivative benefits test, headquarters test, and a rule limiting the benefits that can be derived through a permanent establishment (a branch) located in a third country. Under the new LOB clause, taxpayers who do not qualify under the various LOB tests may request the grant of treaty benefits through competent authority.
In general, the publicly traded test extends treaty benefits to US or Spanish companies that have a principle class of their shares listed in one or more recognised stock exchanges (EU or Spanish exchanges, for Spanish companies, and US or NAFTA exchanges for US companies), and those shares are regularly traded. Alternatively, if the company is traded in a recognised exchange, but not in the correct location (eg Spanish listed in Mexico or US listed in London), then the public test may still be met if the company's primary place of management or control is in Spain or the US. Subsidiaries of a publicly traded company meeting these rules may also qualify for treaty benefits. However, the subsidiary seeking treaty benefits must establish that every intermediate owner is a resident of the US or Spain.
The revamped ownership-base erosion and derivative benefit tests also limit the use of intermediate owners. The ownership-base erosion test requires that each intermediate owner is a resident of the same country as the company claiming treaty benefits. In contrast, the derivative benefit test also allows for intermediate owners that are residents of an EU, or a NAFTA, member state.
The Protocol adds the triangular branch rule to the treaty, providing that income attributed to a Spanish company from a permanent establishment in a third country, may not be fully entitled to the benefits of the treaty. This is applicable if the combined aggregated effective tax rate imposed on the branch income by the third country and by Spain, is less than 60% of the general income tax rate in Spain. A company that fails this test may be subject to a US withholding tax of up to 15% on the gross dividends, interest or royalties and may be subject to US taxes on any other types of income. There are exceptions for royalties or other income from the use of intangible property produced or developed by the permanent establishment itself. Likewise, in cases involving other types of income, the rule may not apply if the income derived from the United States is connected or incidental to the active conduct of a trade or business carried on by the permanent establishment in the third country. Note that the business being conducted in the permanent establishment cannot include the making, managing or holding of investments for the entity's own account, unless the entity is a registered securities dealer and the activities relate to that business.
Spanish Companies with branches outside of Spain may run afoul of this rule. Spanish companies should carefully consider how, and when, the Spanish exemption for branch income applies, and how the branch profits are being taxed before relying on the benefits of the Protocol. In general, Spain does not tax branch income derived from the active conduct of a trade or business. Assuming that the branch is otherwise taxed at a low rate, then this may mean that any US source income derived by the branch may be subject to US taxes (ie 15% withholding). However, if the branch's active trade or business is connected or incidental to the US business and the income derived from the US is related to such trade or business, then the triangular branch rule may not apply. Alternatively, if the business of the branch is in the nature of an investment business generating certain types of passive income and not otherwise conducted by a bank or a registered securities dealer, then that income may be subject to full Spanish taxation and the triangular branch rule may not apply. Thus, structures of this kind should be properly reviewed before the new wording of this clause enters into force.
Fiscally Transparent Entities
The new Protocol states that an item of income, profit, or gain derived through an entity that is fiscally transparent under the laws of either the US or Spain, will be considered to be derived by a resident if the item is considered derived by a resident under the domestic tax laws of the recipient's country. In addition, the fiscally transparent entity must have been formed in either the US, Spain, or in a country having a tax information exchange agreement in force with the country from where the income, profit or gain is derived. The requirement regarding where the fiscally transparent entity is formed is consistent with the focus on the residency of intermediate owners that is reflected in the new Protocol's LOB provision.
Permanent Establishment ("PE") Concept
Under the current treaty, a company operating a building or conducting an installation/assembly project will not be deemed to create a PE unless its operations extend beyond 6 months. The new Protocol extends this time period to 12 months.
The new Protocol must be ratified by Spain and the US, and will enter into force three months after the date both countries notify each other that the treaty has been ratified. For withholding taxes on interest, dividends and royalties the new Protocol will apply to amounts paid or credited on or after the date the Protocol enters into force. With regard to taxes determined with reference to a taxable period, the Protocol will be effective for taxable periods beginning on or after the date on which the Protocol enters into force. All other provisions will be effective on the date the Protocol enters into force.
Taxpayers should be aware that the US may take a long time to ratify the new Protocol. In fact, there are protocols and treaties that have been signed over the last few years that have not been ratified yet (eg Hungary, Switzerland and Luxembourg). Given the current political climate in the US, and the long list of initiatives being currently discussed in Congress, the ratification of the new Protocol may not be a priority in the short term.
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Now is a good time for US and Spanish investors to consider how the new treaty may impact existing operations and/or investments. For example, companies should reconsider investment opportunities or transactions that may not have been viable under the current treaty. Companies should analyse their current ownership structures, and determine whether certain intragroup reorganisations are necessary to benefit from the Protocol. In addition, given Spain's extensive treaty network in Latin America and the Caribbean, US companies may also need to consider whether Spain is a reasonable choice as a hub for LATAM and European operations and investments.