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US/Chile Income Tax Treaty Signed
On 4 February 2010, after more than a decade of negotiations, US Treasury Secretary Geithner and Chilean Finance Minister Velasco signed the first bilateral income tax treaty between the United States and Chile. On signing the new treaty, the two governments also agreed to the provisions of a protocol to the treaty that incorporates some important modifications and definitions. Each country must still ratify the treaty before it will enter into force. Taxand Chile and Taxand US summarise some of the key provisions of the new treaty with respect to interest, dividends, royalties, capital gains, permanent establishment and the ratification procedure. Taxand Chile and Taxand US also identify the impacts and benefits for multinationals looking to structure cross-border investments between Chile and the US.
The new treaty supports the US Treasury's efforts to expand cross-border investments with Chile and brings great expectations to both countries for an increased economic cooperation by means of providing certainty and stability to investors. The new treaty reduces in source-country taxation of cross-border payments of dividends, interest, and royalties. It also provides for the full exchange of information between the tax authorities of the United States and Chile and limits treaty shopping through a comprehensive limitation on benefits clause.
Ratification Process and Effective Date
The treaty will enter into force when Chile and the US exchange the instruments of ratification. The treaty will be ratified in the US when it is approved by a two-thirds majority of the US Senate and the ratification documents are signed by the President. However, the US may take a long time to ratify the treaty. Whether the ratification takes one year or ten will depend on politics and policy objectives of the administration and Congress. Considering the current political climate in the United States and the long list of initiatives that the administration is currently advancing in Congress, it may not take priority.
The ratification process in Chile also requires Congressional approval, followed by the President's signature and finally, publication in the official gazette. This process may take at the very least one year but may go as long as two. However, it is expected that the Chilean government will be interested in an expedient ratification in Congress in order to encourage cross-border investments.
The treaty's withholding provisions will take effect for amounts paid or credited on or after the first day of the second month after the treaty enters into force. All other provisions will take effect for taxable periods beginning on or after 1 January in the year following the date in which the treaty enters into force.
The treaty article on interest payments may provide significant savings for both US and Chilean investors, who without the new treaty may be subject to significant withholding taxes on cross-border interest payments to/from Chile. Once in effect, the treaty will provide for a 4 percent withholding on interest payments where the beneficial owner of the interest is a bank, insurance company, lending or financial institution involved in transactions with unrelated parties or, among others, a vendor of machinery or equipment. The general withholding on interest payments will be 15 percent for the first 5 years starting from the date the treaty enters into force and thereafter, it will be reduced to 10 percent. The interest article incorporates restrictions on using back to back loans or similar arrangements to obtain the 4 percent withholding. Nevertheless, the rates provided under this new treaty are lower than the ones provided in any other Chilean tax treaty.
As with interest, the new treaty may also provide significant savings especially to Chilean investors. For example, dividend payments from the US, which are generally subject to a 30 percent withholding tax, may be subject to a 5 percent withholding if the beneficial owner is a company that owns directly at least 10 percent of the voting stock of the company paying the dividends; or to 15 percent in all other cases. Dividends paid to certain tax-exempt pension funds or similar entities may be exempt from withholding taxes.
Notwithstanding the above, US investors should be aware that the protocol to the treaty preserves some important aspects of Chile's existing tax system as it applies to dividends. Chile currently has an integrated two-level income tax system. Chilean companies are subject to a 17 percent corporate income tax on their taxable income. Then, to the extent the post-tax earnings are remitted abroad, the grossed-up amount of the remittance is subject to an Additional Tax of 35 percent, but the Corporate Tax paid on the profits may be credited against the Additional Tax. The remaining tax due on the Additional Tax is withheld from the remittance. According to the protocol, the treaty provisions regarding dividends shall not limit the application of the Additional Tax (35 percent) provided that under Chilean law the Corporate Tax remains fully creditable against the Additional Tax. The protocol also contains other material modifications and provisions regarding dividends that will warrant further analysis by US investors prior to relying on the treaty.
Royalty payments in connection with the use of, or the right to use, industrial, commercial or scientific equipment (not including ships, aircrafts or containers) will be subject to 2 percent withholding, while payments in connection with the use of, or the right to use, any copyright of literary, artistic, scientific or other work, any patent, trademark, design or model, plan, secret formula or process, or other like intangible property, or for information concerning industrial, commercial, or scientific experience will be subject to 10 percent withholding. The term "royalties" also includes gain derived from the disposition of the property described above.
In general, the treaty preserves the right of the country of residence of the seller to tax capital gains derived from the sale of personal property situated in the other contracting state. Gains on the sale of real property are taxable in the country where the real property is located. Gains on the disposition of personal property attributable to a permanent establishment may be taxed by the country where the permanent establishment is located.
In the case of a disposition of shares or other rights or interests representing the capital of a company resident in one of the contracting states, the treaty allows the country of the company's residence to tax the disposition, but limits the tax to 16 percent. This may not be particularly beneficial for Chilean investors owning US shares because under US domestic law, the gain on the disposition of such shares by a non-resident (not effectively connected with a trade or business) is generally not subject to income tax, except in cases where the entity holds significant US real property interests.
In contrast to the US, Chile taxes the gain derived by a foreign investor from the sale of shares or other interests in the capital of a Chilean company at a rate ranging from 17 to 35 percent. Moreover, there is a withholding mechanism on the total proceeds of the sale to ensure the proper reporting and payment of the taxes in Chile. Accordingly, the 16 percent limitation may be of particular importance to US investors owning shares or interests in the capital of Chilean companies. However, investors must carefully analyse the remaining provisions of the capital gains article of this treaty that may in some cases limit the availability of the 16 percent rate and in other cases, exempt the taxation of disposition of shares altogether.
Permanent Establishment ("PE")
Article 5 of the treaty provides the rules for the creation of a permanent establishment and follows the general provisions found in most US treaties. The article provides specific provisions with respect to installation and construction activities as well as for services. An installation used for the on-land exploration of natural resources would constitute a PE if it lasts for more than 3 months, while a construction or installation project and the supervisory activities in connection therewith would create a PE only if it lasts more than 6 months. The treaty also contains a "service PE" clause under which a PE will include an enterprise that performs services for a period or periods exceeding in the aggregate 183 days in any 12-month period. A "service PE" clause is not commonly seen in US treaties although it has been occasionally included (e.g. the Fifth Protocol to the US/Canada income tax treaty).
Limitations on Benefits ("LOB")
LOB articles have become standard in US tax treaties, and the treaty with Chile is no exception. The LOB article is intended to prevent "treaty shopping" by third-country investors by restricting the application of the treaty only to "qualified persons" of the US and Chile. In general, the LOB clause sets forth a series of objective tests; only members of a contracting state that satisfy one of such tests will be entitled to treaty benefits.
The LOB article of the US/Chile tax treaty includes a headquarters company test, publicly-traded company test, active trade or business test, ownership and base erosion test, and a triangular provision (which would prevent companies from claiming treaty benefits to shelter income attributable to a PE in a third country). These tests require a detailed analysis of the operations and ownership structure of the company claiming treaty benefits. Note that the US/Chile treaty does not include a derivative benefits test, which is typically found when shareholders of third countries are regarded as "qualified persons" under certain circumstances; for example, in the case of some US treaties, companies owned by members of the North American Free Trade Agreement (NAFTA) are sometimes given benefits under the US treaty by virtue of the ownership by a NAFTA member.
No other Chilean treaty contains a LOB clause. (However, other treaties do offer 5% withholding rate and intermediate holdco's may therefore still be useful.) This is new ground, not only for Chilean investors and their tax advisors, but also for the Chilean government who will be expected to provide guidance on this and other articles once the treaty is ratified.
The new treaty is a much awaited breakthrough in the US's stated intent to expand its treaty network in the South American region beyond Venezuela. The new treaty should streamline the structures for cross-border investments between the US and Chile and as a result, may impact existing structures that use European holding companies for investments into Chile and other South American countries. While the treaty may present new opportunities for investors from both countries, investors should carefully analyse their existing structures, including the benefits and costs of migrating existing operations, before deciding on how to best utilise the treaty. Investors have until the tax treaty is ratified to review their structures and make the necessary changes so that they can be ready from day one to qualify for the benefits under the treaty. Now is a good time to begin to consider how the new treaty may impact your existing operations and investments.
Your Taxand contacts for further queries are:
Mar?a Teresa Cremaschi
Juan Carlos Ferrucho