• Paragraph 1
• Paragraph 2
• Paragraph 3
• Paragraph 4
• Paragraph 5
• Paragraph 6

ARTICLE 23 - Limitation of Benefits

Purpose of Limitation on Benefits Provisions

The United States views an income tax treaty as a vehicle for providing treaty benefits to residents of the two Contracting States. This statement begs the question of who is to be treated as a resident of a Contracting State for the purpose of being granted treaty benefits. The Commentaries to the OECD Model authorize a tax authority to deny benefits, under substance- over-form principles, to a nominee in one State deriving income from the other on behalf of a third-country resident. In addition, although the text of the OECD Model does not contain express anti-abuse provisions, the Commentaries to Article 1 contain an extensive discussion approving the use of such provisions in tax treaties in order to limit the ability of third state residents to obtain treaty benefits. The United States holds strongly to the view that tax treaties should include provisions that specifically prevent misuse of treaties by residents of third countries. Consequently, all recent U.S. income tax treaties contain comprehensive Limitation on Benefits provisions.

A treaty that provides treaty benefits to any resident of a Contracting State permits ``treaty shopping'': the use, by residents of third states, of legal entities established in a Contracting State with a principal purpose to obtain the benefits of a tax treaty between the two Contracting States. It is important to note that this definition of treaty shopping does not encompass every case in which a third state resident establishes an entity in a treaty partner, and that entity enjoys treaty benefits to which the third state resident would not itself be entitled. If the third country resident had substantial reasons for establishing the structure that were unrelated to obtaining treaty benefits, the structure would not fall within the definition of treaty shopping set forth above.

Of course, the fundamental problem presented by this approach is that it is based on the taxpayer's intent, which a tax administrator is normally ill-equipped to identify. In order to avoid the necessity of making this subjective determination, Article 23 sets forth a series of objective tests. The assumption underlying each of these tests is that a taxpayer that satisfies the requirements of any of the tests probably has a real business purpose for the structure it has adopted, or has a sufficiently strong nexus to the other Contracting State (e.g., a resident individual) to warrant benefits even in the absence of a business connection, and that this business purpose or connection is sufficient to justify the conclusion that obtaining the benefits of the Treaty is not a principal purpose of establishing or maintaining residence.

For instance, the assumption underlying the active trade or business test under paragraph 3 is that a third country resident that establishes a ``substantial'' operation in Lithuania and that derives income from a related activity in the United States would not do so primarily to avail itself of the benefits of the Treaty; it is presumed in such a case that the investor had a valid business purpose for investing in Lithuania, and that the link between that trade or business and the U.S. activity that generates the treaty-benefited income manifests a business purpose for placing the U.S. investments in the entity in Lithuania. It is considered unlikely that the investor would incur the expense of establishing a substantial trade or business in Lithuania simply to obtain the benefits of the Convention. A similar rationale underlies other tests in Article 23.

While these tests provide useful surrogates for identifying actual intent, these mechanical tests cannot account for every case in which the taxpayer was not treaty shopping. Accordingly, Article 23 also includes a provision (paragraph 4) authorizing the competent authority of a Contracting State to grant benefits. While an analysis under paragraph 4 may well differ from that under one of the other tests of Article 23, its objective is the same: to identify investors whose residence in the other State can be justified by factors other than a purpose to derive treaty benefits.

Article 23 and the anti-abuse provisions of domestic law complement each other, as Article 23 effectively determines whether an entity has a sufficient nexus to the Contracting State to be treated as a resident for treaty purposes, while domestic anti-abuse provisions (e.g., business purpose, substance-over-form, step transaction or conduit principles) determine whether a particular transaction should be recast in accordance with its substance. Thus, internal law principles of the source State may be applied to identify the beneficial owner of an item of income, and Article 23 then will be applied to the beneficial owner to determine if that person is entitled to the benefits of the Convention with respect to such income.

Structure of the Article

The structure of the Article is as follows: Paragraph 1 states the general rule that residents are entitled to benefits otherwise accorded to residents only if the resident is a ``qualified resident'', as defined in the Article. Paragraph 2 lists a series of attributes of a qualified resident, the presence of any one of which will entitle that person to all the benefits of the Convention. Paragraph 3 provides that, with respect to a person that is not a qualified resident, and is, therefore, not entitled to benefits under paragraph 2, benefits nonetheless may be granted to that person with regard to certain types of income. Paragraph 4 provides that benefits also may be granted to a person that is not a qualified person if the competent authority of the State from which benefits are claimed determines that it is appropriate to provide benefits in that case. Paragraph 5 defines the term ``recognized stock exchange'' as used in paragraph 2(e).

Paragraph 1

Paragraph 1 provides that a resident of a Contracting State will be entitled to the benefits otherwise accorded to residents of a Contracting State under the Convention only if it is a qualified resident as provided in the Article. The benefits otherwise accorded to residents under the Convention include all limitations on source-based taxation under Articles 6 through 22, the treaty-based relief from double taxation provided by Article 24 (Relief from Double Taxation), and the protection afforded to residents of a Contracting State under Article 25 (Nondiscrimination). Some provisions do not require that a person be a resident in order to enjoy the benefits of those provisions. These include paragraph 1 of Article 25 (Nondiscrimination), Article 26 (Mutual Agreement Procedure), and Article 28 (Diplomatic Agents and Consular Officers). Article 23 accordingly does not limit the availability of the benefits of these provisions.

Paragraph 2

Paragraph 2 has seven subparagraphs, each of which describes a category of residents that can be a qualified resident and thus enjoy the benefits of the Convention.

It is intended that the provisions of paragraph 2 will be self-executing. Unlike the provisions of paragraph 4, discussed below, claiming benefits under paragraph 2 does not require advance competent authority ruling or approval. The tax authorities may, of course, on review, determine that the taxpayer has improperly interpreted the paragraph and is not entitled to the benefits claimed.

Individuals - Subparagraph 2(a)

Subparagraph (a) provides that individual residents of a Contracting State are qualified residents and thus will be entitled to all treaty benefits. If such an individual receives income as a nominee on behalf of a third country resident, benefits may be denied under the respective articles of the Convention by the requirement that the beneficial owner of the income be a resident of a Contracting State.

Contracting State - Subparagraph 2(b)

Subparagraph (b) provides that certain governmental entities also will be entitled to all benefits of the Convention. These include the entities listed under paragraph 3(a) of Article 4 (Resident) which include a Contracting State, a political subdivision or a local authority thereof, or an agency or instrumentality of such State, subdivision or authority.

Ownership/Base Erosion - Subparagraph 2(c)(i)

Subparagraph 2(c) provides a two part test, the so-called ownership and base erosion test. This test applies under subparagraph 2(c) to a company that is a resident of a Contracting State. As described below, the rules of subparagraph 2(c) also apply, in accordance with subparagraph 2(d), to a trust or estate that is a resident of a Contracting State. Both prongs of the test must be satisfied for the resident to be entitled to benefits under subparagraph 2(c).

The ownership prong of the test, under clause (i), requires that on at least half the days of the taxable year the beneficial owners of at least 50 percent of each class of the company's shares be owned by qualified residents by reason of subparagraphs (a), (b), (e) or (f). The ownership may be indirect through other persons, each of which are, themselves, entitled to benefits under paragraph 2.

The base erosion prong of the test under subparagraph 2(c)(ii) requires that less than 50 percent of the company's gross income for the taxable year be paid or accrued, directly or indirectly, to persons who are not qualified residents of either State nor U.S. citizens (unless income is attributable to a permanent establishment located in either Contracting State), in the form of payments that are deductible for tax purposes in the entity's State of residence. Depreciation and amortization deductions, which are not ``payments'', are disregarded for this purpose. Payments made at arm's length in the ordinary course of business for services or tangible property also are disregarded for the purposes of applying the base-erosion rule. The purpose of this provision is to determine whether the income derived from the source State is in fact subject to the tax regime of either State. Consequently, payments to any qualified resident of either State or U.S. citizens, are not considered base eroding payments for this purpose (to the extent that these recipients do not themselves base erode to non-residents).

The term ``gross income'' is not defined in the Convention. Thus, in accordance with paragraph 2 of Article 3 (General Definitions), in determining whether a person deriving income from United States sources is entitled to the benefits of the Convention, the United States will ascribe the meaning to the term that it has in the United States. In such cases, ``gross income'' will be defined as gross receipts less cost of goods sold.

Trusts or Estates - Subparagraph 2(d)

Trusts and estates may be entitled to benefits under this provision if they are treated as residents under Article 4 (Residence) and they satisfy the requirements of subparagraph 2(c). For purposes of the application of subparagraph 2(c)(i) to trusts, the beneficial interests in a trust or estate will be considered to be owned by its beneficiaries in proportion to each beneficiary's actuarial interest in the trust or estate. The interest of a remainder beneficiary will be equal to 100 percent less the aggregate percentages held by income beneficiaries. A beneficiary's interest in a trust or estate will not be considered to be owned by a person entitled to benefits under the other provisions of paragraph 2 if it is not possible to determine the beneficiary's actuarial interest. Consequently, if it is not possible to determine the actuarial interest of any beneficiaries in a trust or estate, the ownership test under clause (i) cannot be satisfied, unless all beneficiaries are persons entitled to benefits under the other subparagraphs of paragraph 2.

For purposes of the application of subparagraph 2(c)(ii) to trusts and estates, distributions would be considered deductible payments to the extent they are deductible from the taxable base.

Publicly Traded Persons - Subparagraph 2(e)

Subparagraph (e) applies to two categories of persons: publicly-traded persons and subsidiaries of publicly-traded persons. Clause (i) of subparagraph 2(e) provides that a person will be entitled to all the benefits of the Convention if all the beneficial interests representing at least 50 percent of the value of each class of interests in the person are regularly traded on a ``recognized stock exchange''. The term ``recognized stock exchange'' is defined in paragraph 5. If the person is a corporation ``shares'' would be considered to be the equivalent of ``interests''.

If a person has only one class of interests, it is only necessary to consider whether the interests of that class are regularly traded on a recognized stock exchange. If the person has more than one class of interests, it is necessary to make this determination for each class. The term ``substantially and regularly traded'' is not defined in the Convention. Interests are considered to be ``substantially and regularly traded'' if two requirements are met: trades in the class of interests are made in more than de minimis quantities on at least 60 days during the taxable year, and the aggregate number of interests in the class traded during the year is at least 6 percent of the average number of interests outstanding during the year. Authorized but unissued interests are not considered for purposes of this test.

The regular trading requirement can be met by trading on any recognized exchange or exchanges located in either State, or, if the competent authorities so agree, in a third State. Trading on one or more recognized stock exchanges may be aggregated for purposes of this requirement. Thus, a U.S. person could satisfy the regularly traded requirement through trading, in whole or in part, on a recognized stock exchange located in Lithuania.

Tax Exempt Organizations and Pension Funds - Subparagraph 2(f)

Subparagraph 2(f) provides that the tax exempt organizations and pension funds described in subparagraph 3(b) of Article 4 (Resident) will be entitled to all the benefits of the Convention as long as more than half of the beneficiaries, members or participants of the organization, if any, are qualified residents of either Contracting. Tax exempt entities described in subparagraph 3(b) of Article 4 are entities that generally are exempt from tax in their State of residence because they are organized and operated exclusively to fulfill religious, educational, scientific and other charitable purposes. Pension funds are tax-exempt entities that provide pension and other benefits to employees pursuant to a plan. For purposes of this provision, the term ``beneficiaries'' should be understood to refer to the persons receiving benefits from the organization.

Regulated Investment Companies- Subparagraph 2(g)

Subparagraph (g) provides that Regulated Investment Companies, or similar entities in Lithuania as may be agreed by the competent authorities of the Contracting States, will be entitled to all benefits of the Convention.

Paragraph 3

Paragraph 3 sets forth a test under which a resident of a Contracting State that is not generally entitled to benefits of the Convention under paragraph 2 may receive treaty benefits with respect to certain items of income that are connected to an active trade or business conducted in its State of residence.

Subparagraph 3(a) sets forth a three-pronged test that must be satisfied in order for a resident of a Contracting State to be entitled to the benefits of the Convention with respect to a particular item of income. First, the resident must be engaged in the active conduct of a trade or business in its State of residence. Second, the income derived from the other State must be derived in connection with, or be incidental to, that trade or business. Third, if there is common ownership of the activities in both States, the trade or business must be substantial in relation to the activity in the other State that generated the item of income. These determinations are made separately for each item of income derived from the other State. It therefore is possible that a person would be entitled to the benefits of the Convention with respect to one item of income but not with respect to another. If a resident of a Contracting State is entitled to treaty benefits with respect to a particular item of income under paragraph 3, the resident is entitled to all benefits of the Convention insofar as they affect the taxation of that item of income in the other State. Set forth below is a discussion of each of the three prongs of the test under paragraph 3.

Trade or Business - Subparagraphs 3(a)(i) and (b)

The term ``trade or business'' is not defined in the Convention. Pursuant to paragraph 2 of Article 3 (General Definitions), when determining whether a resident of the other State is entitled to the benefits of the Convention under paragraph 3 with respect to income derived from U.S. sources, the United States will ascribe to this term the meaning that it has under the law of the United States. Accordingly, the United States competent authority will refer to the regulations issued under section 367(a) for the definition of the term ``trade or business''. In general, therefore, a trade or business will be considered to be a specific unified group of activities that constitute or could constitute an independent economic enterprise carried on for profit. Furthermore, a corporation generally will be considered to carry on a trade or business only if the officers and employees of the corporation conduct substantial managerial and operational activities. See Code section 367(a)(3) and the regulations thereunder.

Notwithstanding this general definition of trade or business, subparagraph 3(b) provides that the business of making or managing investments, will be considered to be a trade or business only when part of banking, insurance or securities activities conducted by a bank, insurance company, or registered securities dealer. Conversely, such activities conducted by a person other than a bank, insurance company or registered securities dealer will not be considered to be the conduct of an active trade or business, nor would they be considered to be the conduct of an active trade or business if conducted by a bank, insurance company, or registered securities dealer, but not as part of the company's banking, insurance or dealer business.

Because a headquarters operation is in the business of managing investments, a company that functions solely as a headquarter company will not be considered to be engaged in an active trade or business for purposes of paragraph 3.

Derived in Connection With Requirement - Subparagraphs 3(a)(ii) and (d)

Subparagraph 3(d) provides that income is derived in connection with a trade or business if the income-producing activity in the other State is a line of business that forms a part of or is complementary to the trade or business conducted in the State of residence by the income recipient. Although no definition of the terms ``forms a part of'' or ``complementary'' is set forth in the Convention, it is intended that a business activity generally will be considered to ``form a part of'' a business activity conducted in the other State if the two activities involve the design, manufacture or sale of the same products or type of products, or the provision of similar services. In order for two activities to be considered to be ``complementary'', the activities need not relate to the same types of products or services, but they should be part of the same overall industry and be related in the sense that the success or failure of one activity will tend to result in success or failure for the other. In cases in which more than one trade or business is conducted in the other State and only one of the trades or businesses forms a part of or is complementary to a trade or business conducted in the State of residence, it is necessary to identify the trade or business to which an item of income is attributable. Royalties generally will be considered to be derived in connection with the trade or business to which the underlying intangible property is attributable. Dividends will be deemed to be derived first out of earnings and profits of the treaty-benefited trade or business, and then out of other earnings and profits. Interest income may be allocated under any reasonable method consistently applied. A method that conforms to U.S. principles for expense allocation will be considered a reasonable method. The following examples illustrate the application of subparagraph 3(d).

Example 1. USCo is a corporation resident in the United States. USCo is engaged in an active manufacturing business in the United States. USCo owns 100 percent of the shares of Litco, a corporation resident in Lithuania. Litco distributes USCo products in Lithuania. Since the business activities conducted by the two corporations involve the same products, Litco's distribution business is considered to form a part of USCo's manufacturing business within the meaning of subparagraph 3(d).

Example 2. The facts are the same as in Example 1, except that USCo does not manufacture. Rather, USCo operates a large research and development facility in the United States that licenses intellectual property to affiliates worldwide, including Litco. Litco and other USCo affiliates then manufacture and market the USCo-designed products in their respective markets. Since the activities conducted by Litco and USCo involve the same product lines, these activities are considered to form a part of the same trade or business.

Example 3. Americair is a corporation resident in the United States that operates an international airline. LitSub is a wholly-owned subsidiary of Americair resident in Lithuania. LitSub operates a chain of hotels in Lithuania that are located near airports served by Americair flights. Americair frequently sells tour packages that include air travel to Lithuania and lodging at LitSub hotels. Although both companies are engaged in the active conduct of a trade or business, the businesses of operating a chain of hotels and operating an airline are distinct trades or businesses. Therefore LitSub's business does not form a part of Americair's business. However, LitSub's business is considered to be complementary to Americair's business because they are part of the same overall industry (travel) and the links between their operations tend to make them interdependent.

Example 4. The facts are the same as in Example 3, except that LitSub owns an office building in Lithuania instead of a hotel chain. No part of Americair's business is conducted through the office building. LitSub's business is not considered to form a part of or to be complementary to Americair's business. They are engaged in distinct trades or businesses in separate industries, and there is no economic dependence between the two operations.

Example 5. USFlower is a corporation resident in the United States. USFlower produces and sells flowers in the United States and other countries. USFlower owns all the shares of LitHolding, a corporation resident in Lithuania. LitHolding is a holding company that is not engaged in a trade or business. LitHolding owns all the shares of three corporations that are resident in Lithuania: LitFlower, LitLawn, and LitFish. LitFlower distributes USFlower flowers under the USFlower trademark in the other State. LitLawn markets a line of lawn care products in the other State under the USFlower trademark. In addition to being sold under the same trademark, LitLawn and LitFlower products are sold in the same stores and sales of each company's products tend to generate increased sales of the other's products. LitFish imports fish from the United States and distributes it to fish wholesalers in Lithuania. For purposes of paragraph 3, the business of LitFlower forms a part of the business of USFlower, the business of LitLawn is complementary to the business of USFlower, and the business of LitFish is neither part of nor complementary to that of USFlower.

Finally, a resident in one of the States also will be entitled to the benefits of the Convention with respect to income derived from the other State if the income is ``incidental'' to the trade or business conducted in the recipient's State of residence. Subparagraph 3(d) provides that income derived from a State will be incidental to a trade or business conducted in the other State if the production of such income facilitates the conduct of the trade or business in the other State. An example of incidental income is the temporary investment of working capital derived from a trade or business.

Substantiality - Subparagraphs 3(a)(iii) and (c)

As indicated above, subparagraph 3(a)(iii) provides that income that a resident of a State derives from the other State will be entitled to the benefits of the Convention under paragraph 3 only if the income is derived in connection with a trade or business conducted in the recipient's State of residence and that trade or business is ``substantial'' in relation to the income-producing activity in the other State. Subparagraph 3(c) provides that whether the trade or business of the income recipient is substantial will be determined based on all the facts and circumstances. These circumstances generally would include the relative scale of the activities conducted in the two States and the relative contributions made to the conduct of the trade or businesses in the two States.

In addition to this subjective rule, subparagraph 3(c) provides a safe harbor under which the trade or business of the income recipient may be deemed to be substantial based on three ratios that compare the size of the recipient's activities to those conducted in the other State. The three

(i)

the value of the assets in the recipient's State to the assets used in the other State;

(ii)

the gross income derived in the recipient's State to the gross income derived in the other State; and

(iii)

the payroll expense in the recipient's State to the payroll expense in the other State.

The average of the three ratios with respect to the preceding taxable year must exceed 10 percent, and each individual ratio must exceed 7.5 percent. If any individual ratio does not exceed 7.5 percent for the preceding taxable year, the average for the three preceding taxable years may be used instead. Thus, if the taxable year is 2002, the preceding year is 2001. If one of the ratios for 2001 is not greater than 7.5 percent, the average ratio for 1999, 2000, and 2001 with respect to that item may be used.

The term ``value'' also is not defined in the Convention. Therefore, this term also will be defined under U.S. law for purposes of determining whether a person deriving income from United States sources is entitled to the benefits of the Convention. In such cases, ``value'' generally will be defined using the method used by the taxpayer in keeping its books for purposes of financial reporting in its country of residence. See Treas. Reg. 1.884-5(e)(3)(ii)(A).

Only items actually located or incurred in the two Contracting States are included in the computation of the ratios. If the person from whom the income in the other State is derived is not wholly-owned by the recipient (and parties related thereto) then the items included in the computation with respect to such person must be reduced by a percentage equal to the percentage control held by persons not related to the recipient. For instance, if a United States corporation derives income from a corporation in Lithuania in which it holds 80 percent of the shares, and unrelated parties hold the remaining shares, for purposes of subparagraph 3(c) only 80 percent of the assets, payroll and gross income of the company in Lithuania would be taken into account.

Consequently, if neither the recipient nor a person related to the recipient has an ownership interest in the person from whom the income is derived, the substantiality test always will be satisfied (the denominator in the computation of each ratio will be zero and the numerator will be a positive number). Of course, the other two prongs of the test under paragraph 3 would have to be satisfied in order for the recipient of the item of income to receive treaty benefits with respect to that income. For example, assume that a resident of Lithuania is in the business of banking in Lithuania. The bank loans money to unrelated residents of the United States. The bank would satisfy the substantiality requirement of this subparagraph with respect to interest paid on the loans because it has no ownership interest in the payors.

Paragraph 4

Paragraph 4 provides that a resident of one of the States that is not otherwise entitled to the benefits of the Convention may be granted benefits with respect to income arising in the other Contracting State under the Convention if the competent authority of the State from which benefits are claimed so determines. This discretionary provision is included in recognition of the fact that, with the increasing scope and diversity of international economic relations, there may be cases where significant participation by third country residents in an enterprise of a Contracting State is warranted by sound business practice or long-standing business structures and does not necessarily indicate a motive of attempting to derive unintended Convention benefits.

The competent authority of a State will base a determination under this paragraph on whether the establishment, acquisition, or maintenance of the person seeking benefits under the Convention, or the conduct of such person's operations, has or had as one of its principal purposes the obtaining of benefits under the Convention. Thus, persons that establish operations in one of the States with the principal purpose of obtaining the benefits of the Convention ordinarily will not be granted relief under paragraph 4.

The competent authority may determine to grant all benefits of the Convention, or it may determine to grant only certain benefits. For instance, it may determine to grant benefits only with respect to a particular item of income in a manner similar to paragraph 3. Further, the competent authority may set time limits on the duration of any relief granted.

It is assumed that, for purposes of implementing paragraph 4, a taxpayer will not be required to wait until the tax authorities of one of the States have determined that benefits are denied before he will be permitted to seek a determination under this paragraph. In these circumstances, it is also expected that if the competent authority determines that benefits are to be allowed, they will be allowed retroactively to the time of entry into force of the relevant treaty provision or the establishment of the structure in question, whichever is later.

Paragraph 5

Paragraph 5 provides that the term ``recognized stock exchange'' means

(a)

in the United States, the NASDAQ System owned by the National Association of Securities Dealers, and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Exchange Act of 1934; and

(b)

in Lithuania, the National Stock Exchange of Lithuania (Nacionaline vertybiniu popieriu birza), and any other stock exchanges approved by the State Authorities.

In addition, subparagraph (c) of paragraph 5 provides for the competent authorities to agree upon any other recognized stock exchanges. Other exchanges, including exchanges located in third countries, may be recognized for this purpose by agreement of the competent authorities.

Paragraph 6

Paragraph 6 provides additional authority to the competent authorities (in addition to that of Article 26 (Mutual Agreement Procedure)) to consult together to develop a common application of the provisions of this Article, including the publication of regulations or other public guidance. The competent authorities shall, in accordance with the provisions of Article 27 (Exchange of Information and Administrative Assistance) exchange such information as is necessary to carry out the provisions of the Article.

---

Next: ARTICLE 24 - Relief from Double Taxation
Up: Technical Explanation
Previous: ARTICLE 22 - Other Income