Testimony of the Staff of the Joint Committee on Taxation on Treaties and Protocols Before the Senate Committee on Foreign Relations Hearing on Tax Treaties and Protocols With Eight Countries
October 7, 1997
Testimony of the Staff of the Joint Committee on Taxation
My name is Ken Kies. I am Chief of Staff of the Joint Committee on Taxation. It is my pleasure to present the testimony of the staff of the Joint Committee on Taxation ("Joint Committee staff") at this hearing concerning the proposed income tax treaties with Austria, Ireland, Luxembourg, South Africa, Switzerland, Thailand, and Turkey and the proposed protocol amending the existing income tax treaty with Canada.
As in the past, the Joint Committee staff has prepared pamphlets covering each of the proposed treaties and protocols. The pamphlets contain detailed descriptions of the provisions of the proposed treaties and protocols, including comparisons with the 1996 U.S. model treaty, which reflects preferred U.S. treaty policy, and with other recent U.S. tax treaties. The pamphlets also contain detailed discussions of issues raised by the proposed treaties and protocols. We consulted extensively with your Committee staff in analyzing the proposed treaties and protocols and preparing the pamphlets.
Five of the eight agreements at issue today would modify existing U.S. treaty relationships. The proposed protocol with Canada would make two modifications to the current treaty which was amended most recently in 1995. The proposed treaty with Austria would replace an existing treaty that has not been modified since 1956. The proposed treaty with Ireland would replace an existing treaty that has not been modified since 1949. The proposed treaty with Luxembourg would replace an existing treaty that has not been modified since 1962. The proposed treaty with Switzerland would replace an existing treaty that has not been modified since 1951. The other three treaties are with countries with which the United States does not currently have a treaty relationship. The proposed treaties with Thailand and Turkey would represent the entrance into tax treaty relationships where the United States has not previously had such a treaty. The final proposed treaty is with South Africa; the United States previously had a treaty with South Africa which was terminated in 1987, and no treaty currently is in force.
I will highlight some of the key features of these treaties and protocols and the issues they raise.
In connection with consideration of these treaties, an issue was raised regarding the U.S. treaty policy with respect to the treatment of dividends from U.S. Real Estate Investment Trusts ("REITs").
U.S. tax treaties generally limit the maximum rate of withholding tax that may be imposed by the source country on portfolio dividends paid by a corporation resident in one country to residents of the other country; most commonly, the maximum rate of withholding tax on dividends is 15 percent. Treaties negotiated by the United States after 1988 contain specific rules excluding REIT dividends from the reduced rates of withholding tax generally applicable to dividends. Accordingly, under such treaties, REIT dividends may be subject to U.S. withholding tax at the full statutory rate of 30 percent. The exclusion of REIT dividends from the reduced rates of withholding tax generally applicable to dividends reflects the view that REIT dividends should be treated in a manner that generally is comparable to the treatment of rental income earned on a direct investment in real property.
The REIT industry has expressed concern that the exclusion of REIT dividends from the reduced withholding tax rates applicable to other dividends may inappropriately discourage some foreign investment in REITs. The Treasury Department has worked extensively with your Committee staff, the Joint Committee staff, and representatives of the REIT industry in order to address this concern while maintaining a treaty policy that properly preserves the U.S. taxing jurisdiction over foreign direct investment in U.S. real property. As a result of significant cooperation among all parties to balance these competing considerations, the U.S. treaty policy with respect to the treatment of REIT dividends has been modified.
Under this policy, REIT dividends paid to a resident of a treaty country will be eligible for the reduced rate of withholding tax applicable to portfolio dividends (typically, 15 percent) in two cases. First, the reduced withholding tax rate will apply to REIT dividends if the treaty country resident beneficially holds an interest of 5 percent or less in each class of the REIT's stock and such dividends are paid with respect to a class of the REIT's stock that is publicly traded. Second, the reduced withholding tax rate will apply to REIT dividends if the treaty country resident beneficially holds an interest of 10 percent or less in the REIT and the REIT is diversified, regardless of whether the REIT's stock is publicly traded. In addition, the treaty policy with respect to the application of the reduced withholding tax rate to REIT dividends paid to individuals holding less than a specified interest in the REIT will remain unchanged.
For purposes of these rules, a REIT will be considered diversified if the value of no single interest in real property held by the REIT exceeds 10 percent of the value of the REIT's total interests in real property. An interest in real property will not include a mortgage, unless the mortgage has substantial equity components. An interest in real property also will not include foreclosure property. Accordingly, a REIT that holds exclusively mortgages will be considered to be diversified. The diversification rule will be applied by looking through a partnership interest held by a REIT to the underlying interests in real property held by the partnership. Finally, the reduced withholding tax rate will apply to a REIT dividend if the REIT's trustees or directors make a good faith determination that the diversification requirement is satisfied as of the date the dividend is declared.
This new policy with respect to the treatment of REIT dividends will be incorporated into the U.S. model treaty. In addition, the Treasury Department will use its best efforts to negotiate protocols to amend the proposed treaties with Austria, Ireland, and Switzerland to incorporate this policy.
In the case of Luxembourg, it is recommended that this policy be implemented by means of a reservation to the proposed treaty presently under consideration. In addition, it is recommended that this reservation include a special rule for existing investment in REITs by Luxembourg residents. Under this special rule, in the case of any resident of Luxembourg who held an interest in a diversified REIT as of June 30, 1997, dividends paid to such resident with respect to that interest would be eligible for the reduced rate of withholding tax. However, this special rule would not apply to dividends paid after December 31, 1999, unless the stock of the REIT is publicly traded on December 31, 1999 and thereafter. The special rule would apply to existing investment in a REIT as of June 30, 1997 and to reinvestment in the REIT of both ordinary and capital dividends paid with respect to that investment. In addition, if a REIT in which there is a qualifying investment as of June 30, 1997 goes out of existence in a nonrecognition transaction, the special rule would continue to apply to the investment in the successor REIT if any.