December 15, 2022
United States and Croatia sign income tax treaty
On December 7, 2022, Jose W. Fernandez, US undersecretary of state for economic growth, energy and the environment, and Dr. Marko Primorac, Croatia's minister of finance, signed the first income tax treaty and protocol between the United States and Croatia (Treaty). The Treaty is the first treaty based on the revised US Model Treaty released in 2016 (the 2016 Model). The 2016 Model updates its predecessor, the US Model Treaty published in 2006 (the 2006 Model) and introduces several new provisions, including a number of anti-abuse rules.
The most significant provisions of the Treaty include the following:
The Treaty will be referred to the Senate Foreign Relations Committee (SFRC) for a hearing. Upon approval by the SFRC, the Senate must give its advice and consent to ratification with a two-thirds majority vote. Once the Senate takes action, the president must sign an instrument of ratification to the Treaty to complete the approval and ratification process in the United States. The United States and Croatia must notify each other in writing, through diplomatic channels, when their respective ratification requirements for the entry into force of the Treaty have been satisfied. The Treaty will enter into force on the date of receipt of the later of these notifications.
The Treaty generally follows the 2016 Model (2016 Model), with certain modifications. The following discussion focuses on the Articles relating to dividends, interest, royalties (including provisions embedded for income benefitting from STRs and payments made by expatriated entities) and LOB, and certain other provisions in the Treaty.
Article 1(7) restricts the applicable treaty benefits in a Contracting State for amounts that are taxed in the other Contracting State on a remittance basis only (i.e., a regime under which income derived from the source state is taxed only on the amount that is remitted to the residence state, and not by reference to the full amount). In those cases, relief shall be applied "only to so much of the amount as is taxed" in the other Contracting State.
Exempt-permanent establishment (PE) provision — Article 1(8)
Like the 2016 Model, Article 1(8) contains a exempt-PE provision that denies treaty benefits to income attributable to a PE if either of the following occurs: (i) the profits attributable to the PE are subject to a combined aggregate effective rate of tax in the residence state and the state in which the PE is situated that is less than the lesser of the specified threshold; or (ii) the PE is situated in a third state does not have a comprehensive income tax treaty in force with the source state, unless the residence state includes the income attributable to the PE in its tax base. The specified threshold is 15% or 60% of the highest general statutory rate of company tax applicable in the residence state. The use of the highest general statutory rate varies from the 2016 Model.
Unlike other US tax treaties currently in force, no exception applies when an active business is conducted in the PE jurisdiction. However, the Treaty enables a treaty resident to seek relief from the competent authority of the other Contracting State in certain circumstances.
Coordination with BEAT — Article 1(9)
Similar to the SFRC's reservations to the US-Chile Treaty (See Tax Alert 2022-9004), Article 1(9) provides that the Treaty does not prevent the United States from imposing the BEAT under IRC Section 59A (as it may be amended from time to time) on a US resident company or on the profits of a Croatian resident company that are attributable to a PE in the United States.
Special tax regimes — Articles 3(1)(l), 11(2)(c), 12(3)(a) and 21(2)(a)
Consistent with the 2016 Model, treaty benefits do not apply to interest, royalties and guarantee fees (within the scope of Article 21 (Other Income) of the Treaty) paid to connected persons that benefit from an STR for that income in their residence state. This provision is implemented through Articles 11(2)(c) (Interest), 12(3)(a) (Royalties) and 21(2)(a) (Other Income).
According to Article 3(1)(m), two persons are connected if (i) one person owns, directly or indirectly, at least 50% of the beneficial interest or shares representing the aggregate vote and value in the other; or (ii) a third person owns, directly or indirectly, at least 50% of the beneficial interest or shares representing the aggregate vote and value in each person. In any case, a person is connected to another if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the third person(s).
Article 3(1)(l) generally defines an STR in a similar manner as the 2016 Model. An STR is a regime that provides preferential treatment to interest, royalties or guarantee fees as compared to income from sales of goods or services. Such preferential treatment, with the exception of regimes for specified taxpayers, must be in the form of either a preferential rate, a permanent reduction in the tax base for that income, or a preferential regime for companies that do not engage in an active business in the residence state. For royalties, the preferential rate or permanent reduction in tax is not conditioned on the extent of research and development activities that take place in the country granting the favorable rate. Further, an STR would generally be expected to result in a tax rate that is less than the lesser of either: (i) 15%; or (ii) 60% of the highest general statutory rate of company tax applicable in the other Contracting State.
The Treaty will not treat a statute, regulation or administrative practice as an STR until the state invoking the STR provisions, after consultation with the other state, notifies the other state of its intention through a diplomatic note and issues a written public notification.
Expatriated entities — Articles 10(5), 11(2)(d), 12(3)(b) and 21(2)
Like the 2016 Model, the Treaty denies benefits for payments of dividends, interest, royalties and certain guarantee fees made by US companies that are expatriated entities to a beneficial owner that is a connected person to the expatriated entity. The denial of treaty benefits continues for 10 years, beginning on the date on which the acquisition of the domestic entity is completed.
An expatriated entity is defined by reference to IRC Section 7874(a)(2)(A) as of the date on which the Treaty is signed, as well as regulations that are or may be promulgated around that definition. Further, the Treaty provides that an entity that is not otherwise treated as an expatriated entity for purposes of the Treaty may nevertheless become an expatriated entity if certain conditions are met.
Dividends — Article 10
Unlike some of the US tax treaties currently in force (such as the US-UK Treaty), the Treaty does not exempt from withholding taxes dividends paid to a company, except for dividends paid to certain pension funds. If the beneficial owner is a resident of the other Contracting State and meets one of the LOB tests, Article 10(2) sets a maximum dividend withholding tax rate of 15%, with a reduced rate of 5%, if the following conditions are satisfied for the 12-month period ending on the date on which dividend entitlement is determined:
Under Article 10(3)(a), withholding tax does not apply to dividends paid to pension funds if the pension fund is a beneficial owner that is a resident of the other Contracting State (and meets one of the LOB tests), and the dividends are not derived from a trade or business carried on by the pension fund or through a connected person. In addition, Article 10(3)(b) exempts dividends paid by a US resident company to a specified voluntary pension insurance scheme that is a resident of Croatia (and meets one of the LOB tests) from withholding tax if the dividends are not derived from a trade or business carried on by the insurance scheme or through a connected person.
Article 10(4) imposes a 15% withholding tax for dividends paid by a US regulated investment company (RIC) or a US real estate investment trust (REIT), subject to certain conditions. Article 10(10) generally allows for the imposition of a branch profits tax, but limits the tax rate to 5% or the rate that would apply to the beneficial owner's dividends under the derivative benefits test. The latter rate only applies, however, if the company has been a resident of the other Contracting State or of a "qualifying third state" for the 12-month period ending on the date on which the entitlement to the dividend equivalent amount is determined.
Interest — Article 11
Subject to certain exceptions, Article 11 generally exempts interest from withholding tax. Article 11(2), however, applies a 15% withholding tax to certain payments of contingent interest. Interest that is subject to an STR or benefits from notional deductions in the residence state may, under certain circumstances, be taxed under the source state's law. Finally, as described in further detail later, Article 11(2)(f) allows the source state to impose a maximum withholding tax of 10% for interest beneficially owned by a resident that qualifies for treaty benefits through the headquarters company test of the LOB provision (Article 22(5)).
Royalties — Article 12
Article 12(2) applies a 5% withholding tax to royalties paid to a beneficial owner that is a resident of the other state that meets one of the LOB tests. As noted previously, however, domestic law may apply to the extent that the payment is subject to an STR or paid by expatriated entities.
Limitation on benefits — Article 22
To qualify for treaty benefits, a resident of a Contracting State must be a qualified person as determined under paragraph 2 of Article 22 of the Treaty, or meet one of the other tests in that article. Article 22 of the Treaty is largely similar to the LOB article in the 2016 Model. In general, Article 22(2) requires a resident to be a qualified person at the relevant time that treaty benefits are sought for an item of income. For the ownership-base erosion test under Article 22(2)(f), the resident must also satisfy the ownership threshold on at least half of the days of any 12-month period that includes the date when the treaty benefit would be accorded.
Alternatively, a resident that is not a qualified person under paragraph 2 may still be eligible for treaty benefits for an item of income if it meets one of the other tests under the LOB provision, namely the active trade or business test (ATB test), derivative benefits test or headquarters company test under Articles 22(3), (4) and (5) respectively. Finally, a resident may request discretionary relief under Article 22(6).
Subsidiary of a publicly-traded company test
Article 22(2)(d) entitles a resident company (tested resident) to all treaty benefits if both the ownership and base erosion prongs of this test are met. The ownership prong is satisfied if at least 50% of the aggregate vote and value of the company's shares (and of any disproportionate class of shares) is owned, directly or indirectly, by five or fewer companies that qualify under the publicly-traded company test in Article 22(2)(c) (publicly-traded company test). In the case of indirect ownership, each intermediate owner must be a qualifying intermediate owner, similar to the other ownership tests in the LOB article.
Article 22(7)(f) defines a "qualifying intermediate owner" as either:
This definition differs from that in the 2016 Model; the change was needed to enable the operation of the relevant Treaty provisions, considering that no US tax treaties currently in force have been updated to incorporate comparable STR and NID provisions.
The subsidiary of a publicly-traded test also adds a base erosion prong that applies to benefits other than reduced withholding on dividends. It requires less than 50% of the company's gross income, and less than 50% of the tested group's gross income, to be paid or accrued, directly or indirectly, in the form of deductible payments (other than arm's-length payments in the ordinary course of business for services or tangible property) to certain persons that:
Article 22(7)(g) defines a "tested group" as the tested resident and any company or PE that is a member with the tested resident of a tax consolidation regime or similar group regime that allows members of the group to share profits or losses.
Ownership-base erosion test
The ownership-base erosion test in Article 22(2)(f) applies to a resident that is (i) a person other an individual; or (ii) a specified voluntary pension insurance scheme in Croatia. Under this test, the resident must satisfy both the ownership and base erosion prongs at the relevant time. The ownership prong is satisfied if, on at least half the days of the tax year, residents of either Croatia or the United States that are entitled to treaty benefits as individuals, governmental entities, publicly-traded companies, tax-exempt organizations or pension funds own, directly or indirectly, shares or other beneficial interests representing at least 50% of the aggregate voting power and value of the shares or beneficial interests (and of any disproportionate class of shares) of such resident. In the case of indirect ownership, each intermediate owner must be a qualifying intermediate owner (as defined previously). The base erosion prong is identical to that in the subsidiary of a publicly-traded company test (described earlier). Unlike US tax treaties currently in force, the prong requires both the tested resident and the tested group to meet the test.
The active trade or business test
Article 22(3) enables a resident to access treaty benefits for a specific item of income derived from the source state if it satisfies a three-pronged ATB test that applies separately for each item of income. The ATB test is identical to the 2016 Model. Activities from connected persons in the residence state can be attributed to residents seeking to qualify under the ATB test.
First, the resident must be engaged in the active conduct of a trade or business in its residence state. Certain activities are specifically excluded from an active conduct of a trade or business, such as: (i) operating as a holding company; (ii) providing overall supervision or administration of a group of companies; (iii) providing group financing (including cash pooling); or (iv) making or managing investments (unless carried on by a bank, an insurance company or a registered securities dealer in the ordinary course of its business).
Second, the income must emanate from, or be incidental to, the active trade or business in the residence state. This Treaty is the first US tax treaty to use the "emanates from" standard introduced in the 2016 Model (also applied in the 2017 OECD Model Income Tax Convention). Although the US Treasury Department did not release a Technical Explanation for the 2016 Model Treaty, the Preamble to the 2016 Model clarifies that such guidance would differ from the "derived in connection with" standard, which appears in current US tax treaties (Preamble to the 2016 Model). The Commentary on the 2017 OECD Model Income Tax Convention explains that the requisite factual connection for the "emanates from" standard can be established if the line of business in the source state is upstream or downstream to the activity conducted in the residence state.
Third, the trade or business activity in the residence state must be substantial in relation to the same or complimentary activity in the source state if the resident derives an item of income in the source state from (i) a trade or business conducted by that treaty-resident; or (ii) a connected person.
The derivative benefits test
Article 22(4) permits a resident company to access treaty benefits for a specific item of income derived from the source state if it satisfies the ownership prong (at the relevant time) and base erosion prong of the derivative benefits test. The ownership prong requires shares representing at least 95% of the aggregate voting power and value of the company's shares (and at least 50% of any disproportionate class of shares) to be owned, directly or indirectly, by seven or fewer persons that are equivalent beneficiaries. In the case of indirect ownership, each intermediate owner must be a qualifying intermediate owner (as defined previously).
The base erosion prong is met if less than 50% of the company's gross income, and less than 50% of the tested group's gross income, is paid or accrued, directly or indirectly, in the form of payments (subject to certain exceptions) that are deductible for purposes of the taxes covered by the treaty in the company's residence state to persons that (i) are not equivalent beneficiaries; (ii) are equivalent beneficiaries solely by reason of the headquarters test (described below) or a substantially similar provision in the relevant income tax treaty; (iii) are equivalent beneficiaries that are connected persons with respect to the company seeking benefits under the treaty and benefit from an STR with respect to the deductible payment; or (iv) are equivalent beneficiaries that are connected persons with respect to the company seeking benefits under the treaty and that benefit from an NID with respect to a payment of interest.
Unlike the derivative benefits test in current US tax treaties, the base erosion prong also applies to the tested group.
The definition of "equivalent beneficiaries" under Article 22(7)(e), is substantially similar to the 2016 Model, and includes three categories of persons; i.e., residents of any state, the residence state or the source state. Similar to the definition of a qualifying intermediate owner, the definition of equivalent beneficiaries differs from 2016 Model to enable the operation of this provision in the Treaty.
In a departure from the derivative benefits test in current US tax treaties, the Treaty incorporates taxpayer-favorable changes to the definition of equivalent beneficiary that expand the applicability of this test. For example, equivalent beneficiaries can be resident in countries that are not EU or NAFTA members. Under certain circumstances, individuals may qualify as equivalent beneficiaries for dividends. As individuals must apply a 15% treaty rate to their dividends, they generally cannot meet the necessary rate-comparison test in current US tax treaties. Accordingly, a modified definition of equivalent beneficiary in Article 22(7)(e)(i)(B) permits individual shareholders to be treated as publicly traded companies for purposes of the rate-comparison test for dividends, subject to the condition that the company seeking to qualify under the derivative benefits test has sufficient substance through the conduct of a substantial active trade or business in its residence state.
Unlike current US tax treaties, this Treaty eliminates the so-called cliff effect that applies to certain income by altering Articles 10(6) (Dividends), 11(3) (Interest) and 12(4) (Royalties). If a third-state resident fails the rate-comparison test, the treaty resident seeking derivative benefits may still claim a reduced withholding tax rate equal to the highest rate of withholding to which its third-state resident owners would be entitled.
Headquarters company test
Under Article 22(5), a resident company that serves as the active headquarters of a multinational corporate group (headquarters company) may also be entitled to treaty benefits for dividends and interest paid by members of its multinational corporate group, if it satisfies the specified multi-factor requirements, including a base erosion test. These requirements are broadly similar to those in the 2016 Model, but differ in key respects from current US tax treaties, which could limit the applicability of this provision.
First, the Treaty requires a headquarters company to exercise primary management and control functions (not merely supervision and administration) in its residence state for itself and its geographically diverse subsidiaries. Second, a headquarters company must meet a base erosion prong (which is the same as the subsidiary of a publicly-traded company test).
The other requirements, which are broadly similar to current US tax treaties, consist of the following:
For interest, Article 11(2)(f) applies a source state tax rate of 10% to interest beneficially owned by headquarters companies that qualify for treaty benefits under this test.
Competent authority relief
Article 22(6) allows the competent authority of a Contracting State to grant benefits to a resident, taking into account the object and purpose of the Treaty. The resident must demonstrate that it has a substantial non-tax nexus to its state of residence, and that neither its establishment, acquisition or maintenance, nor the conduct of its operations had as one of its principal purposes the obtaining of treaty benefits.
Relief from double taxation — Article 23
In the case of Croatia, double tax will be relieved by allowing a deduction for an amount equal to the income tax paid in the US. In the case of the United States, to the extent allowed under U.S. law, Article 23(2) provides relief from double tax for U.S. persons. First, Article 23(2)(a) permits US residents and citizens to claim, as a credit against US tax, income tax paid or accrued to Croatia by or on behalf of the resident or citizen. Article 23(2)(b) permits a US company owning at least 10% of the aggregate vote and value of the shares of a Croatian resident company to deduct the dividends received from the Croatian company in computing its taxable income.
Exchange of information and administrative assistance — Article 26
Generally, Article 26 allows the competent authorities to exchange information as is "foreseeably" relevant to carry out the purposes of the Treaty or domestic law of one of the Contracting States. The use and disclosure of this information is limited to the specified purposes. Article 26(2) enumerates the circumstances where this information may be disclosed for other purposes, with either written consent of, or after consultation with, the other competent authority.
Subsequent changes in law — Article 28
Article 28 enables either the United States or Croatia to initiate a diplomatic process to amend the Treaty in certain circumstances. In particular, a diplomatic process to amend the Treaty may be initiated if either country subsequently changes its domestic law after the treaty has been signed to:
If consultations do not progress to restore an appropriate allocation of taxing rights, the provisions of Articles 10 (Dividends), 11 (Interest), 12 (Royalties) and 21 (Other Income) will cease to apply.
Entry into force — Article 29
When ratified, the Treaty's withholding provisions will take effect for amounts paid or credited on or after the first day of the second month following the date on which the Treaty enters into force. For all other taxes, the provisions will take effect for tax periods beginning on or after the first day of January following the date on which the Treaty enters into force.
The exchange of information under Article 26 will take effect on the date on which the Treaty enters into force, irrespective of the tax year to which the matter relates.
As noted previously, a Protocol accompanies the Treaty. The Protocol defines the term "pension funds" for United States and Croatia. In addition, it considers a specified voluntary pension insurance scheme in Croatia to be a resident for purposes of Article 4. The Protocol also describes how to determine the rate of taxation for STRs.
Finally, the Protocol enables Croatia to request a consultation on possible amendments to the Treaty if it enacts regimes similar to BEAT (IRC Section 59A) or those for expatriated entities (IRC Section 7874), US RICs or US REITs.
In addition to the benefits it will provide to US companies with current or contemplated business activities in Croatia, this Treaty is significant because it is the first bilateral treaty that the United States has signed that is based upon the 2016 Model (it does not substantially depart from that model). Given the changes in the international tax landscape that have occurred since 2016, particularly commitments by many jurisdictions to minimum tax rates, some may have questioned whether the US Treasury Department would continue to view certain new provisions, such as those concerning STRs, and subsequent changes in law as important objectives of tax treaty policy. This Treaty makes clear that the United States still views these policy concerns as important to address bilaterally, so that treaty partners retain the right to curtail treaty benefits under certain conditions. As no technical explanation was issued for the 2016 Model, stakeholders will get a more complete explanation of how the US Treasury Department intends to interpret these new provisions when it releases its technical explanation of this Treaty (which typically occurs concurrently with the SFRC hearing).
At present, it is unclear how long the hearing and ratification process will take; other outstanding US tax treaties with Chile and Poland are pending ratification in the Senate. It remains to be seen whether the US Treasury Department will take an approach similar to the US-Croatia Treaty, and follow the 2016 Model, in treaty-modernization negotiations with Switzerland and Israel or other US tax treaties currently in force.
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor