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December 28, 2023

U.S.-Chile Income Tax Treaty Enters Into Force

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U.S.-Chile Income Tax Treaty Enters Into Force

On December 19, 2023, the U.S. Treasury Department (“Treasury”) announced the entry into force of the U.S.-Chile Income Tax Treaty (the “Treaty”).[1] The Treaty provides for reduced withholding tax rates on income such as dividends, interest and royalties with the goal of reducing double taxation and increasing commerce and investment between the United States and Chile. The Treaty is effective (i) on February 1, 2024 (for taxes withheld at source), and (ii) for taxable periods beginning on or after January 1, 2024 (for all other taxes).

The Treaty is the first income tax treaty signed by the United States that contains rules incorporating some of the U.S. tax law changes introduced by the 2017 Tax Cuts and Jobs Act (“TCJA”).[2] It is also the first income tax treaty signed by the United States to enter into force in more than ten years, and it is only the second U.S. income tax treaty with a South American country, following the agreement with Venezuela (signed in 1999 and in force since 2000).

U.S. multinationals engaged in operations and transactions involving Chile should assess how the provisions of the Treaty might affect their activities to maximize the potential benefits of the Treaty.

Key Provisions of the Treaty

The Treaty closely follows the framework of the 2006 U.S. Model Treaty (the “Model Treaty”) with certain modifications, including a more stringent limitation on benefits (“LOB”) clause (further discussed below). It also subjects interest and royalties to higher withholding tax rates than those of the Model Treaty, as follows:

  • Dividends (Article 10): The Treaty limits to 15 percent the withholding tax rate on dividends paid by a resident company to a beneficial owner that is a resident of the other country. The withholding tax rate is lowered to five percent where the beneficial owner is a company holding a minimum of 10 percent of the voting stock in the company distributing the dividends. Unlike many other U.S. income tax treaties, the Treaty does not provide for a full exemption on dividend withholding tax except for dividends paid to pension funds. The Treaty also expressly allows the United States to impose the branch profits tax (“BPT”), at a rate not exceeding five percent, on the “dividend equivalent amount” (as such term is defined in section 884)[3] that is attributable to a U.S. permanent establishment of a Chilean corporation.
  • Interest (Article 11): The Treaty reduces the withholding tax rate on interest to 15 percent, which is lowered to 10 percent after a five-year period beginning once the Treaty takes effect. Regarding interest paid to certain specific entities (including banks, insurance companies and companies engaged in lending or finance businesses),[4] the withholding tax rate is four percent without a phase-in period. The treatment of interest under the Treaty differs from the Model Treaty and some other U.S. income tax treaties, which provide for full exemption from source-country taxation on interest payments.
  • Royalties (Article 12): The Treaty generally reduces the withholding tax rate on royalties to 10 percent. The withholding tax rate is further reduced to two percent with respect to royalties for the use of, or the right to use, industrial, commercial or scientific equipment, but not including ships, aircraft or containers. This treatment of royalties also differs from the Model Treaty and some other U.S. income tax treaties, which generally provide for full exemption from source-country taxation on royalty payments.
  • Capital Gains (Article 13): Generally, under the Treaty, gains from the alienation of (i) real (immovable) property may be fully taxed in the country in which the real property is situated (Article 13(1)); (ii) personal (movable) property attributable to a permanent establishment or a “fixed base” that is available for the purpose of performing independent personal services—or from the alienation of the permanent establishment or “fixed base” itself—may be fully taxed in the country in which the permanent establishment or “fixed base” is situated (Article 13(3));[5] and (iii) shares or other rights or interests representing the capital of a U.S. or Chilean company may be taxed in the United States or Chile, respectively, at the maximum rate of 16 percent (except for certain substantial holdings (which contains (i) a 50 percent threshold for shares and (ii) a 20 percent threshold for other equity interests), which are not subject to such rate limitation) (Article 13(5) and (7)).[6] Furthermore, the Treaty provides for exemptions from taxation in the other contracting state for gains recognized by (i) a pension fund that is a resident of a contracting state from the sale of shares of a company that is a resident of the other contracting state, (ii) a mutual fund or other institutional investor that is a resident of a contracting state from the sale of shares of a company that is a resident of the other contracting state and whose shares are substantially and regularly traded on a recognized stock exchange located in that other contracting state and (iii) a resident of a contracting state from the sale of certain shares of a company that is a resident of the other contracting state and whose shares are substantially and regularly traded on a recognized stock exchange located in that other contracting state (Article 13(6)).

Article 13(5) of the Treaty should be a favorable provision for U.S. taxpayers if and when final foreign tax credit regulations issued in 2021[7] ever become effective. As discussed in our recent alert, Treasury and the IRS have recently deferred indefinitely, at taxpayers’ election, the effectiveness of these regulations, which would significantly limit the availability of foreign tax credits under the Code. However, if these regulations apply, a Chilean tax imposed on the sale of shares by a U.S. taxpayer in a Chilean company, absent the Treaty, would not be creditable as it would not be expected to satisfy the so-called “attribution requirement” contained in such regulations. By being treated as a creditable tax under Article 23(1) of the Treaty, such Chilean tax should be deemed to be creditable under the treaty coordination rule of the final foreign tax credit regulations.[8]

LOB Article of the Treaty

To be eligible for the benefits of the Treaty, a resident of the United States or Chile (within the meaning of Article 4 of the Treaty) must also satisfy at least one of the tests provided in the LOB article of the Treaty (Article 24). The LOB article contains anti-treaty shopping provisions that are intended to prevent residents of third countries from inappropriately enjoying benefits that are exclusively meant for residents of the United States or Chile. 

The Treaty contains a comprehensive LOB article that is consistent with other U.S. income tax treaties based on the Model Treaty. Accordingly, under Article 24 of the Treaty, a resident company may be eligible for benefits of the Treaty if it (i) qualifies as a “publicly traded company” of the United States or Chile, (ii) is a 50-percent or greater directly or indirectly owned subsidiary of five or fewer companies that meet the publicly traded company test above, (iii) functions as a headquarters company for a multinational corporate group and satisfies certain specific conditions, (iv) satisfies an ownership-base erosion test based on a 50-percent threshold, or (v) conducts an active trade or business in its country of residence and satisfies certain other conditions.

Following the Model Treaty, certain LOB tests of the Treaty are more restrictive than their counterparts in other U.S. income tax treaties. For example, a company generally meets the publicly traded company test if its principal class of shares is regularly traded on a “recognized stock exchange.” In many U.S. income tax treaties, such term includes not only the stock exchange of the country of residence of the foreign company seeking treaty benefits, but also U.S. stock exchanges as well as stock exchanges in other jurisdictions (e.g., Amsterdam, London, Paris, Tokyo). In the Treaty, however, a company meets the publicly traded company test only if it also meets a substantial presence test by either: (i) having its principal class of shares primarily traded on a recognized exchange in its country of residence or (ii) being primarily managed and controlled there.[9] The effect of such provision is that many publicly traded companies that have decentralized management structures and listings on multiple exchanges outside the United States or Chile, as the case may be, may not have access to the benefits of the Treaty. 

Moreover, unlike U.S. income tax treaties with some European countries, Mexico and Canada, for example, but consistent with the Model Treaty, the Treaty does not include a derivative-benefits test, which would allow a U.S. or Chilean company to qualify for treaty benefits even if it is owned by residents of certain third countries that have an income tax treaty with the United States or Chile, as the case may be.

Reservations

The Treaty was approved by the Senate in June 2023 with two reservations, which have been incorporated in the ratified version of the Treaty. The Senate added these reservations after the Treaty was signed in 2010 to address two changes in U.S. tax law under the TCJA. 

BEAT Reservation

The first reservation addresses how the Treaty interacts with the base erosion and anti-abuse tax provided under section 59A (the “BEAT”). Enacted by the TCJA, the BEAT generally imposes an additional tax on certain large corporate taxpayers that make “base erosion payments,” which include deductible payments and other categories of payments to certain foreign related persons.

The reservation generally provides that the Treaty does not prevent the imposition of the BEAT on a U.S. company or on the profits of a Chilean company that are attributable to a U.S. permanent establishment. Such reservation, thus, counters potential arguments that the Treaty should limit the United States’ ability to impose the BEAT. In the absence of this reservation, taxpayers could argue that the disallowance of a foreign tax credit under section 59A would violate the Relief from Double Taxation Article of the Treaty (Article 23) or that the disallowance of deductions only with respect to payments to foreign related persons would infringe upon the Nondiscrimination Article of the Treaty (Article 25)).

However, the BEAT reservation also prompts questions about what the apparent need for such a reservation means in relation to all other U.S. income tax treaties currently in force, which do not contain a similar provision. In this regard, the new U.S.-Croatia Income Tax Treaty, which has been recently negotiated but is not yet effective, includes language that is identical to the reservation added to the Treaty. We anticipate that this provision will be included in future U.S. income tax treaties.

Relief from Double Taxation Reservation

The second reservation modifies the Relief from Double Taxation Article of the Treaty (Article 23) to reflect the TCJA’s elimination of the indirect foreign tax credit rules of section 902 and the addition of the dividends-received deduction (“DRD”) under section 245A.

Article 23 of the Treaty, as modified by the reservation, provides that, “[i]n accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof),” any relief from double taxation in the case of a U.S. corporation receiving a dividend from a 10-percent owned Chilean company shall be granted by means of a deduction in the amount of such dividends in computing the taxable income of the U.S. corporation. Accordingly, if a U.S. corporation receives a dividend payment from a 10-percent or greater owned Chilean corporate subsidiary, the U.S. corporation should be able to deduct the amount of such dividends in computing its taxable income.[10] Similar to the BEAT reservation, the recently negotiated U.S.-Croatia Income Tax Treaty also includes language providing for the allowance of a DRD with respect to dividends received from 10-percent owned subsidiaries, and such provision should be expected to be part of future U.S. income tax treaties.

Prior to such a change, Article 23 of the Treaty, like most U.S. income tax treaties, allowed an indirect foreign tax credit for a U.S. company with respect to dividends paid by a 10-percent owned Chilean company. Based on this provision, coupled with the historical treatment of subpart F inclusions as dividends prior to the repeal of section 902 by the TCJA, commentators have argued that a section 960 indirect foreign tax credit may be claimed under U.S. income tax treaties with respect to foreign taxes paid by a controlled foreign corporation within the definition of section 957(a) (“CFC”). The significance of this technical position depends in large part on the effectiveness of the final foreign tax credit regulations issued in 2021.[11] However, if and when the final foreign tax credit regulations apply, the Treaty’s removal of the foreign tax credit language from Article 23 and its replacement with a DRD would appear to close the door on such a technical position with respect to Chilean CFCs.

Footnotes

[1]  References to the “U.S.-Chile Income Tax Treaty” or the “Treaty” are to the Convention Between the Government of the United States of America and the Government of the Republic of Chile for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital, signed at Washington February 4, 2010, with a Protocol signed the same day, as corrected by exchanges of notes effected February 25, 2011, and February 10 and 21, 2012.
[2]  The TCJA is also known as “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018,” P.L. No. 115-97.
[3]  All section references herein are to the Internal Revenue Code of 1986, as amended (the “Code”), or the Treasury regulations promulgated thereunder.
[4]  Regarding the term “lending or finance business,” the Treaty itself defines it for purposes of Article 11 to include the business of issuing letters of credit or providing guarantees, or providing charge and credit card services. Conversely, the terms “bank” or “insurance company,” for example, are not defined under the Treaty. In the absence of a specific treaty definition, Article 3(2) of the Treaty provides that such terms will have the meaning provided under the law of the country whose tax is being applied (the United States or Chile, as the case may be), unless the context requires otherwise.
[5]  This would also cover gains from the disposition of an interest in a partnership that are treated as effectively connected income under section 864(c)(8), as added by the TCJA.
[6]  Under Article 13(2)(b) of the Treaty, the term “real property (immovable property)” includes a U.S. real property interest (“USRPI”), as defined in section 897. As provided in the Treasury’s Technical Explanation to the Treaty, under section 897(c), a USRPI includes shares in a U.S. real property holding corporation (“USRPHC”), as defined in section 897(c)(2). Interestingly, the Treaty does not provide a clear coordination rule between Article 13(1) and Article 13(5), which arguably could both apply to the sale of shares in a USRPHC.
[7]  T.D. 9959, 87 F.R. 276.
[8]  See section 1.901-2(a)(1)(iii) of the Treasury regulations.
[9]  Generally, under Article 24(6)(d) of the Treaty, a company’s “primary place of management and control” will be its country of residence only if executive officers and senior management employees, as well as the staff of such persons, exercise day-to-day responsibility for more of the strategic, financial and operational policy decision making for the company (including its direct and indirect subsidiaries) in that country than in any other country.
[10]  Based on the introductory language of Article 23, the DRD provided under the Treaty appears to be subject to the various limitations provided under U.S. tax laws for the application of the section 245A DRD, such as the holding period requirement of section 246, the restrictions regarding hybrid dividends, as well as the limitations contained in section 1.245A-5 of the Treasury regulations.
[11]  T.D. 9959, 87 F.R. 276.

Authors and Contributors

Larry Crouch

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Ryan Bray

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Todd Lowther

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Jay M. Singer

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Matthew Brown

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Jose Rego

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