Highlights of the New Dutch Tax Treaty Policy

Volume 62, Number 9 May 30, 2011 Highlights of the New Dutch Tax Treaty Policy by Jean-Paul van den Berg and Johan Vrolijk Reprinted from Tax Notes Int l, May 30, 2011, p. 727

Highlights of the New Dutch Tax Treaty Policy by Jean-Paul van den Berg and Johan Vrolijk Jean-Paul van den Berg and Johan Vrolijk are Dutch tax lawyers with Stibbe New York. In a February 11, 2011, memorandum, Dutch State Secretary of Finance Frans Weekers set out his tax treaty policy for the coming years. The memorandum acknowledges that the Netherlands has a relatively small home market and an open economy. It is therefore in the best interest of the Netherlands to have a broad tax treaty network and to embrace capital import neutrality and the exemption method for the avoidance of double taxation, leveling the playing field for Dutch residents who do business abroad. Against this background, the memorandum intends to set out the main policy positions while recognizing that each tax treaty requires its custom-made solutions. One item that is reiterated throughout the memorandum is the desire to provide clarity in the application of tax treaties to issues when that may have been lacking in the past. The main positions are: a clearer rule for residency of exempt entities; case-by-case review of eligibility of entities subject to a special regime; clear language for hybrid entities; 0 percent withholding rates for participating dividends, interest, and royalties; the use of recent OECD commentary under the dynamic interpretation method; inclusion of an arbitration clause; and explicit language curbing treaty abuse accompanied by a main purpose rebuttal. The memorandum received much attention in Dutch tax literature. The Dutch Association of Tax Advisers (Nederlandse Orde van Belastingadviseurs, or NOB) issued detailed comments on the memorandum. Also, the Dutch Ministry of Finance together with three universities organized a seminar on the Dutch tax treaty policy to discuss the memorandum. This article sets out the highlights of the positions taken in the memorandum. It addresses issues related to the residency of taxpayers, the main positions taken regarding specific types of income/gains, and some miscellaneous matters. Residency Issues The memorandum seeks to create clarity regarding the residency of entities. This is understandable. The memorandum acknowledges that past uncertainty has been created by such things as the lack of more detailed comments to the OECD model treaty and guidance in case law, differences in general and special tax regimes of jurisdictions around the globe, and different approaches in dealing with hybrid entities. The main topics are exempt entities, corporate tiebreaker (for dual resident companies), and hybrid entities. Exempted and Not (Fully) Subjected Entities The memorandum acknowledges that the OECD commentary to article 4 (resident) of the OECD model treaty is not entirely clear. A recent Dutch Supreme Court case held that a Dutch association (vereniging) that was not subject to corporate income tax in the Netherlands (it did not carry on a business enterprise) is not a resident of the Netherlands for purposes of the TAX NOTES INTERNATIONAL MAY 30, 2011 727

PRACTITIONERS CORNER Netherlands-U.S. income tax treaty. 1 The Supreme Court considered that the Netherlands-U.S. tax treaty explicitly provides that some exempt entities (pension funds and charities) may qualify as residents, while that provision did not apply to the association. It is unclear whether this rule exempt, so no treaty residence also applies to treaties that do not contain an explicit provision for some exempt entities. The intention of the Dutch state secretary of finance is to create more clarity on this subject in (future) tax treaties. The Dutch goal is to create treaty residency status for all entities in the state whose laws govern the entity, or where its place of effective management is located. 2 Tax transparent entities would be explicitly barred from the residency status. The main entities to which this would apply are pension funds, charities and foundations, or associations without a business enterprise. One can, however, also think of fiscal investment institutions (fiscale beleggingsinstellingen, or FBIs) that are not exempt from taxation, but subject to a 0 percent corporate income tax rate. Although the Dutch government has always supported the position that FBIs are treaty residents, it seems helpful to clarify in treaties that the other contracting state agrees with that position. Pending discussions at the OECD level, the treatment of sovereign wealth funds will be addressed on a case-by-case basis. A special treatment may be the fate of exempt investment institutions (vrijgestelde beleggingsinstellingen, or VBIs). The VBI regime can be distinguished from the FBI regime because it has a full exemption from corporate income tax and dividend withholding tax on its distributions (the FBI must withhold 15 percent dividend withholding tax), it has no requirement to distribute its profits (the FBI must do so within eight months after the end of the financial year), and no stringent shareholder requirements (which, again, the FBI has). However, the investments by the VBI are restricted to financial instruments. When the VBI regime was introduced the Dutch government was clear that the VBI is not entitled to Dutch treaty resident status, but under the memorandum, that may change for future treaties. According to the memorandum, the Dutch treaty resident status of VBIs would mainly serve to preserve the right of the Netherlands to levy tax from the VBI s individual shareholders and board members. At the request of the other contracting state the VBI could be disallowed the reduced withholding tax rates for the dividends, interest, and royalties it receives. 3 If there is no such restriction, the VBI could under future tax treaties be an interesting vehicle by combining the status of treaty resident with a full exemption of Dutch corporate income and dividend withholding tax. Currently, a VBI is not considered a treaty resident by the Dutch tax authorities, and they would not issue a residency statement for a VBI. This approach is not changed by the memorandum for existing treaties. Some developments are expected soon. After the memorandum has been discussed in parliament a new policy statement is expected regarding treaty entitlement of VBIs under current tax treaties. The content of that statement is still unclear, pending discussions on the memorandum in parliament. If the new policy statement would entitle VBIs to residency certificates for current tax treaties, that would be good news for the Dutch fund industry, especially if the treaty partners would concede and grant VBIs treaty benefits. Corporate Tiebreaker Some Dutch tax treaties contain a so-called mutual agreement tiebreaker provision for corporate residency. Under the more common corporate tiebreaker, an entity resident in both contracting states under their domestic laws would be resident in the state where its place of effective management is situated. In contrast, the mutual agreement tiebreaker provision requires the two contracting states to reach a mutual agreement on the place of residency of dual resident entities and may restrict treaty benefits as long as no mutual agreement is reached. 4 The relatively recent update of the Netherlands-U.K. tax treaty contains a tiebreaker and its inclusion created quite a backlash. The main concern is that this alternative tiebreaker creates uncertainty. The current policy would be to aim for inclusion of the tiebreaker based on the place of effective management. Situations of perceived abuse would be challenged based on the definition of place of effective management as recently adopted in the OECD commentary. The NOB commented that this policy is too informal and that no deviations should be made from the tiebreaker based on the place of effective management (unless the other contracting state does not apply the place of effective management for residency purposes). Since tax treaty benefits are available only to treaty residents, there should not be any uncertainty as to whether an entity is considered as resident for tax treaty purposes. 1 Dutch Supreme Court, Dec. 4, 2009 (No. 07/10383), BNB 2010/177. 2 A similar residency provision (although different in terms of wording) has been included in the recently signed, but not yet ratified, tax treaty with Panama. According to the protocol to the treaty, by mutual agreement the Netherlands and Panama will decide to what extent a resident of one of the contracting states that is subject to a special regime will not be entitled to the benefits of this treaty. 3 If entities are subject to a special regime of the other contracting state, these entities may also be disallowed these treaty benefits, depending on the characteristics of this regime. 4 For a more elaborate discussion, see Jean-Paul van den Berg and Bart van der Gulik, The Mutual Agreement Tiebreaker OECD and Dutch Perspectives, Tax Notes Int l, May 4, 2009, p. 417, Doc 2009-7742, or2009 WTD 88-20. 728 MAY 30, 2011 TAX NOTES INTERNATIONAL

Hybrid Entities The memorandum observes that much has been written on situations involving hybrid entities (tax transparent in one state, taxable in the other), but complications still may occur. Complications do, indeed, occur frequently in practice. The government intends to curb situations of double taxation and double exemption by adopting specific language addressing qualification differences in tax treaties (for instance, this has been done in the Netherlands-U.S. tax treaty and in the 2010 Japan-Netherlands tax treaty 5 ) and by addressing individual cases in mutual agreements. Regarding Dutch tax transparent mutual funds or closed funds for joint account, the government hopes to get consensus with as many treaty partners as possible regarding its tax transparent status, preferably in competent authority agreements (like the ones recently concluded with Canada, the U.K., and Denmark). Types of Income and Gain Dividends The memorandum indicates that the Netherlands will, consistent with the current policy, endeavor to include a 0 percent dividend withholding tax rate in the source country for participation dividends (that is, the beneficial owner is a company holding a minimum percentage usually 10 to 25 percent of the share capital or voting power of the distributing entity). To curb treaty shopping, specific antiabuse rules may be included in tax treaties. For example, the recent update of the Japan-Netherlands tax treaty contains both a limitation on benefits clause and specific beneficial ownership language. 6 Interest and Royalties Consistent with the current policy, the Netherlands will endeavor to include a 0 percent withholding rate for the source country for cross-border interest and royalty payments. This is only logical since the Netherlands does not levy withholding tax on royalties and ordinary interest. The memorandum states that at the request of a tax treaty partner, the Netherlands is willing to consider, within reasonable limits, a specific antiabuse rule. Capital Gains Real Estate Companies Under current Dutch policy, capital gains realized in connection with the sale of shares will be taxable only in the seller s country of residence, regardless of the nature of the underlying assets. The memorandum PRACTITIONERS CORNER states that if the tax treaty partner, in accordance with the OECD model treaty, requests exclusive source country taxation for capital gains on shares in real estate companies, the Dutch government may concede to this, but its policy would then be to limit the scope of this provision as much as possible. This could be done by increasing the minimum percentage of real estate held by the company (usually this is 50 percent, but some Dutch tax treaties contain a percentage of 70 percent or 90 percent) or by including exceptions for shares in listed companies, minor interests, commercial real estate, interests held by pension funds, and capital gains made in the course of reorganization. Substantial Equity Interest Fearful of tax flight of Dutch high-net-worth individuals, the Netherlands typically includes a substantial interest reservation. Under that reservation, the right to tax capital gains made by an individual on shares in an entity of one contracting state may be taxed by that contracting state if the individual was a resident of that state at any time within the five preceding years. The Netherlands endeavors to include a clarification that the former country of residence can levy tax only on the value accrued during the period of residency of that individual and that language should be included that follows the Dutch definition of substantial interest more closely. If the other contracting state does not levy tax on these gains under its domestic laws, the Netherlands would propose an unlimited taxing right for the source state. An accompanying provision may be included in the dividend clause. The NOB notes that this may contradict language in some recently concluded tax treaties already following the Dutch substantial interest definition more closely. The parliamentary history to those treaties indicates that the Netherlands will not levy tax on increases in value after emigration. It should also be helpful, the NOB furthermore notes, that the new country of residency would grant a step-up for the value accrued upon emigration. In the case of immigration into the Netherlands, a step-up would usually be granted (even if the other contracting state does not levy tax on emigration). The memorandum also indicates that the Netherlands endeavors to include a provision in the protocol to a tax treaty to clarify that the dividend clause (and not the capital gains clause) will apply on proceeds from the repurchase of shares or liquidation of a company. This has been done in reaction to a Dutch Supreme Court case that reached the opposite conclusion when the treaty did not specify the character of the proceeds, the capital gains article applied. 7 5 For prior coverage, see Jean-Paul van den Berg and Johan Vrolijk, A Look at the New Japan-Netherlands Income Tax Treaty, Tax Notes Int l, Oct. 18, 2010, p. 181, Doc 2010-19752, or 2010 WTD 200-17. 6 Id. 7 Dutch Supreme Court, Dec. 12, 2003 (No. 38 461), BNB 2004/123. The Supreme Court considered that in this situation the capital gains treatment also applied under Dutch domestic law. TAX NOTES INTERNATIONAL MAY 30, 2011 729

PRACTITIONERS CORNER Pensions Contrary to the position taken in the 1998 memorandum, the 2011 memorandum indicates that the Netherlands wants to agree on taxation in the source country for accrued pensions and annuities that were granted a relief in the source country. In view of practical constraints, or as part of tax compromise, the memorandum indicates that the Netherlands may also agree with the tax treaty partner that the source country could levy tax only up to a predetermined maximum percentage. Miscellaneous Developing Countries The memorandum indicates that the Netherlands endeavors to extend the network of tax treaties with developing countries (such as Ethiopia and Angola). According to the memorandum, the special position of developing countries and the importance that the Netherlands attaches to a successful development of these countries justify deviations from the Dutch tax treaty policy. In tax treaty negotiations with developing countries, the Netherlands will be willing to accept parts of the U.N. model treaty provided that the interests of Dutch taxpayers would not be disproportionately harmed. The Netherlands will also support developing countries bilaterally and through international initiatives to improve their tax systems and organization of the tax administrations. OECD Commentary The memorandum emphasizes the importance of the OECD commentary. It is significant as a tool for interpreting a treaty that uses wording similar to the wording of the OECD model treaty (also if the other contracting state is not an OECD member), especially when the commentary has not changed since the conclusion of the treaty. If the OECD commentary has changed, but the corresponding text of the OECD model treaty has not, the Netherlands will seek to apply the dynamic method of interpretation, under which the most recent OECD commentary should prevail. The memorandum goes even further by stating that if there is a change in interpretation of a treaty provision, the question of which interpretation should prevail should be determined case by case. Moreover, if both the text of the OECD model treaty and the OECD commentary change, the memorandum states it can in some cases be argued that the new OECD commentary can be used to interpret an old treaty text. The reason for this liberal use of the most recent OECD commentary is that tax treaty negotiations may take a long time. The flexibility of using the OECD commentary in the described way, albeit certainly not uncontroversial, may be welcome for the taxing authorities. The NOB states that this position undermines the legal certainty because taxpayers should be able to rely on the interpretation of treaty provisions at the time they act. The NOB suggests that if a change in the OECD commentary results in a different interpretation of a treaty provision, a five-year transitional period should be observed to give taxpayers the possibility to adapt to the new interpretation of the existing tax treaty. We feel this flexible use of the OECD commentary may also undermine the democratic legitimacy of a tax treaty. In extreme cases a tax treaty may evolve into something very different than what parliament agreed to when it ratified the treaty. It may also place less of an incentive on the government to renegotiate a treaty when changed circumstances should compel it to do so. The memorandum also suggests including some framework provisions in treaties that facilitate, through delegation, an easy implementation of new provisions or interpretation methods by the competent authorities. There is also some tension between these policies and the democratic approval that all treaties are subject to. We expect this to be an important topic of the discussions with the Dutch parliament. Arbitration The memorandum indicates that the Netherlands will endeavor to include an arbitration clause in line with article 25(5) of the OECD model treaty. This paragraph provides for a binding arbitration procedure at the initiative of the taxpayer if the competent authorities of the two contracting states do not reach an agreement within two years. Treaty Overrides The Netherlands considers that sovereign states entering into treaties should abide by their obligations thereunder (pacta sunt servanda). This principle is also laid down in the Dutch Constitution, which considers an international treaty as being of a higher order than the national statute. Treaty overrides possible under some other systems are a concern. In specific cases, to remedy any negative effects the override may have, the Netherlands intends to enter into close discussions with the treaty partner that is turning to a treaty override. In the most extreme case the Netherlands may suspend or terminate the treaty. GAAR Some states apply general antiabuse rules (GAAR) in tax treaty situations. Even if that is permitted under the national law of a contracting state, the memorandum states that for purposes of clarity, it is better to make a reference to the domestic antiabuse principles in the treaty. It is understandable that the Dutch government prefers inclusion of a reference in such a situation, as without it the Netherlands can as a rule not apply its GAARs. If the reference is made, one concern is that the antiabuse rules will develop in different directions in the two contracting states. It is therefore the policy of the Dutch government, if a reference is made to domestic antiabuse rules, to provide that the rules will be applied only after consultation with the competent authority of the other state. One can wonder whether the mere consultation will be adequate. 730 MAY 30, 2011 TAX NOTES INTERNATIONAL

8 Under a main purpose test, treaty benefits are generally refused if the main reason (or one of the main reasons) of a transactions is to obtain treaty benefits. PRACTITIONERS CORNER Treaty Abuse A final topic addressed by the memorandum is that of treaty abuse. Abuse is divided in three categories: tax flight (migration for tax purposes); shopping within a treaty (qualifying income in a beneficial way); and treaty shopping (treaty application to persons for whom the treaty was not intended). The memorandum does not provide a specific antiabuse policy but rather lays down some general ways to curb treaty abuse. These should be applied case by case. The Netherlands wants to make abuse of tax treaties impossible, so it may include explicit antiabuse language. The memorandum states that this language may be accompanied by a main purpose test. 8 Furthermore, the memorandum states that to avoid uncertainty, the main purpose test may explicitly describe specific types of transactions or entities that will be granted treaty benefits. Next Steps Parliament s discussions of the memorandum have been postponed until June 8, 2011. Before those discussions a roundtable discussion will be held on June 1, 2011, with some leading tax practitioners and scientists. The discussions will hopefully result in a further interpretation of policy positions taken in the memorandum. It would be advisable if these positions were put in writing, such as in an appendix to the memorandum. This would provide the clarity on the issue of applying tax treaties intended by the memorandum. TAX NOTES INTERNATIONAL MAY 30, 2011 731