June 25, 2023
U.S. Senate approval of U.S.- Chile tax treaty brings treaty closer to entering into force
On June 22, 2023, the U.S. Senate gave its advice and consent to ratification of 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 Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital (Treaty). The Treaty's approval was subject to two reservations concerning the Base Erosion and Anti-abuse Tax (BEAT) and Article 23 (Relief from Double Taxation).
The Treaty's significant provisions include the following:
The Treaty was signed on February 4, 2010 (along with a Protocol) and has been pending ratification since then. It was reported on favorably by the U.S. Senate Foreign Relations Committee (SFRC) in 2014, 2015, and March 2022, and most recently, on June 1, 2023.
The Treaty generally follows the 2006 U.S. Model Income Tax Convention (2006 U.S. Model Treaty), with certain distinctions highlighted in the following discussion. The discussion focuses on the dividends, interest, royalties and LOB articles, and certain other provisions in the Treaty.
Permanent establishment — Article 5
The definition of a PE in the Treaty generally follows the 2006 U.S. Model Treaty, with some significant modifications. First, Article 5(3)(c) introduces a "services PE" provision under which a PE will be deemed to arise if (1) an enterprise performs services in the other country for a period or periods exceeding, in the aggregate, 183 days in any 12-month period, and (2) these services are performed through one or more individuals who are present and performing those services in that country. In addition, Article 5(3)(a) of the Treaty deems that a PE exists if an installation used for on-land exploration of natural resources lasts, or the activity continues, for more than three months (rather than 12 months, as in the 2006 U.S. Model Treaty). A PE also exists under Article 5(3)(b) if any of the following lasts or the activity continues for more than six months:
Business profits — Article 7
Regarding business profits, the Treaty differs from the 2006 U.S. Model Treaty in that Article 7(8) allows the United States to impose excise tax on insurance premiums paid to foreign insurers, while Chile may tax payments for insurance policies contracted with foreign insurers. Under the Treaty, the rates may not exceed 2% of the gross amount of the premiums for reinsurance policies, and 5% for all other policies.
Dividends — Article 10
Article 10's provisions are generally consistent with the 2006 U.S. Model Treaty, and provide for a maximum dividend withholding tax rate of 15%, with a reduced rate of 5% when the beneficial owner of the dividend is a company that holds directly at least 10% of the voting stock of the company paying the dividend. An accompanying Protocol, however, alters these rates for dividends paid by a Chilean company to a US shareholder. Chile has an integrated tax system with two levels of tax. A 27% "First Category Tax" applies to Chilean resident corporations; a 35% "Additional Tax" applies to income remitted by these corporations to nonresident shareholders (for example, dividend payments). Shareholders that are subject to this Additional Tax may credit the First Category Tax against the Additional Tax. For example, taking into account the gross-up mechanism in Chile, a dividend of $73 ($100 Net Taxable Income-$27 of the First Category Tax) paid by a Chilean resident company to a US shareholder would be subject to an effective tax rate of 10.96% (taking into account the Chilean withholding tax of $8 computed as follows: ($100 X 35%) - $27 (First Category Tax paid)). If the rate of the Additional Tax imposed by domestic law exceeds 35%, the Protocol requires the United States and Chile to consult to reassess the balance of benefits of the Treaty with a view to concluding a protocol to incorporate terms limiting the right of the source country to tax dividends under Article 10.
Article 10(3) exempts dividends paid to pension funds, provided that the dividends are not derived from a trade or business carried on by the pension fund or through an associated enterprise. The Treaty does not otherwise provide a complete exemption from withholding tax for certain dividends as is found in other US tax treaties.
Consistent with the 2006 U.S. Model Treaty, paragraph 14 of the Protocol applies a 15% withholding rate to the gross amount of dividends paid by a Regulated Investment Company (RIC). The 15% withholding rate also applies to dividends paid by a Real Estate Investment Trust (REIT), provided that:
The Treaty also allows a 5% branch profits tax to be imposed and prohibits one country from imposing taxes, other than a branch profits tax, on undistributed earnings of a company resident in the other country. The Technical Explanation clarifies that this provision does not limit a Contracting State's right to tax its resident shareholders on undistributed earnings of a corporation resident in the other State. For example, this provision does not restrict US authority to impose taxes on subpart F income, earnings invested in US property, and passive foreign investment company income.
Interest — Article 11
Article 11(2) of the Treaty limits the rate of withholding to 4% for interest payments made to a beneficial owner that is:
In all other cases, Article 11(3) provides that the maximum withholding rate may not exceed 15% for five years from the date on which the interest withholding provisions take effect. This rate will drop to 10% after that five-year period.
Article 11(4) contains an anti-abuse rule and provides that the reduced 4% rate will not apply if the interest is paid as part of an arrangement involving back-to-back loans or their economic equivalent. The Technical Explanation notes that the reference to economically equivalent arrangements is intended to target transactions that would not meet the legal requirements of a loan but would nevertheless serve that purpose economically. For example, the term would encompass securities issued at a discount or certain swap arrangements intended to operate as the economic equivalent of a back-to-back loan.
If the payer of the interest (whether a resident of a Contracting State or not) has a PE or fixed base in the United States or Chile that incurred the indebtedness on which the interest is paid, and pays the interest expense, Article 11(7) of the Treaty sources that interest to the Contracting State where the PE or fixed base is located.
Article 11(8) of the Treaty adds a provision addressing non-arm's-length interest payments in cases of a special relationship between a payor and a beneficial owner. In that case, the applicable treaty rate will apply to the arm's-length amount, and the excess of the payments will remain taxable under the domestic laws of the United States and Chile, as modified by any other applicable provisions of the Treaty. In addition, Article 11(9) provides anti-abuse provisions: the first applies to interest that is so-called contingent interest, and the second applies to excess inclusions from US real estate mortgage investment credits.
Royalties — Article 12
Article 12(2) of the Treaty imposes a maximum withholding tax of 2% on royalties paid for the use of, or right to use, industrial, commercial, or scientific equipment (but not including ships, aircraft or containers covered by Article 8 (International Transport)). A maximum withholding tax of 10% applies for royalties paid for the use of, or right to use, any copyright, patent, or other intangible property, or for information on industrial, commercial or scientific experience.
Article 12(5)(a) of the Treaty departs from the typical US sourcing rules for royalties by sourcing them according to the payer's country of residence. Where, however, the payer of the royalties (whether a resident of a Contracting State or not) has a PE or fixed base in the United States or Chile that pays the royalties, then those royalties are sourced in the Contracting State where the PE or fixed base is located. If the provisions of Article 12(5)(a) do not operate to treat royalties as arising in a Contracting State, then Article 12(5)(b) sources the royalties by reference to the place of use of (or the right to use) the intangible.
Capital Gains — Article 13
Article 13(5) allows capital gains derived by a resident of a Contracting State from the sale of shares of (or other rights to or interest in) a company that is a resident of the other Contracting State to be taxed in that other State at a maximum rate of 16%. Certain exemptions are provided by Article 13(6) (e.g., for sales of shares by pension funds, mutual funds and other institutional investors in certain cases). For dispositions of shares by residents that are not pension funds, mutual funds or institutional investors, Article 13(6) exempts gains derived by a resident of a Contracting State from the sale of shares of a company that is a resident of the other Contracting State and has shares substantially and regularly traded on a recognized exchange located in the other Contracting State, provided the sale occurred on a recognized exchange located in the other Contracting State.
Article 13(7) provides two exceptions to the limitation on tax imposed under Article 13(5), which is meant to reflect the unique operation of Chile's integrated tax system and intended to prevent the avoidance of the Additional Tax in Chile. Specifically, Chile imposes a 16% nonresident capital gains tax instead of the regular 35% rate on gains derived from direct transfers of shares (or other interests) in a Chilean entity if certain requirements are satisfied (e.g., the seller owns less than 50% of the shares of a Chilean entity or less than 20% of the rights in a Chilean entity during the prior 12 months). Article 13(7) allows the state of source to tax gains derived by a resident of the other Contracting State if the recipient of the gain directly or indirectly owned, at any time within the 12 months prior to the sale, shares (i.e., shares in a Chilean S.A.) representing more than 50% of the capital of the company resident in the source country. Article 13(7) also allows the state of source to tax gains derived by a resident of a Contracting State from the disposition of other rights (aside from shares of debt claims) in the capital of a company that is resident in the source state if the recipient of the gain owned other such rights consisting of 20% or more of the company's capital at any time during the 12-month period preceding the disposition. Paragraph 16 of the Protocol limits the rate of Additional Tax imposed by Chile under Article 13(7) to 35%; accordingly, in either of these two situations, the tax imposed by Chile would be 35% of the capital gain. It is possible that the Treaty may prevent the application of the Chilean indirect transfer tax, for example, if a US person is selling stock in a foreign entity that holds a Chilean company.
Limitation on benefits — Article 24
Article 24 of the Treaty contains a comprehensive LOB article that includes limitations similar to those in the 2006 U.S. Model Treaty, but adds a "headquarters company test" and a triangular provision. Under the LOB provisions, a resident company may be eligible for benefits under the Treaty if it (i) meets the requirements to qualify as a publicly-traded resident of the United States or Chile (Publicly-Traded Company Test); (ii) is a subsidiary that has at least 50% of its vote and value owned by five or fewer companies that qualify under the Publicly-Traded Company Test (Subsidiary of Publicly-Traded Company Test); (iii) satisfies an Ownership-Base Erosion Test; or (iv) functions as a headquarters company for a multinational group (Headquarters Company Test). Unlike some more recent treaties, the Treaty does not include a derivative-benefits test.
Alternatively, a resident company that fails all of these tests may still qualify for treaty benefits for an item of income if it meets the Active Trade or Business Test or is granted treaty benefits by the relevant competent authority.
Each of these tests is discussed next in more detail.
Publicly-Traded Company Test — Article 24(2)(c)(i)
A resident company may be entitled to all of the benefits under the Treaty if its principal class of shares (and any disproportionate class) is regularly traded on one or more recognized stock exchanges and either one of the following requirements are satisfied: (i) the company's principal class of shares is primarily traded on one or more recognized stock exchanges located in its country of residence; or (ii) its primary place of management and control is in its country of residence.
Subsidiary of a Publicly-Traded Company Test — Article 24(2)(c)(ii)
A resident company may be entitled to all of the benefits under the Treaty if at least 50% of the aggregate vote and value of the company's shares (and at least 50% 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 the case of indirect ownership, each intermediate owner must be a resident of the United States or Chile.
Headquarters Company Test — Article 24(2)(d)
Although the 2006 U.S. Model Treaty does not include a Headquarters Company Test, some other US tax treaties include a similar provision. A resident that functions as a headquarters company for a multinational corporate group may be entitled to all of the benefits under the Treaty. An entity will generally be considered a headquarters company under Article 24(2)(d) if:
If these gross income requirements are not fulfilled, they will be deemed fulfilled if the required ratios are met when averaging the gross income of the preceding four years.
Ownership-Base Erosion Test — Article 24(2)(g)
The Ownership-Base Erosion Test is an LOB test under which a resident of a Contracting State, other than an individual, may qualify for full treaty benefits. This test has two prongs that must be satisfied.
The ownership prong requires persons that are residents of that Contracting State and are entitled to treaty benefits as individuals, publicly traded companies, tax-exempt organizations or pension funds to own, directly or indirectly, on at least half the days of the tax year, shares or other beneficial interests representing at least 50% of the company's aggregate voting power and value (and at least 50% of any disproportionate class of shares). In the case of indirect ownership, each intermediate owner must be a resident of that Contracting State.
The base-erosion prong requires that less than 50% of the person's gross income for the tax year is paid or accrued, directly or indirectly, to persons that are not qualified residents entitled to benefits under specific provisions of Article 24(2) (i.e., individuals, publicly traded companies, certain tax-exempt organizations or pension funds) in the form of payments that are deductible in the person's State of residence (but not including arm's-length payments in the ordinary course of business for services or tangible property).
The Active Trade or Business Test — Article 24(3)
An entity that is a resident of the United States or Chile may also be entitled to treaty benefits for a specific item of income derived in the other State if the entity satisfies the Active Trade or Business Test. The Active Trade or Business Test applies separately to each item of income derived from the source country.
To satisfy the Active Trade or Business Test, a resident must satisfy the following three-prong test: (i) the resident is engaged in the active conduct of a trade or business in its country of residence; (ii) the income is derived in connection with, or is incidental to, the business; and (iii) the trade or business is substantial in relation to activity in the other State. For this purpose, the business of making or managing investments is not considered an active trade or business, unless the activities are banking, insurance, or securities activities conducted by a bank, insurance company or registered securities dealer
Competent authority relief — Article 24(4)
A resident of the United States or Chile that is not otherwise entitled to benefits under the other LOB tests may nevertheless be granted benefits at the discretion of the competent authority of the country from which benefits are claimed.
Triangular provision — Article 24(5)
The Treaty provides a special anti-abuse rule that addresses the use of "triangular structures" — those where an enterprise of a Contracting State derives income from the other Contracting State and that income is attributable to a PE that the enterprise has in a third jurisdiction. The otherwise applicable tax benefits under the other provisions of the Treaty will not apply if the combined tax that is actually paid on the income in the residence country and in the third jurisdiction is less than 60% of the tax that would have been payable in the residence country if the income were earned there and were not attributable to the PE in the third jurisdiction. Any dividends, interest or royalties to which the provision applies may be subject to a maximum withholding tax rate of 15%. Other income subject to this provision is taxable as provided under applicable domestic tax laws.
The triangular provision does not apply to (i) royalties received as compensation for the use of, or the right to use, intangible property produced or developed by the PE, or (ii) any other income derived from the other Contracting State in connection with, or incidental to, the active conduct of a trade or business carried on by the PE in the third jurisdiction (other than the business of making, managing or holding investments for the enterprise's own account, unless these activities are banking or securities activities conducted by a bank or registered securities dealer).
Exchange of information — Article 27
The Treaty requires the competent authorities to exchange information considered foreseeably relevant to carrying out the provisions of the Treaty or the domestic laws of the United States or Chile regarding any taxes imposed by either Contracting State.
Entry into force — Article 29
For the Treaty to enter into force, the United States and Chile must notify each other, in writing, through diplomatic channels, that their respective applicable procedures for ratification have been satisfied. The Treaty will enter into force on the date of receipt of the later of these notifications. Once the Treaty enters into force, the withholding provisions would become effective for amounts paid or credited on or after the first day of the second month following the date of entry into force. For all other taxes, the provisions would take effect for tax periods beginning on or after the first day of January following the date the Treaty enters into force.
Paragraph 22 of the Protocol requires the countries to consult within five years of the date the Treaty enters into force "to assess the terms, operation and application of the Convention." If Chile concludes a treaty with another country that provides lower interest or royalty withholding tax rates than the U.S.-Chile treaty or contains terms that further limit the source country's right to tax capital gains, the Protocol requires the United States and Chile to consult to "reassess the balance of benefits of this Convention with a view to concluding a protocol to incorporate such lower rates or limiting terms into this Convention."
Reservations on BEAT and Article 23 (Relief from Double Taxation)
The Treaty was approved subject to two reservations concerning BEAT and Article 23 (Relief from Double Taxation). The reservation on BEAT clarifies that the Treaty does not prevent the imposition of BEAT under IRC Section 59A. Under the second reservation, Article 23(1) of the Treaty would be deleted and replaced with the following:
1. In 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 thereof):
a) the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income applicable to residents and citizens the income tax paid or accrued to Chile by or on behalf of such citizen or resident. For the purposes of this subparagraph, the taxes referred to in subparagraph b) of paragraph 3 and paragraph 4 of Article 2 (Taxes Covered), excluding taxes on capital, shall be considered income taxes; and
b) in the case of a United States company owning at least 10% of the aggregate vote or value of the shares of a company that is a resident of Chile and from which the United States company receives dividends, the United States shall allow a deduction in the amount of such dividends in computing the taxable income of the United States company.
The reservation on Article 23 is intended to reflect the repeal of IRC Section 902 and adoption of IRC Section 245A. In a declaration, the Senate also indicated that further work is required to fully evaluate the policy of "Relief From Double Taxation" articles in future tax treaties and their relationship to US tax laws in light of the substantial changes made to the international provisions of the Internal Revenue Code (Code) in 2017.
The Treaty is a significant development in the US tax treaty network, representing only the third tax treaty with a Latin American country. To complete the approval and ratification process in the United States, the president must now sign an instrument of ratification to the Treaty. For the Treaty to enter into force, the United States and Chile must also notify each other in writing, through diplomatic channels, that their respective ratification requirements for the Treaty have been satisfied. The government of Chile undertook all the steps necessary to approve the Treaty in 2015. Although Chile has made no formal announcements about the Treaty to date, it is anticipated that the two reservations inserted by the SFRC would need to be reviewed and ratified by Chile's Senate before the Treaty could take effect in Chile.
Though the date of the Treaty's entry into force remains uncertain, it would be prudent for multinational companies to assess the Treaty's impact now on their activities in the United States and Chile. For example, companies should begin to model the anticipated impact of reduced withholding rates on dividends, interest and royalties when they become effective. Companies should also assess current or prospective activities in the United States and Chile in light of the inclusion of the "services PE" provision and the shortened time frame for certain activities to constitute a PE, as well as the capital gains provisions.
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor