Last Updated on December 12, 2022 by Anda Malescu
On 16 July 2019, the United States Senate ratified the new protocol amending the income tax treaty between Spain and the United States (DTT). This protocol was initially signed in 2013, but its ratification had been delayed due to taxpayer privacy concerns. The amendment was a much-needed update that brings the Spain-U.S. income tax treaty in line with other European countries, and reflects a business and financial landscape that is significantly different from when the original treaty was signed in 1990.
The DTT establishes rules that determine how income flowing between Spain and the United States is taxed, and which country has the authority to tax certain items of income, so that taxpayers can avoid or mitigate paying taxes in both countries on the same income. It was approved by the United States and Spain, together with amendments to three other existing conventions with Switzerland, Japan, and Luxembourg.
The most relevant changes in the new protocol from the 1990 text are as follows:
Permanent Establishments (Article 5)
Companies doing business in a foreign country are generally subject to the domestic tax laws of the country where they are engaged in business. For companies hailing from one of the countries that have ratified an income tax treaty with the United States, their business operations are protected from local taxation for certain activities that do not rise to the level of a permanent establishment (PE).
Under the DTT, a company is generally considered to have a PE if it has a fixed place of business, such as a factory, in the treaty country. Certain activities, such as storage, display, or delivery of goods, are excluded from the definition of PE. The previous DTT provided an exception for “building site or construction or installation project, or an installation or drilling rig or ship used for the exploration or exploitation of natural resources.” This meant, for example, that a U.S. company engaged in a construction project in Spain would be subject to Spanish taxation if the project lasted more than six months.
The amended DTT raises the threshold for building sites, construction, or installation projects to be considered a PE to twelve months, meaning a company would not be subject to local taxation unless the project exceeded a year. Additionally, the protocol eliminates the branch tax on the repatriation of earnings from a foreign PE. This means that, even if the local business operations of a company are considered a PE, the company would only pay 5% on the repatriation of the profits from its U.S. operations.
Dividends (Article 10)
The new protocol reduces the taxation on the distribution of dividends from a resident company to a resident of the other treaty country, depending on the payee. Under the previous language, dividend payments were taxed at 15%, which would be reduced to 10% if the beneficial owner of the dividends owned at least 25% of the company paying the dividends. As a point of reference, payments of dividends from a U.S. company to a foreign resident of a non-treaty country are generally subject to a 30% flat rate. The modifications introduced by the new protocol maintain the 15% general rate, but lower the tax rate to 5% for dividends paid to related companies (where the beneficial owner owns at least 10% of the voting stock of the company paying the dividend), and eliminates withholding completely on dividends paid by a subsidiary to its foreign parent (provided the beneficial owner has held shares representing 80% of the voting stock in the company paying the dividends for at least a twelve-month period), provided certain tests of the limitation on benefits clause are met. It is also worth mentioning that the reduced 5% rate will not apply to dividends paid by SOCIMIs (which is the Spanish version of a real estate investment trust (REIT)) or by collective investment vehicles in Spain, nor to those paid by real estate investment companies (RIC) or REITs in the United States.
Interest (Article 11)
Under the amended DTT, interest will only be taxed by the country of residence of the beneficial owner. This means that, in most cases, there will be 0% withholding in the source country, compared to the 10% set forth in the previous DTT version for all but very few cases. The 10% withholding will still apply to certain contingent interest arising in the United States (unless it qualifies as portfolio interest under U.S. law) and to excess inclusion income generated by residual interests in real estate mortgage investment conduits subject to tax under U.S. law.
Royalties (Article 12)
Similar to dividends, royalty payments under the amended DTT will only be taxed in the country of residence of the beneficial owner of the royalty. Under the previous DTT version, royalty payments were subject to a 5%, 8%, or 10% withholding tax, depending on the type of rights granted. Additionally, the definition of the term royalty no longer includes payments for technical assistance (specialized services generally provided by a licensor that are related to the intellectual property being licensed), which were previously taxed as royalties. This change will significantly promote the licensing of intellectual property between Spain and the United States.
Capital Gains (Article 13)
One of the most interesting changes in the amended DTT is the elimination of capital gains taxation, except for real estate holding companies. The previous DTT version provided for the taxation by the source country of capital gains arising from the alienation of stock of a company in which the recipient of the gain directly or indirectly owned, for a twelve-month holding period, at least 25% of the shares. The new protocol deletes this provision, effectively exempting all source withholding on capital gains. This is particularly relevant in relation to the sale of stock in a Spanish company, since the United States does not generally tax Spanish investors on the sale of U.S. stock.
The amended DTT establishes, however, that when capital gains arise from the alienation of shares that directly or indirectly transfers rights to real estate, the income is taxable in the country where the real estate is located.
Pensions (Article 20)
The amended DTT provides that income earned by a pension fund may be taxed as income of the individual only when it is paid to or for the benefit of the individual. The protocol and related memorandum of understanding contain detailed definitions of which plans in each country meet the definition of a pension plan for purposes of the treaty, but generally, qualified U.S. retirement plans such as 401(k) or IRAs would be included. This means, for example, that a U.S. worker that is transferred to Spain and continues to participate in a U.S. retirement plan would not be taxed on that income, unless the worker is receiving distributions from the plan.
Limitation on Benefits (Article 17)
The limitation on benefits (LOB) clause determines the subjective scope of the DTT. In order to qualify for benefits under the DTT, a foreign person must satisfy the tests contained in the LOB. The LOB is meant to prevent abuse and treaty shopping, and to ensure the benefits of the treaty are limited to the residents of the treaty countries.
The LOB clause introduced by the new protocol is relatively complex, and must be analyzed on a case-by-case basis bearing in mind the multitude of scenarios covered by this provision. In addition to the qualified persons test, the new LOB clause includes an ownership base erosion test, a derivative benefits test, and a headquarters test. One of the more interesting updates is that the protocol extends treaty benefits to entities that function as the headquarters of a multinational corporate group (based primarily on supervision and authority, not ownership). This update makes Spain, which already offers a tax-efficient ETVE regime, an even more attractive holding company jurisdiction for U.S. investors, and provides an alternative to other holding jurisdictions such as the Netherlands, Luxembourg, or Ireland.
Exchange of Information (Article 27)
The protocol updates the exchange of information provisions to conform to the standards of the Organization for Economic Cooperation and Development. Where the previous DTT provided that competent authorities in Spain and the United States would exchange information that was “necessary” to carry out the provisions of the DTT, the amended DTT provides for the exchange of “foreseeably relevant” information. This application of this provision exceeds the scope of the treaty, and could potentially be used to exchange information on residents of third-party countries with certain ties—such as a bank account to either treaty country.
Mutual Agreement Procedure (Article 26)
The previous DTT provided that taxpayers that believed they were being improperly taxed under the treaty by one or both of the treaty countries could present their case to the competent authority of the treaty country in which they resided. The competent authorities were meant to resolve the case by mutual agreement, but were not required to reach a decision within a specified period of time.
Under the provisions of the new protocol, when the competent authorities do not reach a mutual agreement within two years (unless the competent authorities agree to a different date), a taxpayer may submit the dispute to an arbitration panel. The decision of the panel must be based on the resolution proposed by one of the contracting states, and is only binding on the contracting states if the taxpayer accepts the decision of the arbitral panel. This amendment creates an incentive for the competent authorities of Spain and the United States to resolve their claims by mutual agreement within two years.
Transparent Entities (Article 1)
The new protocol adds rules for items of income derived through fiscally transparent or flow-through entities. Under these rules, an item of income derived through an entity that is fiscally transparent under the laws of either the United States or Spain, and that is formed or organized either in Spain, the United States, or a third-party country with a tax information exchange agreement in force with the country from which the income is derived, will be considered derived directly by the resident of the treaty country. Under the new rules, an entity must be considered a fiscally transparent entity by either the United States or Spain, even if the entity is organized under the laws of a third-party country. For purposes of the treaty, the tax treatment by the third-party country is irrelevant to this analysis.
The main purpose of these rules is to ensure that these entities are effectively entitled to treaty benefits and to
prevent the claiming of treaty benefits when a resident of one country does not consider the income as a taxable event because the entity is not considered fiscally transparent in its country of residence. For example, under Section 894(c) of the Internal Revenue Code, income derived through an entity that is treated as a partnership or other fiscally transparent entity is not considered as derived by a treaty resident, unless the entity was also considered a flow-through in the resident country, or a tax treaty specifically allows treaty benefits.
Effective Date
All the main changes detailed above, and other changes considered in the new protocol, will enter into force on 27 November 2019, and shall be effective:
a. For the new withholding rates, for amounts paid or credited on or after the date the protocol enters into force;
b. For taxes determined with reference to a taxable period, for taxable periods beginning on or after the date the protocol enters into force; and
c. For all other purposes, on or after the date the protocol enters into force.
The new amendment to the DTT between Spain and the United States is expected to impact how multinational companies and international families structure their businesses and investments, and will certainly facilitate direct investment in Spain and the United States. The treaty now makes Spain an attractive destination for direct investment by U.S. companies compared to other European companies, and will make Spanish companies doing business in the United States more competitive compared to other foreign subsidiaries operating there.
Most of the modifications introduced to the DTT provide an advantage to U.S. and Spanish taxpayers; however, the applicability of these measures as well as any possible limitations that may apply according to each country’s interpretation must be analyzed on a case-by- case basis.
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