New US-Sweden tax treaty follows the new trend for zero withholding tax rate
On September 30, 2005 Sweden and the United States signed a new protocol amending the 1994 income tax treaty between the countries. With the entry into force on 31 August 2006 the protocol modernises the existing treaty and takes into account recent legislative developments. The most significant change is the elimination of withholding tax on certain inter-company dividend payments. With the set of various tax advantages the protocol also introduces specific rules aiming to circumvent exploitive tax planning.
The new provisions of the protocol relating to withholding taxes are effective as of October 1, 2006.
0% on cross-border dividend payments
The new tax treaty provides for an elimination of withholding tax paid between the companies resident in the two contracting states. In practice the protocol will only have effect on dividends paid by a US subsidiary to a Swedish parent company since Sweden has in most cases already waived withholding tax on most of the cross-border dividend payments. From now on also Swedish investments in US will, under the new provisions of the tax treaty, receive the same beneficial tax treatment as the one granted to US holdings in Sweden.
In general, the Swedish parent companies will be entitled to benefit from the zero withholding tax rate if the holding in the US subsidiary will meet the condition of 80 percent or more of the voting rights during a twelve months period. A further criterion is that the parent company must satisfy a so called treaty benefits test, see below.
In cases where the companies will not meet the primary conditions or will be otherwise disqualified by the treaty benefits test, a withholding tax of 15 or 5 per cent will be levied, the latter if the recipient is a company owning at least 10% of the shares in the company paying the dividends.
0% withholding tax on dividends paid to pension funds
The reciprocal withholding tax exemption will apply to dividends paid to pension funds resident in the other contracting state. This new provision is undeniably a major benefit for pension funds. As the formal tax treaty would generally only reduce the withholding tax to 15%, pension funds will from now on be able to make great savings on their US respectively Swedish investments. The conditions stipulated by the protocol is that the dividends paid to a pension fund are not derived from the carrying on of a trade or business by the pension fund or through an associated enterprise, and the stocks are not sold within a two month period following its acquisition.
Elimination of branch profit tax
The protocol also provides for the elimination of so called branch profits tax. Even in this case the protocol will only be relevant to US branches of Swedish companies, since Sweden lacks internal provisions on branch profits tax. The exemption will apply to a US branch net payment to a Swedish company, provided that the Swedish company would have been conferred withholding tax exemption on dividends, had the branch activities instead been carried out by a US subsidiary.
Treaty benefits tests
Although the protocol eliminates many tax related barriers that hindered the investment flows between the United States and Sweden, it also prescribes far strengthened so called limitation on benefits provisions, aiming to better combat abusive tax treaty shopping. The zero withholding tax rate will only be available to companies that can pass at least one of the four treaty benefit tests, i) the publicly traded company test, ii) the ownership/base erosion test including an active trade or business test, iii) the derivative benefits test, or iv) a so called competent authority relief.
EC law considerations
It has been debated whether the limitation of benefits articles, so routinely imposed by the US, may in fact be in breach with the fundamental freedoms of the EC Treaty. The treaty benefits tests imposed to Swedish companies in most cases restrict the freedom of establishment guaranteed in article 43 EC Treaty as the benefits may in some cases not granted depending on where the shareholder company is established. Undeniably this kind of condition may deter companies of other Member States to set up Swedish subsidiaries. The same argumentation can also be valid to the free movement of capital in article 56 EC Treaty, which by its wording not only applies to intra-community transactions but also to third countries. Recent developments in the ECJ case law suggest however that the infringement of community law is not a definite outcome. The D case has already shown that the ECJ is not in favour of expanding the tax treaty benefits and the currently pending case Test Claimants in Class IV of the ACT Group Litigation may show that this trend may keep on.
For more information or to receive a copy of the new US-Sweden treaty, please contact the author.
