Double tax treaties are bilateral sovereign agreements by which countries agree to reduce taxes that they would otherwise impose on residents of the other country in exchange for reciprocal relief for their own residents. While the original focus was on reducing uneconomic double taxation, an increasing recent focus is on preventing the use of treaties to achieve double nontaxation where neither country taxes the income.
Among many other requirements that must be met to achieve “access” to the benefits of a treaty with the United States, a resident of the other treaty country that earns income through a legal entity must show that the resident entity or its owner, as the case may be, “derives” the income under regulations promulgated pursuant to section 894. The rules generally define this to mean that the same item of underlying income is reflected in the other country’s tax base whether or not actually taxable (i.e., whether the other country “sees” in its own tax base the same item of income for which treaty relief would be granted by the United States). The Article explains and illustrates the ways in which this regulatory requirement that income be derived, focusing as it does on tax base consistency principles, may fail to prevent instances of actual double nontaxation while denying treaty protections in situations that may involve, at worst, temporary deferral of other country taxes rather than double nontaxation.
The regulatory rule is limited by its terms to fairly narrow classes of treaty benefits (primarily, withholding tax relief on items of portfolio income). By contrast, comparable provisions included in certain specific treaties, override the regulatory rules and may be broader in scope, although this is not always entirely clear. The Article considers the complications that arise when these principles are extended to treaty benefits available in relation to business rather than portfolio income. The Article analyzes the policy considerations underlying these rules and evaluates whether the regulatory and treaty-specific provisions should be more consistent, as well as investigating the relationship of these rules to other requirements that police access to treaty benefits.