8/20/2009 – This article, by Paul Tadros, was originally published in Tax Notes International by Tax Analysts and has not been updated for any subsequent changes. All rights reserved^©.

INTRODUCTION
On July 14, 2004, Barbados and the US signed the second Protocol to the 1984 Income Tax Treaty (“treaty”). There are two (2) significant changes arising from this Protocol: (1) a totally revised limitation on benefits (“LOB”) article and (2) an added feature to the exchange of information article.

L OB
The discussions herein are solely from a corporate perspective. Of course, in all cases it is a given that the company is a resident of the US or Barbados, as the case may be.

Article II of the Protocol deletes Article 22 of the treaty and substitutes a new Article 22. (Hereinafter, all references are to the new Article 22 and, where applicable, the Internal Revenue Code, 1986, as amended and the regulations promulgated thereunder, unless stated otherwise.) Although the intent is clearly to blunt the use of inversions, the results seem to significantly close any potential treaty shopping which may have arisen under the previous LOB. This can be seen in the following provisions:

• The publicly traded test [clauses 1(c)(i) and (ii)];
• The ownership and base erosion test, in particular the ownership test [clause 1(d)(i)];
• The active trade or business test (paragraph 2); and,
• Carve-outs of tax-privileged entities.

It should be noted that, at the time of writing of this article, a revised technical explanation had not been released by Treasury. Therefore, absent any clarification, the general rules of interpretation should apply. The simplest provision will be firstly discussed i.e. the carve-outs.

Carve-outs
The benefits applicable to dividends, interest and royalties are denied to entities which are licensed under the  following statutes of Barbados:

• The Exempt Insurance Act;
• The International Financial Services Act;
• The International Business Companies Act;
• The Societies with Restricted Liability Act; and,
• The Insurance (Miscellaneous Provisions) Act (termed Qualifying Insurance Companies (“QIC”) which could enjoy, currently, an effective income tax rate of 2.52%).

However, it should be noted that the list is not exhaustive since any similar legislation enacted after July 14, 2004 would be included in the exclusionary list. In addition, this provision goes one step further by including the granting of similar tax benefits through “administrative practice”. The reason for this is logical. One of the main features pervasive in the statutes of Barbados is “at the discretion of the Minister”. Therefore, where a company would have been subject to the current normal corporate income tax rate of 36% but is granted a reduction or elimination (to yield a similar result for those enumerated in the aforementioned list) through this discretionary provision, it would seem that the benefits under the dividends, interest and royalties articles would be denied.

This provision is of no effect (one possible exception, viz. a QIC) where the payments are being made by these entities to a US resident since, under the respective statutes, these entities are exempt from all withholding taxes. In the case of a QIC, the domestic withholding rates may be applicable.

Publicly Traded
A company is entitled to the benefits of the treaty if [clause 1(c)(i)]:

• Its principal class of shares are listed on a recognized stock exchange viz., NYSE, NASDAQ, etc. in the US , the Barbados, Jamaica and Trinidad and Tobago Stock Exchanges;
• Such class of shares is primarily traded on a (1) recognized stock exchange in the US if the company is a resident of the US or (2) if the company is a resident of Barbados, primarily traded on the Barbados or Jamaica or Trinidad and Tobago Stock Exchange; and,
• Such class of shares is regularly traded on a recognized stock exchange.

It should be noted that all three tests must be met. Therefore, in essence, a Bermuda inverted company which is publicly traded in the US and is a resident of Barbados will not qualify under this provision. In casting this net, a “local” Barbados company which may be contemplating an IPO in the US would also not qualify as long as it is a resident of Barbados.

In the alternative, a company is entitled to the benefits of the treaty if [clause 1(c)(ii)]:

• At least 50% of each class of shares in the company is owned directly or indirectly by companies qualifying under clause 1(c)(i). Where the ownership is indirect, each intermediate owner must qualify under this clause i.e. clause 1(c)(ii); and,
• It satisfies the base erosion test (discussed hereinafter).

It should be noted that both tests must be met. As a result, where there is a publicly traded US parent holding a Jamaican subsidiary which holds the Barbados company, the Barbados company will not qualify for the benefits of the treaty notwithstanding that the US parent will.

Ownership/base erosion
A company is entitled to the benefits of the treaty if [subparagraph 1(d)]:

• More than 50% of each class were beneficially owned for, at least, half the days of the taxable year and is owned directly or indirectly by residents qualifying as either individuals or under clause 1(c)(i) (other qualifying persons have been intentionally excluded for this discussion. In any event, clause 1(c)(ii) is not listed as one of the qualifying provisions). In the case of indirect ownership, each intermediate owner must be a resident of the US or Barbados; and,
• Deductible payments (whether paid or accrued and whether directly or indirectly) to nonresidents who do not qualify for the benefits of the treaty must be less than 50% of the tested company’s gross income.

Two critical points to note: (1) if any of the owners are those described in the carve-out, the ownership test fails and (2) arm’s length payments for services and tangible property made in the ordinary course of business are excluded.

Active trade or business
Firstly, it should be noted that it is no coincidence that the expanded provisions of paragraph 2 are similar or identical to the provisions of §367(a) and Reg. §1.367(a)-2T(b)(2) and, it is also no coincidence that these references are also found in Reg.§1.884-5(e)(2)(i). To illustrate: clause 2(d)(iii) states, in part: “ To constitute a trade or business, the activities conducted by the resident ordinarily must include every operation which forms a part of, or a step in, a process by which an enterprise may earn income or a profit. A resident…actively conducts a trade or business if it regularly performs active and substantial management and operational functions through its own officers…”
The changes made to paragraph 2 are significant. Firstly, in addition to the resident having to meet the active trade or business test, that resident must also satisfy any of the other qualifying conditions in the LOB. Secondly, the concept of substantiality is specifically stated (previously, it was implicit) with specific ratios as a safe harbor (similar to the US-Netherlands treaty but also very different and is discussed hereinafter). Last but not least, the terms “bank” and “insurance company” are defined.

The following points should be noted:

1. Similar to Reg.§1.884-5, associated enterprises carrying on a trade or business can be included in the determination of whether the trade or business activity (“activity”) in, say, Barbados is substantial in relation to that in the US or not;
2. The determination of whether the activity is substantial or not is based on all the facts and circumstances. However, the activity would be deemed to be substantial (“substantiality safe harbor”) if for the preceding taxable year or for the three (3) preceding taxable years:

• the ratio of assets used in the activity in the resident’s Contracting State to total assets is at least 7.5%;
• the ratio of gross income derived from the activity in the resident’s Contracting State to total gross income is at least 7.5%;
• ratio of payroll expense related to the activity in the resident’s Contracting State to total payroll expense is at least 7.5%; and,
• the average of all three ratios is greater than 10%.

1. If the activities are conducted through a partnership, the activities will be deemed to be conducted by that partner or persons connected thereto (the term “connected” is measured by a minimum 50% beneficial interest or in the case of a company, by a minimum of 50% by vote and value). However, if the partner is one of the carved-out entities, the test fails.

It is hoped that a technical explanation would be issued by Treasury. If one is issued, it is possible that it may or may not elaborate on this provision. As a result, taxpayers would have to rely on the respective domestic laws. As far as Barbados is concerned, there are no specific sourcing rules which are the basis for these ratios. In the case of the US, guidance is found in Reg.§1.884-5(e)(3)(ii).
It is understood that some Barbados-based advisors are recommending that the principles under the US-Netherlands treaty should be applied. I do not believe that is appropriate. The calculations of the ratios in the Netherlands treaty are more specific. For example, the denominator in each ratio in the Netherlands treaty is that applicable to the activity conducted in the US/Netherlands, as the case may be while the equivalent in the Barbados treaty is “total”. In fact, paragraph 2 of the technical explanation to Article 26 of the Netherlands treaty states, in part: “Article 26 is unprecedented in its complexity and level of detail. Such detail is normally not desirable from the standpoint of simplicity…In this case, however, the two delegations each had a significant concern that could only be addressed by additional complexity” (emphasis added). I believe that the technical explanation will not provide any further elaboration other than what is stipulated in the Protocol. As a result, the principles of Reg.§1.884-5(e)(3)(ii) would be applied.

This paragraph examines the case where a company, being a resident of Barbados, provides services or sells tangible property and the calculation of the gross income ratio. As a general rule, the sourcing rules of §§861-865 should apply. In the case of tangible property, the place of title passage determines source while, for services, the place where rendered. However, these are overridden in Reg.§1.884-5(e)(3)(ii)(B)(4). In both cases, the residency of the purchaser/recipient of the services determines source. For example, goods shipped f.o.b. Barbados to a purchaser in Brazil would have been considered as Barbados source since title passed in Barbados. However, this is resourced as Brazilian source as indicated above.
In order to remove any question as to what constitutes a “bank” or an “insurance company”, subparagraph 2 provides specific definitions. This inclusion may have been due to the numerous opinions expressed by non-US advisors stipulating that non-US owned entities licensed under the Exempt Insurance Act or the International Financial Services Act, qualify for the benefits of the US-Barbados treaty since they are “banks” or “insurance companies” under Barbados’ law.

Unfortunately, in those cases, neither met the definition of a “bank” under §581 or an “insurance company” under §816, etc. As a result, the definitions in the Protocol are even more stringent [e.g. compare definition of what constitutes “banking activities” in Reg. §1.864-4(c)(5)(i)]. A resident of, say, Barbados will be treated as a bank only if:

• It is licensed to accept deposits from residents of Barbados and to conduct, in Barbados, lending or other banking activities;
• It regularly accepts deposits from residents of Barbados in the ordinary course of business and the amount of deposits reflected on the balance sheet is substantial; and,
• It regularly lends to customers in the ordinary course of business.

Note that all three tests must be met.

In the case of an insurance company, a resident of, say, Barbados will be treated as an insurance company only if:

• It is licensed to insure risks of residents of Barbados; and,
• It regularly insures risks of customers who are resident in Barbados (reinsurance is excluded)

EXCHANGE OF INFORMATION
Article III of the Protocol amended Article 26 by adding a new paragraph 4. Paragraph 4, in effect: (1) overrides paragraph 3 (which prevents “fishing expeditions”); and (2) allows the US to demand from Barbados any information held by any financial institution or any nominee or any agent or any trustee. The only information which is excluded relates to confidentiality information covered under attorney-client privilege.

This, of course, is not surprising given the passage of the USA Patriot Act.

C ONCLUSION
It is clear that first and foremost on the minds of Treasury was the inversions. Secondly, the net effect of this type of LOB is not that dissimilar to the anti-abuse provisions found in other recent concluded treaties between other states given the OECD’s revised commentary in January 2003.

In some instances, the revised LOB will not have any effect. For example, where an election has been made by a US parent to treat its Barbados captive insurance company as a domestic corporation under §953(d).