Diana H. van der Merwe obtained a B.A. degree from Potchefstroom University, South Africa, LL.B. and LL.M. degrees from the University of the Free State, South Africa, an LL.M. degree from Kyushu University, Japan, and an LL.M. degree in International Taxation from New York University Law School, United States.

Table of Contents

1. Introduction
2. New US-UK Treaty
Entry into force
Salient feature – zero direct dividend withholding
Purpose of the Treaty
3. US Model Tax Treaty – Article 10 (Dividends)
Treasury Department’s request for comments on reform of the Model
4. Debate on Reduction of Withholding Tax Rate to Zero
US perspective
Arguments in favor of eliminating withholding tax
US revenue effect
US macroeconomic effect
Unintended beneficiaries
International trends
Promotion of capital export neutrality
Promotion of capital import neutrality
US classical system
Lack of policy
Simplification
Free trade principles
Eliminating opportunities for avoidance
Withholding as a “backup” tax
No capital flight
Arguments against eliminating withholding tax
OECD’s situation
Tentative conclusion
Developing country perspective
International non-taxation and CEN
Tax revenue need of developing countries
Revenue loss from forfeiture of withholding tax greater than benefit of capital attracted
Donation to fiscs of residence countries
Race to the bottom
Capital retention
5. UN Model Tax Treaty
6. Conclusion

1. Introduction

The signing of the new US-UK tax treaty could potentially again draw the attention to the debate on whether or not the US should adopt in its model tax treaty a zero withholding tax policy on direct dividends (http://www.treas.gov/press/releases/po503.htm, http://www.intltaxlaw.com/TREATIES/UK/frontpage.htm). In spite of commentators pointing out during the past decade or more that a move towards a zero withholding policy would, seen as a whole, not influence the US negatively but possibly even work in its favor, the withholding tax rate policy in this respect has remained unchanged. The purpose of this paper is to contribute to this debate by reinvestigating the most important arguments that have been raised in favor of adopting a fresh policy. The paper then continues to focus on the potential reaction elsewhere in the world, possibly from developing countries in particular, who may not necessarily find a zero withholding tax rate on direct dividends as favorable as when evaluated from a US (or developed country) perspective.

The paper concludes that a move by the US to enforce a zero withholding tax policy when new treaties are negotiated may not work in favor of those countries that are dependent on withholding tax revenues, those who grant tax incentives in order to attract foreign capital, those who cannot afford to compete with developed countries in a withholding tax race to the bottom, or those who may favor maintaining a high withholding tax rate in order to ensure retention of invested foreign capital. The paper suggests that a model similar to the UN Model, with its policy of non-predetermined withholding tax rates, would leave the US and its developing country treaty partners the flexibility to lower the rate of withholding tax imposed on direct dividends either in the US or in the developing country, or in both.

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2. New US-UK Treaty

Entry into force

On July 24, 2001, the US Treasury Secretary and the UK Chancellor signed a Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion (“the Treaty”), http://www.treas.gov/press/releases/po503.htm. The Treaty, once in force, will replace the existing tax treaty between the two countries that has been in force since April 25, 1980 (http://www.intltaxlaw.com/TREATIES/UK/frontpage.htm).

The Treaty will enter into force after it is approved by the legislatures of the two governments, followed by subsequent exchange of instruments of ratification through diplomatic channels. If there is a fall 2002 Senate hearing and the Senate approves the treaty in 2002, the Treaty will have effect for US and UK withholding taxes on the first day of the second month after the Treaty enters into force. In general, the current treaty will cease to exist on this effective date, but if a person is entitled to benefits under the current treaty, he or she can elect to have the current treaty continue in effect in its entirety for 12 months beyond the date on which the Treaty otherwise would take effect.

Salient feature – zero direct dividend² withholding

Possibly the most notable feature, and the most relevant for the purposes of this paper, of the Treaty is that for the first time in any US tax treaty, the US has agreed not to impose withholding tax on outbound dividends paid to UK-resident shareholders³ in specified circumstances⁴. In general, the complete exemption will apply if the dividend is paid by a US company that is, and has been for the 12-month period ending on the dividend declaration date, owned at least 80%⁵ by a qualifying UK company, and also if dividends are paid to a UK pension fund as long as the dividends are not derived from the carrying on of a business, directly or indirectly.

Other dividends qualify for withholding tax relief as follows: a 5% upper limit for dividends the beneficial owner of which is a company that owns shares representing directly or indirectly at least 10% of the voting power of the payer corporation, and a 15% cap applies to all other dividends.

Purpose of the Treaty

During the signing of the Treaty the Secretary of the Treasury pointed out that the Treaty would modernize the tax treatment of cross-border trade and investment between the US and the UK to reflect the increasing importance of international activity to the respective economies and developments in the countries’ tax laws during the past two decades. The importance of the transatlantic relationship in the field of taxation, the similarities of the two countries’ respective tax systems, encouragement of investment in both directions, continuing cooperation, and the countries’ close economic ties were given as reasons for the elimination in certain cases of withholding tax on dividends.

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3. US Model Tax Treaty – Article 10 (Dividends)

As mentioned, the Treaty is the first case of deviation from the US’ practice of imposing withholding tax on cross-border dividends in its bilateral treaties.⁶ The Treaty’s new provisions on certain cross-border dividends thus also constitutes a deviation from provisions of the 1996 version of the United States Model Income Tax Convention (“the Model”)’s Article 10, which imposes a 5% withholding tax on direct dividends if the beneficial owner is a company that owns directly at least 10% of the voting stock of the company paying the dividends, and 15% on all other dividends, http://www.ustreas.gov/taxpolicy/t0txmod2.html.

Treasury Department’s request for comments on reform of the Model

During 1992, the US Treasury Department requested private sector comments for the purpose of drafting a new model tax treaty to replace the 1981 Model. Comments on the issue of the appropriate withholding tax rate for dividends were in particular requested.

In spite of subsequent private sector reaction⁷ advocating a 0% withholding tax rate on direct dividends,⁸ the 1996 Model continued to permit a 5% withholding tax on direct dividends as was the case in the 1981 and 1977 Models. Treasury’s Technical Explanation of the 1996 Model does not state any policy or other rationale for continuing to allow withholding at source on direct dividends. Further, no evidence could be found that the Treasury Department actually evaluated the policy basis for this position in compiling the 1996 Model, http://www.ustreas.gov/ .

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4. Debate on Reduction of Withholding Tax Rate to Zero

It seems that the direct dividends provision in the Treaty gave a practical basis to the discussion on whether to eliminate withholding tax on cross-border direct dividends or not. The following focuses on the main arguments that have been put forth in defending the viewpoint that the withholding tax rate on direct dividends should be reduced to 0%, followed by those arguments that have been raised against eliminating the relevant withholding tax.

US Perspective

The arguments below were written mainly from a US perspective and focus on the benefits that the US could derive from reducing their withholding tax rates on direct dividends to zero.

Arguments in favor of eliminating withholding tax ⁹

US revenue effect

A concern regarding reciprocally eliminating withholding tax by treaty on direct dividends relates to the revenue implications for the US. However, some commentators¹⁰ are of the opinion that reducing the withholding tax rate to zero will likely increase federal tax receipts. The reduction in current tax revenues resulting from eliminating withholding tax on dividends paid to foreign shareholders is likely to be more than offset by the reduction in foreign tax credits claimed by those US shareholders who are in an excess foreign tax credit position and who have received non-taxed dividends from foreign subsidiaries.¹¹

US macroeconomic effect

US capital flow and equities

A likely result prior to adoption of a zero-withholding policy is that investors, particularly those in an excess credit position, would reduce dividend payments in the short term, which could result in a temporary revenue loss for the US. When the repatriation rate rises subsequent to a zero-withholding policy adoption, the US could benefit from the increase in capital (i.e., when the dividends received from treaty countries exceed dividends paid). Eventually, the zero withholding rate could make US equities more attractive for foreign investors. The increase in foreign capital should lower the cost of capital in the US and increase domestic investment.

Direct investment in the US

Further, the result of a 0% policy should be increased direct investment in the US that, in turn, should lead to greater US corporate tax collections. Foreign companies should be encouraged to invest directly in the US instead of manufacturing abroad and exporting their products to this country. The upshot of this shift in investment patterns by foreign companies should be stimulation of US production, US jobs and, as mentioned, US corporate tax collections.

Unintended beneficiaries

A concern regarding elimination of the withholding tax rate to zero is that unintended beneficiaries will seek to claim this benefit. A counter-argument to lay this concern to rest is that the standard US limitation of benefits provision suffices for the elimination of 25% of withholding tax from the domestic 30%. Similarly, the limitation of benefits provisions should protect the Treasury’s interest on the reduction of a further 5%.

International trends

Bilateral treaties

Many countries, including a majority of OECD member countries, have chosen to eliminate withholding tax on direct dividends in various of their bilateral treaties,¹² and this is becoming a common feature of various of the treaties negotiated by some of these countries. Furthermore, this approach has been adopted by several of these countries not only in respect of OECD member countries, but also many non-OECD member states, http://www.oecd.org/EN/home/0,,EN-home-0-nodirectorate-no-no-no-0,FF.html.

EC Parent-Subsidiary Directive

The implementation of the Parent-Subsidiary Directive¹³ that generally eliminates withholding tax on dividends paid by a subsidiary resident in one EU member state to a parent company in another EU member state was adopted to, among other things, foster the “competitive strength at the international level” of companies of EU member states. http://europa.eu.int/scadplus/leg/en/lvb/l26037.htm The resulting competitiveness issue for US and other non-EU resident companies who do not enjoy such an exemption with respect to dividends received from their EU subsidiaries argues for the provision of such an exemption by treaty.

Zero withholding provided for by statute

Many countries, including most recently the United Kingdom, Ireland, and Mexico, have chosen to eliminate the bias towards cross-border investment resulting from imposing of withholding tax and have adopted statutes to provide for zero withholding on outbound dividend distributions.

Global trend toward lower taxes on corporate income

A global trend has emerged to lower the tax rate on corporate income as a means of increasing economic wealth and employment. In the Tax Reform Act of 1986, the US reduced the maximum rate on corporate income from 46% to 34%, followed by similar downward moves in the UK, Germany, and France, http://www.fourmilab.ch/ustax/www/contents.html. Elimination of the withholding tax on most inter-corporate dividend distributions would be consistent with this trend.

Promotion of capital export neutrality (“CEN”)

CEN requires that the effective tax rate on investment abroad by a US company be equal to the effective tax rate on domestic investment. Withholding taxes, however, hamper CEN resulting from the cumulative effect of corporate taxes and withholding taxes on the same corporate income where withholding taxes are not fully creditable, the result of which is a disincentive to invest abroad as opposed to investing domestically.

Promotion of capital import neutrality (“CIN”)

CIN requires that a US multinational must be able to compete with foreign multinationals in international markets, which means that in every market US and other foreign capital investors are taxed at the same rate on that capital as are domestic investors in that market.

Since withholding tax at source is not imposed on domestic investors on the payment of direct dividends, the competitiveness of US companies in a foreign tax credit limitation position is clearly negatively affected by withholding tax on direct dividends. The same applies to foreign investors in the US market to the extent that such foreign companies do not obtain a full tax credit or exemption in their home countries.

Although it is widely accepted that CEN and CIN cannot be achieved at the same time, a 1992 OECD report concluded that the elimination of withholding tax would be a move closer to CEN and CIN.

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US classical system

US classical system suited for zero withholding

Some argue that the elimination of withholding tax in cross-border situations would provide favorable treatment over purely domestic investment in that the withholding tax functions as equivalent to the second level of tax on corporate income, namely at shareholder level, of the classical system.¹⁴ Firstly, however, since US domestic shareholder-level tax is levied on a net basis whereas withholding tax is levied on a gross basis, this analogy is not necessarily valid, and does not serve as good reason to justify imposing the withholding tax. Furthermore, as a result of the substantial dividends received deduction in the case of direct dividends that the US offers, there is no real full second level tax on the shareholders unless a subsequent dividend is distributed to individual shareholders. Some commentators¹⁵ further point out that cross-border income is often subject to as much as four levels of tax,¹⁶ and that elimination of withholding tax would serve to reduce this disadvantageous potential multiple-layered taxation on cross-border investment and also the disadvantage that US-based multinational companies suffer when compared to competitors in countries with integrated tax systems.

Even if the treaty partner country of the US has an integrated system, with resulting fewer potential layers of taxation, the zero-withholding policy should be maintained due to the fact that removal of withholding tax would only remove one layer of taxation. Consequently, even when a treaty partner country has a fully integrated tax system, zero withholding would not create an unfair advantage relating to cross-border investment when compared to domestic investment.

Treaty negotiations

The US frequently finds itself at a negotiating disadvantage in treaty talks with countries that have integrated corporate and individual tax systems. The ability of the US to offer a zero withholding rate on dividend distributions to foreign shareholders of US companies would help strengthen the bargaining position of the US in seeking the reduced taxes on US investments in those countries.

Lack of policy

No policy reason opposing elimination

Neither the US Treasury nor Congress seemed to have had any policy objections to the elimination of withholding tax on dividends when the Luxembourg treaty¹⁷ was ratified( http://www.ustreas.gov/, http://www.access.gpo.gov/congress/, http://www.irs.gov/pub/irs-trty/luxem.pdf). Additionally, the US tax treaty with Mexico grants to Mexico a “most-favored-nation” clause, which provides that if the US agrees in another treaty to a withholding tax rate lower than 5%, Mexico would automatically be granted identical treatment (http://www.irs.gov/pub/irs-trty/mexico.pdf, http://www.law.nyu.edu/library/foreign_intl/intrade.html). Neither the Foreign Relations Committee report nor the Joint Tax Committee explanation of this treaty noted any policy concerns in respect of the possible elimination of withholding tax on direct dividends (http://www.senate.gov/~foreign/, http://www.house.gov/jct/).

No policy reason for 5%

As outlined above, no clear policy reason seems to underlie the 1996 Model’s 5% withholding allowable on direct dividends, http://www.ustreas.gov/taxpolicy/t0txmod2.html. A reason often cited to support adherence to the 5% rate involves conformance with international practice and customs. However, as identified above, the perspective on withholding rates has changed, and an international trend toward elimination of withholding tax on most dividend distributions has gained momentum.

Simplification

The elimination of withholding tax on direct dividends would greatly simplify the foreign tax credit calculation where a withholding tax was imposed on a deemed dividend distribution under the US’ Subpart F rules, http://www.fourmilab.ch/ustax/www/t26-A-1-N-III-F.html. The complexity of recalculation of a US taxpayer’s tax liability to take, for the purposes of timing of foreign tax credits, into account the withholding tax on deemed dividend distributions under the Treasury regulations would be eliminated if the withholding tax rate is reduced to 0%.

Free trade principles

It is a widely accepted assumption that free trade benefits worldwide economic welfare.¹⁸ As a result, the US and other nations have reduced tariffs on a consistent basis under the WTO and later GATT, //www.llrx.com/features/wto2.htm. Some commentators¹⁹ are of the opinion that withholding tax on payments for the use of capital (including dividends) has the same effect as tariffs²⁰ have on the import of goods,²¹ with the adverse effect of raising the cost of capital in the capital-importing capital above the world market price. The withholding tax imposed on dividends, while interest income is generally exempt from withholding tax under US tax treaties, creates a certain bias towards equity investment, which would be eliminated when the relevant withholding tax rate would be reduced to zero. Elimination of the withholding tax on direct dividends would also remove the “tariff”, a barrier to capital flows, on the importation of equity capital. This is particularly true for the US, a leading capital exporting country.

Eliminating opportunities for avoidance

Some commentators²² point out that the imposition of withholding tax on portfolio dividends is easy to circumvent due to the administrative rule that payers should withhold tax on dividends based on the address to which the dividend is sent, without certification of the actual residence of the recipient. Portfolio investors can thus avoid withholding tax by directing their dividends to an address in a country with a more favorable tax treaty with the US. Further, in many cases dividends can be disguised as interest and investors can then take advantage of the portfolio interest exemption. Levying of withholding tax is thus greatly dependent on the classification of the nature of the payment made. Also, portfolio dividends escape withholding tax easily because of the availability of equity swaps – dividend equivalent payments on derivatives are sourced to the residence of the recipient. When the resulting complexity and uncertainty is added to the proneness to failure in collecting the relevant withholding tax some argue²³ that it would be more logical to abandon the withholding tax altogether.

Withholding as a “backup” tax

Another argument against eliminating direct dividend withholding is that the US corporate income tax may fail to collect sufficient revenue from foreign-owned US corporations. However, the need for withholding on direct dividends as a “backup” tax seems doubtful in the view of the Tax Reform Act of 1986, which eliminated many corporate tax incentives and imposed a 20% corporate alternative minimum tax (“AMT”), http://www.fairmark.com/amt/. The measure of income under the AMT includes 75% of the adjusted current earning (“ACE”), which is the tax code’s measure of economic income. As a result of the AMT and the ACE preference, corporate tax liability cannot be less than 15% (20% AMT rate multiplied by 75% of ACE) of economic income.

In addition, the 1986 Act also included “earnings stripping” rules to prevent tax avoidance through excessive debt financing, and subsequent legislation, enacted in 1989 and 1990, has given the IRS expanded tools to combat avoidance of US tax through related-party transactions, http://www.intltaxlaw.com/inbound/earnings/frontpage.htm.

No capital flight

Some argue that many capital-importing countries who consider lowering withholding tax rates in an effort to attract new equity investment abstain from doing so based on the fear that such a measure would lead to increased flight of the accumulated multinational equity “trapped” by existing high withholding taxes. Some commentators²⁴ hold that as long as the withholding tax reduction is seen as permanent the fears are unfounded. Permanent changes in withholding tax rates appear likely mainly to attract new equity investment and not encourage repatriation of equity accumulated from past earnings.

Based on the above, the dividend withholding tax seems a poorly targeted mechanism for ensuring compliance by foreign-owned corporations because it applies equally to companies that pay their fair share of US corporate income tax and those who do not.

Arguments against eliminating withholding tax

Few arguments from a US perspective against eliminating the withholding tax on direct dividends could be found. One cryptic comment²⁵ warns against the approval of the Treaty by the Senate. As a result of the favored nation provision in paragraph 8(b) in the protocol to the tax treaty between the US and Mexico,²⁶ a zero rate on dividends will be extended to Mexico when the Treaty becomes effective, http://www.irs.gov/pub/irs-trty/mexico.pdf. The author of the article warns that once the Treaty is approved, the zero withholding would thus have to be extended to Mexico, and that Canada is likely to demand the zero withholding tax treatment as well,²⁷ http://www.irs.gov/pub/irs-trty/canada.pdf.

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OECD’s situation

Although not the focus of this paper, it is interesting to point out that the 5% withholding on direct dividends in Article 10 of the OECD Model Income Tax Convention (“the OECD Model”) cannot be substantiated by a clear policy reason but is the result of a historic compromise in 1961 of the OECD’s predecessor organization, the Organization for European Economic Cooperation (“the OEEC”), http://www.intltaxlaw.com/TREATIES/OECD%20Model.pdf. At the time, the OEEC pointed out that taxation of dividends at source only is less in keeping with the nature of dividends than residence taxation only, but that it would be unrealistic to assume that it could be agreed upon that all taxation of dividends at source should be relinquished. A similar viewpoint was taken by the OECD, but the Commentaries of the Committee on Fiscal Affairs on the OECD Model indicates that the dividend withholding tax is a pragmatic compromise in the absence of broad consensus among all OECD member states. The position has most likely not been revisited in the four decades since 1961.

Tentative conclusion

As becomes clear from the discussion above, there are a myriad of well-formulated arguments to support abolishing withholding tax on direct, and where relevant, portfolio dividends. A debate on the issue could potentially conclude at this stage in favor of elimination, pointing out that there is overwhelming support for the stance. However, since the above-mentioned arguments are formulated mainly from the perspective of the US, the purpose of the next section of this paper is to act as devil’s advocate by inquiring as to what the perspective of the developing world could potentially be, since the result of such an investigation could possibly lead to a different conclusion from the one that could be reached at this stage of the paper.

Developing country perspective

The following section of this paper outlines potential objections that developing countries, based on specific relevant circumstances as outlined below, could potentially raise when confronted with the zero withholding tax option.

International non-taxation and CEN

The combination of the incidence of tax competition for inbound investment, withholding tax elimination on investments,²⁸ and tax havens, creates the situation where significant amounts of cross-border revenue can go untaxed. The interaction of these three elements that combine to form, in the worst-case scenario, a vicious non- or under-taxation circle is explained below.²⁹

Countries wishing to attract foreign capital reduce their corporate tax rate or eliminate tax on corporate income altogether, which, together with the non-withholding on income repatriation leads to under- or zero taxation at source. When such income is then repatriated to tax haven jurisdictions, countries find it virtually impossible to collect tax on the foreign income of their individual residents in the absence of withholding tax in the source countries. Consequently, cross-border investment can be earned largely free of source or residence country taxation.³⁰

It is a well-established international tax policy principle³¹ that all nations are likely to do best economically over the long term by establishing international tax policies that encourage private investors to make the best use of resources. Thus, it is advisable not to establish policies that promote national short-term interests at the expense of global economic welfare, because establishing such policies is likely to encourage other nations to seek to advance their own short-term national interests at the expense of global economic welfare. Non-taxation of both corporate and investment income in the source country followed by non-taxation in the residence country resulting from repatriation of profits to tax havens clearly leads to an inequitable distribution of resources and will not benefit global economic welfare in the long term.

From a tax policy viewpoint, efficiency suffers to a large extent from under-taxation of cross-border capital flows because it leads to “deadweight losses”,³² which decrease global welfare by leading to an inefficient global allocation of capital.

As a result of the above, it makes sense to argue that even though withholding tax may not be the most efficient way of ensuring that income is taxed,³³ even a flawed system of withholding tax may be better than none at all, since it may ensure that at least income does not go completely untaxed, which of course poses the problem of markedly lower revenue-generation for those countries that are not tax havens.

Tax revenue need of developing countries

It is easy to make the case that developing countries need to tax revenues to, among others, ensure the survival of organized government or to provide adequate education, which many regard as the key to promoting development. Through elimination of the withholding tax rate on direct dividends, derived from income that has been earned within the applicable country’s borders, such country is giving up a potential source of tax revenue, which could have been applied – ideally – towards one or more development goal.

Further, some authors³⁴ hold that the principle of inter-nation equity indicates that when balancing the competing revenue needs of developed and developing countries, tax structures should provide preference of the latter over the former.

Revenue loss from forfeiture of withholding tax greater than benefit of capital attracted

One of a few possible steps that a country could take to discourage foreign investment is increasing its withholding tax rates. Thus, conversely, a country rescinding its right to withholding tax on direct investment could potentially gain in terms of attracting foreign capital, which in turn should benefit the country’s economy in the long term due to increased employment and increased foreign spending within the country’s borders. However, it is not clear whether the economic benefits of the potential increased capital investment would outweigh those of increased tax revenues derived from withholding. Consensus does not exist on whom out of current shareholders or capital providers, old shareholders or consumers, actually bears the final tax burden. However, since the majority of these are not resident in the source country, it might be valid to say that the source country, especially if this is a developing country, gains by collecting the tax.

Donations to fiscs of residence countries

When a source country decides, in order to attract foreign capital, not to tax a foreign investment or to tax it at a tax holiday rate, the difference between the source country level of tax and the residence country level of tax will be collected by the fisc of the residence country.³⁵ Consequently, what the residence country is giving away as an incentive to the foreign investor is snatched up again by the residence country making not only the source country the poorer for it, but also eliminating the power of the incentive granted by the source country.

Race to the bottom

When the US enacted the portfolio interest exemption in 1984, abolishing withholding tax on interest paid to foreigners, the result was that no major capital-importing country has been able to impose such a tax for fear of driving mobile capital elsewhere. When a country of the scale of the US decides to adopt a zero withholding policy on direct dividends, it could be argued that in a similar vein few, if any, other country in the world would like to maintain a withholding tax on direct dividends in fear of causing a capital flight. Competition of this scale may deprive many countries, especially developing countries that can hardly compete with a capital-importer the size of the US, of the liberty to decide if and at what rate they wish to impose withholding tax relating to investments made in their respective countries.

On the other hand, it could be argued that in the case of withholding tax on interest all countries, including the US, who reduced their withholding tax rates on interest as a result of the US’ portfolio interest exemption in 1984, would benefit if all re-introduced the withholding tax on interest because they would gain revenue without the risk that the capital would be shifted to another country. However, no country is willing to accept the risk of re-imposing a withholding tax unilaterally. It is not unlikely that after a period of a compulsive race to the zero withholding tax on dividends bottom, countries would find that their economies were better off under the old regime but with a similar “you first” problem as is currently the case in respect of the portfolio interest exception.

Capital retention

One possible reason that could motivate some countries to desire to retain a relatively high withholding tax on repatriation of direct investment income and enjoy liberty from the pressure to reduce its withholding tax rate resulting from competition by significant capital-importers who eliminated withholding tax on investment income relates to the goal of capital retention. By maintaining a constantly relatively low corporate tax rate or by providing tax holidays such countries succeed to attract foreign capital, which such countries then attempt to retain by imposing a relatively high withholding tax rate on repatriation of profits.³⁶

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5. UN Model Tax Treaty

Article 10 of the United Nations Model Double Taxation Convention Between the Developed and Developing Countries (“the UN Model”) keeps the withholding tax rate on direct dividends and other dividends open and subject to bilateral negotiations, http://www.law.wayne.edu/mcintyre/text/UN_Model-color.pdf. The policy reason for this is clear from the decisions made by the United Nations Group of Experts on Tax Treaties Between Developed and Developing Countries: the desire was to limit the withholding tax rates on dividends only if the limitation benefits the investor and not the fisc of the residence country.³⁷ This consideration led to negotiation guidelines relating to the limitation of withholding tax rates on inter-corporate profits. In cases where the residence country uses a credit system, the withholding tax rate in the source country should be reduced to, combined with the source country corporate tax rate,³⁸ not exceed the foreign tax credit that the residence country would provide on the investment. In cases where the residence country employs an exemption system, the withholding tax rate in the source country may need to be limited based on the CEN principle. However, treaty partners are allowed to negotiate the appropriate level of withholding tax to the extent that this would benefit the free movement of capital particularly in the direction where the investment is needed, ensuring that the investor is the party who enjoys the benefit.

6. Conclusion

This paper used the Treaty with its unique 0% withholding tax on direct dividends as the point of departure to investigate the question whether the US needs to finally revisit the topic in its treaty policy. It is clear that there is strong support in the US for such a change in policy. This is further backed by overwhelming and convincing evidence that a new direction in this respect would even work in the US’ favor. The paper then focused on various objections that especially the developing world might raise when a US treaty policy decision compels such countries to accept 0% withholding tax on direct dividends in treaty negotiations.

Although a 0% withholding tax rate between major trade partners like the US and the UK may be in line with the purpose of the Treaty and beneficial to both parties, a similar policy may not necessarily be equally beneficial when one treaty partner is a developing country. The latter might, in specified circumstances, desire to retain a withholding tax rate on direct dividends. Realizing the impact of this potential discrepancy, the UN Model provided for a policy which leaves treaty negotiators the flexibility to decide on withholding tax rates taking into account whether the treaty partner employs a credit system or an exemption system, http://www.law.wayne.edu/mcintyre/text/UN_Model-color.pdf.

When the UN Model’s policy and negotiation guidelines were laid down, the goal was not to use the UN Model as an instrument to grant foreign aid; further, it is common knowledge that the US prefers not to employ tax instruments to grant foreign aid, http://www.law.wayne.edu/mcintyre/text/UN_Model-color.pdf. However, since the US with its generally powerful economy ensuring similar negotiation power has a distinct impact on the economies of other countries, it should – as it seems to have done in the past – consider any move towards a 0% withholding tax policy with caution. A 0% policy on withholding tax on direct dividends in the Model may be the first swallow of summer in the northern hemisphere, but might be the start of winter in other parts of the world.

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Merrill, P.R. et al. Tax Treaties in a Global Economy: the Case for Zero Withholding on Direct Dividends. Tax Notes International Magazine, December 14, 1992, p. 1387.

O’Neill, P.H. U.S. Treasury Announces New U.S.-U.K. Income Tax Treaty. Worldwide Tax Daily, July 25, 2001.

Pantaleo, N. New Canada-US Protocol: Someday Soon? PricewaterhouseCoopers Cross Borders Newsletter, Issue 7, November 13, 2001, http://pwcglobal.com/extweb/pwcpublications.nsf/DocID/0A9941C4EEC4FCF685256B0300609C63.

Slemrod, J. Free Trade Taxation and Protectionist Taxation. Tax Analysts, March 1994.

Surrey, S.S. United Nations Group of Experts and the Guidelines for Tax Treaties Between Developed and Developing Countries. Harvard International Law Journal, Volume 19, Number 1, 1978, p. 1, http://heinonline.org/HeinOnline/show.pl?handle=hein.journals/hilj19&id=9&size=4. **The database is fee-based and can be accessed only by subscribers.

US Department of the Treasury, Office of Public Affairs. United States and United Kingdom Sign New Income Tax Convention. Treasury News, July 24, 2001, http://www.treas.gov/press/releases/po503.htm.

VanderWolk, J. New U.K.-U.S. Income Tax Treaty: A U.K. Perspective. Worldwide Tax Daily, August 7, 2001.

West, P.R. Highlights of the New U.S.-U.K. Tax Treaty. Tax Notes, July 30, 2001, p. 663.

West, P.R. Highlights of the New U.S.-U.K. Tax Treaty. Tax Notes International Magazine, August 6, 2001, p. 757.

3. Model Conventions

OECD Model Tax Convention on Income and Capital. 1977/1992-2000, http://www.intltaxlaw.com/TREATIES/OECD%20Model.pdf.

United Nations Model Double Taxation Convention Between the Developed and Developing Countries. 2001, http://www.law.wayne.edu/mcintyre/text/UN_Model-color.pdf.

United States Model Income Tax Convention. September 20, 1996, http://www.ustreas.gov/taxpolicy/t0txmod2.html.

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Footnotes:

¹My sincere thanks to Ron Grabov-Nardini, recent graduate from New York University’s LL.M. program in International Taxation, for his encouragement that inspired the research for this project, and also to Radu D. Popa, Associate Director for Legal Research & Online Services, New York University Law School Library, for his assistance.
²“Direct dividends” in this paper is used to refer to dividends paid to another company that has a specified minimum ownership interest in the company paying the dividends.
³Under the current tax treaty cross-border dividends are subject to a maximum 5% withholding tax at source.
⁴In practice, the provision will be inapplicable to US shareholders of UK corporations because they are in any event exempt from dividend withholding taxes under domestic UK law.
⁵Determined on the basis of voting power.
⁶The US did agree to allow in the 1996 tax treaty with Luxembourg that the latter unilaterally eliminates its withholding tax on certain direct dividends paid by Luxembourg companies to US company shareholders, http://www.irs.gov/pub/irs-trty/luxem.pdf.
⁷See, for example, Green, R.H., and Merrill, P.R. et al.
⁸The contents of some of these submissions are investigated in further detail below.
⁹Institutions strongly lobbying for the elimination of withholding taxes as discussed include the Zero Dividend Withholding Coalition (the members of which include US and non-US-based multinational companies) and the National Foreign Trade Council (“NFTC”), http://www.nftc.org/2002%20Priorities.html.
¹⁰See, for example, Dilworth, R.H. et al.
¹¹The Dilworth, R.H. et al. study shows that, assuming no change in taxpayer behavior, the combined effect of a bilateral zero-withholding treaty rate on direct dividends would have been a gain for the US of $367 million in 1995.
¹²OECD member countries that have entered into such treaties include the following: Austria, Denmark, Finland, France, Germany, Iceland, Ireland, Japan, Luxembourg, Mexico, the Netherlands, Norway, Sweden, Switzerland, and the United Kingdom.
¹³Council Directive 90/435/EEC of July 23, 1990, http://europa.eu.int/scadplus/leg/en/lvb/l26037.htm, http://europa.eu.int/prelex/detail_dossier_real.cfm?CL=en&DOSId=11787.
¹⁴See, for example, Merrill, P.R. et al. on this so-called “proxy tax” view.
¹⁵See, for example, Dilworth, R.H. et al.
¹⁶US federal income tax on the distributing company, US withholding tax on the dividend distribution, foreign income tax on the recipient company, and foreign shareholder-level income tax on dividends distributed by the recipient company, http://www.irs.gov/.
¹⁷See footnote 7 above.
¹⁸See Slemrod.
¹⁹See, for example, Slemrod, and Merrill, P.R. et al.
²⁰Some commentators, however, view withholding taxes on direct dividends as non-tariff barriers to the free flow of capital. See, for example, Green, R.H.
²¹This argument does not hold true, however, to the extent that the residence country provides an indirect foreign tax credit on withholding tax paid in the source country. The recipient who, in the absence of a foreign tax credit, would in all events have to pay the full applicable tax rate in the residence country is indifferent to the withholding tax rate in the source country as long as this tax is creditable in the residence country and levied at a lower rate than the residence country’s tax rate applicable to the taxpayer. On the other hand, the tax cost is automatic if the residence country uses the exemption method.
²²See, for example, Avi-Yonah, R.S., 1996. The author comments in respect of portfolio dividends rather than direct dividends, the relevant arguments which are nonetheless included here since the debate may at some stage in the future expand to include eliminating withholding tax on portfolio dividends as well.
²³See, for example, Avi-Yonah, R.S., 1996 and Avi-Yonah, R.S., 2001.
²⁴See, for example, Altshuler, R. et al., 1994.
²⁵See Anon., 2001.
²⁶See above.
²⁷The 1995 protocol to this treaty provides that the parties would meet three years later to consider, among other things, further reductions in the withholding tax rates provided in that treaty. Although the negotiators agreed in 2000 in principle to some changes to that treaty, finalization is still pending.
²⁸Some may argue that this concern does not necessarily apply in respect of dividends since dividends are not deductible and the underlying income has already been taxed once. However, as has already briefly been pointed out above, dividends can easily be disguised as interest by an investor entering into a “total return equity swap” in which (s)he receives payments equivalent to dividends from an investment banker in the source country, who in turn hedges by holding the underlying stock and receiving the actual dividends. Most countries do not subject the dividends-equivalent payments to withholding, and the underlying dividends are free from withholding because they are paid to a domestic recipient.
²⁹All three elements need not necessarily be present at the same time to create the problem of under-taxation.
³⁰Admittedly, this problem may arise only as a result of very sophisticated tax planning, where source country withholding tax is reduced or eliminated on repatriation of profits to a non-treaty tax haven.
³¹See, for example, under II. Bibliography (Books and Working Papers), US Department of the Treasury.
³²See Avi-Yonah, 2000.
³³Withholding tax may not be a completely reliable source of taxation since compliance depends largely on withholding at source or alternatively, reliable information reporting. When neither is available the result is that compliance rates drop dramatically.
³⁴See Avi-Yonah, 2000, who refers to this Musgravian concept of entitlement in the tax competition context namely which country is entitled to revenue, and which is used to defend source-based taxation.
³⁵This is true if the residence country provides a foreign tax credit for the tax paid in the source country on the income. Further, this is particularly true of direct investment income, since portfolio income is rarely taxed in the residence country.
³⁶Israel, for example, offers certain corporate tax incentives, leading to 0% in some cases when capital is invested in particular zones, but maintains a domestic rate of 15% withholding tax on dividends paid to foreign investors.
³⁷See above where the problem of donations to the fiscs of residence countries in the case of low corporate tax rates or tax holidays in the source country is described. This results in the elimin
ation of the benefit of the tax incentive.
³⁸Taking investment incentives into account.

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