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Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Sweden

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Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Sweden EXPLANATION OF PROPOSED PROTOCOL TO THE INCOME TAX TREATY BETWEEN THE UNITED STATES AND SWEDEN Scheduled for a Hearing Before the COMMITTEE ON FOREIGN RELATIONS UNITED STATES SENATE On February 2, 2006 ____________ Prepared by the Staff of the JOINT COMMITTEE ON TAXATION January 26, 2006 JCX-1-06 CONTENTS Page INTRODUCTION .......................................................................................................................... 1 I. SUMMARY.............................................................................................................................. 2 II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE AND INVESTMENT AND U.S. TAX TREATIES .......................................................................... 4 A. U.S. Tax Rules .................................................................................................................... 4 B. U.S. Tax Treaties ................................................................................................................ 6 III. OVERVIEW OF TAXATION IN SWEDEN........................................................................... 8 A. National Income Taxes....................................................................................................... 8 B. International Aspects of Taxation in Sweden ................................................................... 10 C. Other Taxes....................................................................................................................... 11 IV. THE UNITED STATES AND SWEDEN: CROSS-BORDER INVESTMENT AND TRADE ................................................................................................................................... 12 A. Introduction....................................................................................................................... 12 B. Overview of International Transactions Between the United States and Sweden............ 13 C. Income Taxes and Withholding Taxes on Cross-Border Income Flows .......................... 16 D. Analyzing the Economic Effects of Protocols to Income Tax Treaties............................ 17 V. EXPLANTION OF PROPOSED PROTOCOL...................................................................... 18 Article I. Personal Scope........................................................................................................ 18 Article II. Taxes Covered....................................................................................................... 19 Article III. Residence............................................................................................................. 20 Article IV. Dividends............................................................................................................. 20 Article V. Limitation on Benefits .......................................................................................... 26 Article VI. Government Service ............................................................................................ 36 Article VII. Relief from Double Taxation ............................................................................. 36 Article VIII. Entry into Force ................................................................................................ 36 Exchange of Notes .................................................................................................................. 37 VI. ISSUES ................................................................................................................................... 38 A. Zero Rate of Withholding Tax on Dividends from 80-Percent-Owned Subsidiaries....... 38 B. Treaty Shopping................................................................................................................ 42 C. Treatment of Certain Pensions With Respect to Government Service............................. 45 D. U.S. Model Income Tax Treaty ........................................................................................ 47 i INTRODUCTION This pamphlet,1 prepared by the staff of the Joint Committee on Taxation, describes the proposed protocol to the existing income tax treaty between the United States and Sweden (the “proposed protocol”).2 The proposed protocol was signed on September 30, 2005. The Senate Committee on Foreign Relations has scheduled a public hearing on the proposed protocol for February 2, 2006.3 Part I of the pamphlet provides a summary of the proposed protocol. Part II provides a brief overview of U.S. tax laws relating to international trade and investment and of U.S. income tax treaties in general. Part III contains a brief overview of the Swedish tax laws. Part IV provides a discussion of investment and trade flows between the United States and Sweden. Part V contains an article-by-article explanation of the proposed protocol. Part VI contains a discussion of issues relating to the proposed protocol. 1 This pamphlet may be cited as follows: Joint Committee on Taxation, Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Sweden (JCX-1-06), January 26, 2006. References to “the Code” are to the U.S. Internal Revenue Code of 1986, as amended. 2 The proposed protocol is accompanied by official understandings implemented by an exchange of diplomatic notes (the “notes,” collectively). 3 For a copy of the proposed protocol, see Senate Treaty Doc. 109-8. 1 I. SUMMARY The principal purposes of the existing treaty between the United States and Sweden are to reduce or eliminate double taxation of income earned by residents of either country from sources within the other country and to prevent avoidance or evasion of the taxes of the two countries. The existing treaty also is intended to promote close economic cooperation between the two countries and to eliminate possible barriers to trade and investment caused by overlapping taxing jurisdictions of the two countries. The proposed protocol modifies several provisions in the existing treaty (signed in 1994) to make it similar to more recent U.S. income tax treaties, the 1996 U.S. model income tax treaty (“U.S. model”), and the 1992 model income tax treaty of the Organization for Economic Cooperation and Development, as updated (“OECD model”). However, the existing treaty, as amended by the proposed protocol, contains certain substantive deviations from these treaties and models. The proposed protocol replaces Article 10 (Dividends) of the present treaty with a new article that generally allows full residence-country taxation and limited source-country taxation of dividends. The proposed protocol would retain both the generally applicable maximum rate of withholding at source of 15 percent and the reduced five-percent maximum rate for dividends received by a company owning at least 10 percent of the dividend-paying company. However, like several other recent treaties and protocols, the proposed protocol would provide for a zero rate of withholding tax on certain dividends received by a parent company from a subsidiary that is at least 80-percent owned by the parent. A zero rate also generally would apply to dividends received by a pension fund. As in the current treaty, special rules would apply to dividends received from RICs and REITs, with some new modifications applicable to dividends from REITs, similar to provisions included in other recent treaties and protocols. The proposed protocol replaces Article 17 (Limitation on Benefits) of the existing treaty with a new article that reflects the anti-treaty-shopping provisions included in the U.S. model and more recent U.S. income tax treaties. Unlike the U.S. model, but like the recent protocol amending the Netherlands income tax treaty,4 the proposed protocol includes a requirement to determine whether a company’s public trading or management constitutes an adequate connection to its residence in a treaty country to prevent certain companies from qualifying for treaty benefits. The proposed protocol amends Article 20 (Government Service) of the existing treaty to include a special new rule related to Swedish tax on a U.S. Government pension. The proposed protocol expands the “saving clause” provision in Article 1 (Personal Scope) of the existing treaty to allow the United States to tax certain former citizens and long- term residents regardless of whether their termination of residency has as one of its principal purposes the avoidance of tax. This provision generally allows the United States to apply special 4 See Joint Committee on Taxation, Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and the Netherlands (JCX-54-04), September 16, 2004. 2 tax rules under section 877 of the Code as amended in 1996 and 2004. The proposed protocol makes coordinating changes to Article 23 (Relief from Double Taxation) with respect to foreign tax credits allowed in such situations. The proposed protocol updates Article 1 of the existing treaty to include the rules in recent U.S. treaties related to fiscally transparent entities, modifies outdated references in Article 2 (Taxes Covered), and brings Article 4 (Residence) of the existing treaty into conformity with the U.S. model and more recent U.S. income tax treaties. Article VIII of the proposed protocol provides for the entry into force of the modifications made by the proposed protocol. 3 II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE AND INVESTMENT AND U.S. TAX TREATIES This overview briefly describes certain U.S. tax rules relating to foreign income and
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