U.S. taxpayers will continue to receive favorable treatment under the U.S. income tax treaties with Denmark, Luxembourg, Malta and Mexico. On July 31, 2023, the Internal Revenue Service (IRS) published competent authority arrangements (CAA) regarding the interpretation of the term “North American Free Trade Agreement” (NAFTA) in the Limitation of Benefits articles of the respective U.S. income tax treaties with these countries. The CAAs that reference the NAFTA in these treaties will be interpreted as references to the United States-Mexico-Canada Agreement (USMCA).
USMCA and Impact on Limitation of Benefits
To prevent residents of non-treaty countries from claiming treaty benefits, most U.S. income tax treaties require a resident of a treaty country to also satisfy a treaty’s limitation of benefits provision. This provision often includes different tests to determine whether a resident is entitled to benefits under the treaty. A resident must generally satisfy only one of the tests in order to obtain benefits under the treaty.
Several of these tests include reference to the NAFTA, and the replacement of the NAFTA with the USMCA in 2020 raised uncertainty as to whether residents of the United States, Mexico, or Canada would meet these tests which still reference NAFTA.
In 2020, the IRS stated in Announcement 2020-6, that “any reference to the NAFTA in a U.S. bilateral income tax treaty should be interpreted as a reference to the USMCA.” The Treasury and IRS, however, still needed to have treaty partners confirm that they agreed with this interpretation.
Limitation of Benefits Tests
The common tests impacted by the reference to the NAFTA include the Derivative Benefits Test and the Publicly Traded Test.
Derivative Benefits Test
The “derivative benefits test” confers treaty benefits to third-country shareholders as long as ultimate investors that are “equivalent beneficiaries” under the treaty own a certain amount of shares (directly or indirectly) of the company and meet a base erosion test. An “equivalent beneficiary” generally includes a party to the NAFTA, provided that certain additional requirements are met.
Publicly Traded Test
The “publicly traded” test confers treaty benefits to residents of treaty countries if the company’s principal class of shares is traded on one or more recognized stock exchanges and certain other requirements are met. Many U.S. treaties provide references to the NAFTA, albeit in different contexts, with respect to meeting the publicly traded test.
Countries with CAAs
The new CAAs with Denmark, Luxembourg, Malta and Mexico add to the similar arrangements with the United Kingdom and Finland that were agreed to in 2021. There is uncertainty, however, for tax treaties that contain references to NAFTA and for which the IRS has not signed a CAA. Under these treaties, the references to NAFTA could be interpreted to not apply to USMCA member countries.
For information about whether this announcement may affect your tax situation, contact us. We are here to help.