Background

In July 2020, the USMCA replaced NAFTA. As detailed in our insight, this created uncertainty for some taxpayers for whom the reference to NAFTA was relevant to satisfying the LOB requirements for treaty eligibility. 

To access a US income tax treaty, a taxpayer generally must satisfy the treaty’s relevant LOB requirements. In many US income tax treaties, one way to access the treaty is to satisfy a derivative benefits test. This test relies in part on the entity seeking treaty benefits being owned in large part by a limited number of ‘equivalent beneficiaries.’ The definition of an equivalent beneficiary in the treaties that have such a provision generally includes as an equivalent beneficiary a person that is a resident of a state that is a party to NAFTA. In addition, some US tax treaties contain a reference to NAFTA in the definition of a recognized stock exchange for the purpose of another LOB test -- the publicly traded test. The replacement of NAFTA with the USMCA resulted in uncertainty for taxpayers relying in part on ownership by a resident of the United States, Mexico, or Canada, or on trading on a stock exchange in one of those jurisdictions. 

The IRS and the Treasury addressed this issue on a unilateral basis with Announcement 2020-6, by announcing that the IRS and the Treasury will interpret references to NAFTA in all US income tax treaties as references to the USMCA and would reach out to countries that have an applicable tax treaty containing references to NAFTA to confirm that they agreed with this interpretation. However, since this was a unilateral announcement by the United States, it was not binding on other countries and, thus, when treaty relief from a foreign income tax is sought under the treaty, the issue as to how the treaty partners would interpret such references remains.   

For example, in the case of a US company receiving dividends from a Luxembourg subsidiary, the derivative benefits test could have been satisfied prior to the replacement of NAFTA by the USMCA if the US company were at least 95% owned by a publicly traded company resident in Mexico (as a party to NAFTA). After the USMCA replaced NAFTA, without a competent authority agreement between the United States and Luxembourg expressly providing that references to NAFTA in the US-Luxembourg tax treaty will be treated as references to the USMCA, it was uncertain whether Luxembourg still would treat the US company mentioned above as eligible for the benefits of the treaty with respect to Luxembourg-source dividend income. With the competent authority agreement between the United States and Luxembourg, effective July 1, 2020, such uncertainty was resolved and the US company at issue would qualify for treaty benefits.  

Conversely, prior to the entry into force of the USMCA, a US company would have been expected to qualify for treaty benefits as a publicly traded company under the US-Belgium tax treaty, for example, if its stock regularly traded on a recognized stock exchange in Canada (as a party to NAFTA). Unlike Luxembourg, Belgium has not yet reached an agreement with the United States regarding the replacement of NAFTA by the USMCA for treaty eligibility purposes (or at least no competent authority agreement has been made public yet); thus, until Belgium expressly agrees with the United States that references to NAFTA in the US-Belgium tax treaty should be read as references to the USMCA, it is not clear whether such a US company would be treated as qualifying for treaty benefits as a publicly traded company. 

Observation: In 2021, competent authority agreements were reached with the United Kingdom and Finland. The four agreements that have just been published with Denmark, Luxembourg, Mexico, and Malta bring the total to six and provide greater certainty for some taxpayers whose eligibility for treaty benefits has been affected by the replacement of NAFTA with the USMCA. However, 11 other treaties contain references to NAFTA for which no agreement has been made public (i.e., Austria, Belgium, Bulgaria, France, Germany, Iceland, Ireland, the Netherlands, Spain, Sweden, and Switzerland). As a result, taxpayers affected by this situation may be at risk that the treaty partner may not agree to interpret the NAFTA references as incorporating the USMCA. Thus, with respect to these 11 treaties, when the benefit sought is for foreign income taxes, the derivative benefits test or the publicly traded company test might not be available until additional agreements addressing this issue are reached or the treaty partner unilaterally agrees to treat NAFTA references as including the USMCA.