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Newly signed treaty with Croatia reflects a major shift in US income tax treaty terms
December 2022
In brief
The United States and Croatia on December 7 announced that the two parties had signed a new income tax treaty. Once the treaty process has been completed this will be the first bilateral income tax treaty between the United States and Croatia, the only EU member country that currently does not have an income tax treaty with the United States. While trade and investment between the United States and Croatia may be relevant for only a relatively small subset of taxpayers, the implications of this new treaty’s reach may be broader than initially apparent.
Observation: Taxpayers relying on benefits under a US bilateral income tax treaty should monitor this development and may wish to engage with their advisors and potentially with lawmakers, as the new treaty provisions may signal trends for other US treaty negotiations.
The new bilateral income tax treaty between the United States and Croatia represents the first new treaty signed by the United States in more than a decade. The signing of the treaty by the treaty partners is one required step (among several) in the process of a treaty moving toward entry into force; the remaining actions include consideration by the Senate Foreign Relations Committee, and approval by the Senate by a two-thirds majority.
Observation: Among the most notable provisions, the treaty contains certain new, restrictive limitation on benefits (LOB) and non-LOB provisions that are consistent with the 2016 US Model Treaty. These new provisions could have significant impact in limiting the ability of taxpayers to access a treaty beyond limitations in any existing US tax treaty, as well as limiting treaty benefits in many cases under provisions not previously included in any existing US tax treaty.
In addition, the treaty contains an updated relief from double taxation article that reflects changes to the foreign tax credit rules that were brought about by the TCJA. Moreover, the treaty provides explicit language that preserves the United States’ ability to impose tax under the base erosion and anti-abuse tax (BEAT), which also was part of the TCJA.
The new treaty also provides an exemption from source State taxation on dividends paid to certain pension funds, an exemption from source State taxation on most interest payments, and a 5% rate of source State taxation on royalty payments.
As the first treaty fully negotiated post-TCJA and on the basis of the 2016 US Model Treaty, the US-Croatia treaty may set a precedent for future treaties, including those currently in negotiation. Some of these provisions are briefly discussed below.
The 2016 US Model: Background
In 2016, the US Treasury Department issued a new US Model Treaty. See PwC Insight: Final US Model Income Tax Treaty could significantly reduce access to treaty benefits. The 2016 US Model signaled a shift in US treaty policy, away from the goal of encouraging cross-border investment by reducing incidences of double taxation, toward an overarching concern of preventing the use of income tax treaties to facilitate ‘stateless income.’ As a result, common business structures that typically may not be viewed as abusive may be unable to benefit from a treaty that incorporates the 2016 US Model Treaty’s provisions.
Provisions of note in the newly signed treaty with Croatia
Tighter LOB article
The LOB article aligns closely with the highly restrictive LOB article that is in the 2016 US Model (discussed in greater detail in the PwC Insight linked above), with one significant change regarding the definition of a ‘qualifying intermediate owner.’ Under the LOB provisions of both the 2016 US Model and the newly signed US-Croatia Treaty, the subsidiary of a publicly traded company test, the ownership/base erosion test, and the derivative benefits test each contain intermediate ownership requirements providing that, for such tests to be satisfied, any ‘intermediate owner’ must be organized in one of the two treaty countries or must be a ‘qualifying intermediate owner’ resident in a third country that has a tax treaty with the source State.
Under the 2016 US Model, such third-country treaty also would have to include provisions addressing special tax regimes and notional interest deductions similar to those in the 2016 US Model. Because no other US tax treaty currently includes such provisions, no intermediate owner currently would be able to meet the ‘qualifying intermediate owner’ standard of the 2016 US Model. Instead of requiring a third-country treaty to contain provisions dealing with special tax regimes and notional interest deductions, the US-Croatia Treaty provides that an intermediate owner qualifies as a ‘qualifying intermediate owner’ if such owner does not actually benefit from special tax regimes or notional interest deductions, as defined in the US-Croatia Treaty, thus loosening this new restrictive requirement of the 2016 US Model.
New non-LOB provisions that limit or deny benefits
Special tax regimes: The newly signed treaty contains provisions that deny treaty benefits for income subject to ‘special’ (i.e., preferential) tax regimes, broadly defined (including administrative practices) and including certain territorial tax regimes that exclude foreign source income.
Notional interest deduction regimes: The interest article of the newly signed treaty contains a provision—also in the 2016 US Model—under which income paid to a resident of a State will not qualify for treaty benefits if the beneficial owner of the interest is related to the payor and benefits from a notional interest deduction.
Payments to expatriated entities: The treaty provides that payments (i.e., interest, dividends, royalties, guarantee fees) made by ‘inverted companies’—defined with reference to Section 7874(a)(2)(A)—to connected persons are not eligible for reduced rates of US tax under the treaty.
Exempt permanent establishments (PEs): The newly signed treaty contains a rule eliminating benefits for income allocable to so-called ‘exempt permanent establishments,’ which is an expansion of the triangular branch rule contained in other US tax treaties. This new rule applies to deny treaty benefits if an enterprise of one State derives income from the other State where the residence State treats such income as attributable to a PE situated outside the state of residence (i.e., in the source State or a third country) and if the profits that are treated as attributable to the PE are subject to a combined aggregate effective tax rate in the residence State and the State in which the PE is located that is less than the lesser of 15% or 60% of the general statutory rate in the residence State.
Other provisions
Termination of treaty provisions: Consistent with the 2016 US Model, the treaty adds a new Article 28 to address situations in which, after a treaty is signed, one treaty partner changes its overall corporate tax system so that significant tax no longer would be imposed on cross-border income of resident companies.
Relief from double taxation: The relief from double taxation article adopts the post-TCJA changes to US law in respect of foreign tax credits. Other treaties currently in force allow a US resident or citizen a credit for income tax paid or accrued to a foreign government by or on behalf of such resident or citizen. Those treaties also provide that a US company that owns at least 10% of the voting stock of a foreign company is entitled to an indirect foreign tax credit for taxes paid or accrued to a foreign government with respect to the profits out of which dividends are paid – this equates to the prior-law indirect foreign tax credit under Section 902. In contrast, the newly signed US-Croatia Treaty does not include the indirect foreign tax credit language; it has been replaced with a provision that permits a US corporate shareholder owning at least 10% of the vote or value of a Croatian tax-resident company to deduct the amount of dividends received from the Croatian subsidiary in computing its taxable income (which equates to the current-law dividends received deduction under Section 245A).
Observation: There is a significant change to the language that introduces the provisions of paragraph 2 of the Relief from Double Taxation article. Where the standard formulation refers to being “[i]n accordance with the provisions and subject to the limitation of the law of the United States (as it may be amended from time to time without changing the general principle hereof),” the language in the newly signed treaty is “to the extent allowed under the law of the United States (as it may be amended from time to time).” This suggests that any benefit accorded under the Relief from Double Taxation article that is not also available under domestic law is inoperative.
BEAT: Article 1 (General Scope) preserves the United States’ right to impose a tax under Section 59A on a company that is a resident of the United States or on the profits of a company that is a resident of Croatia that are attributable to a US permanent establishment. (See also PwC Insight: Proposed reservations to pending US-Chile Treaty: action in the stalled treaty ratification process.)
Mandatory binding arbitration: The treaty’s Mutual Agreement Procedure article contains rules requiring that certain disputes between tax authorities of the two treaty partners must be resolved through mandatory arbitration. This provision is substantively the same as the arbitration provision that is found in several other US income tax treaties that were in force prior to the 2016 US Model.
Dividends, Interest, Royalties Articles
Dividends: The Dividends article generally provides for a reduced 15% rate of source State taxation on dividends. The rate is 5% if certain ownership and a 12-month holding period requirements are met. The holding period requirement for a 5% rate is not typical. The Dividends article also provides for favorable treatment of certain pension funds, which may qualify for an exemption from source State taxation. However, the treaty definition of a pension fund appears restrictive.
Interest: In line with current US tax treaty policy and the 2016 US Model, the Interest article provides for an exemption from source State taxation on interest.
Royalties: The Royalties article provides for a reduced 5% rate of source State taxation, which differs from the rate in the 2016 US Model.
The takeaway
While for many, the announcement of this newly signed treaty may have been met with a mere passing glance, it has deeper significance and impact for US tax treaties than it may otherwise appear. While there are clearly benefits for taxpayers that trade with, invest in, and work in Croatia, these provisions signal trends for future treaties.
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