The Norwegian Tax Appeal Board changes established practice and grants tax treaty protection to Regulated Investment Companies (RICs) on dividends from Norway to the USA

The question at hand was whether a RIC resident in the USA is entitled to a reduced withholding tax rate on dividends from Norwegian companies under Article 8 of the tax treaty with the USA.

According to section 10-13 of the Taxation Act, the general rule is that a withholding tax rate of 25% is to be deducted on dividends distributed to shareholders abroad. However, the withholding tax rate of 25% of the dividend may be reduced based on the participation exemption method in section 2-38 of the Taxation Act or a provision in an invoked tax treaty with the state in which the shareholder is resident.

 In the relevant case, the Tax Appeal Board found that the participation exemption method did not apply. The question was therefore whether the tax treaty with the USA could reduce the withholding tax from 25% to 15%. The reduced rate under the tax treaty with the USA depended on two sub-questions:

• whether the American RIC could be considered as the beneficial owner of the dividend; and
• whether the limitation rule for tax treaty benefits in Article 20 of the treaty (the so-called «Limitation on Benefits clause») was to be applied.

The reduced rate under the tax treaty thus required the RIC to be the beneficial owner of the dividend and the LOB clause not to apply.

A RIC A RIC can take the shape of, among other things, a «mutual fund» and a «unit investment trust». Such funds are considered an independent entity (a «corporation») for tax purposes*. According to the website of the U.S. Securities and Exchange Commission (SEC), the form used to register the RIC (form N-1A) is intended for «open-ended mutual funds». Such an open-ended fund can issue unlimited shares. Since a RIC can receive capital contributions from an unlimited number of persons, it has, from a Norwegian perspective, similarities with a collective investment fund or a mutual fund.

Although the RIC appears to have been established as a trust under corporate law, it was referred to as a «U.S. corporation» and a «resident of the United States of America for purposes of U.S. taxation» in the certificate of residence.

In the Ministry of Finance’s statement of 9 May 2008, it is assumed that undertakings that meet the conditions for being considered a RIC under U.S. domestic law are to be considered U.S. companies within the meaning of the tax treaty. Thus, they are resident in the USA under the tax treaty, cf. Art. 3 no. 1 letter b) (i). The fact that the RIC was resident in the USA was not disputed in the case.

*United States Code, Title 26 (IRC), Subtitle A, Chapter 1, Subchapter M, Part I (Regulated investment companies), § 851 letter g (1)

It follows from the OECD Model Tax Convention on Income and on Capital that a consistent condition for limiting taxation to the tax rate set out in the treaty is that the dividend is paid to «the beneficial owner of the dividends». This is referred to in Norwegian as a condition that the recipient of the dividend must be the «beneficial owner» («virkelig rettighetshaver») of the dividend in order to claim a reduced withholding tax rate. It is not sufficient for the recipient to solely be a formal recipient in order to claim a reduced rate.

However, the tax treaty with the USA has the peculiarity that it does not contain an explicit condition of «beneficial ownership». This is due to the fact that the treaty was concluded quite some time ago (it was signed on 3 December 1971), whereas the wording «beneficial owner» was first introduced in the OECD Model Tax Convention in 1977. At the time, the OECD considered whether it would be better to include a «subject to tax» condition but settled instead on a «liable to tax» condition, supplemented by a «beneficial owner» condition.

Although the treaty with the USA does not contain any explicit reference to the term «beneficial owner», such a condition has nevertheless been interpreted into the agreement. This is because, according to the OECD commentary, the term is intended to clarify the meaning of the expression «paid […] to a resident». According to Article 10 on the taxation of dividends, clause 12.2 of OECD’s commentary to the Model Tax Convention, it would not be in accordance with the «object and purpose» of the treaty to apply a reduced rate of withholding tax to payments to an «agent or nominee» or to «conduit companies».

More specifically, the question to be determined in the abovementioned Tax Appeal Board case was whether the RIC was the beneficial owner of the dividends from the Norwegian companies. The question arises because, under U.S. law, the RIC must distribute at least 90 percent of its Investment Company Taxable Income (ICTI) to retain its status as a RIC, including obtaining exemption from federal income tax. If the fund failed to distribute all ICTI, or net capital gains, it would be subject to tax on the remaining amount.

When assessing whether the RIC could be considered a beneficial owner, the Tax Appeal Board placed decisive emphasis on the assessment criterion included in 2014 in the comments to the OECD Model Tax Convention, Article 10, clause 14.4:

«[T]he recipient’s right to use and enjoy the dividend is constrained by a contractual or legal obligation to pass on the payment received to another person»

In the Tax Appeal Board’s view, the comments indicate that the decisive factor is whether the recipient has a specific legal obligation to redistribute the same dividend amount. Such a specific obligation to redistribute must not be confused with typical distribution obligations for pension schemes and collective investment vehicles, cf. Article 1, clauses 22-48 of the commentary on the Model Tax Convention.

The Tax Appeal Board concludes that the RIC has no such legal obligation to redistribute and that the RIC’s redistribution in practice has similarities with that of a collective investment fund. The Tax Appeal Board therefore concludes that the distribution obligation is so general and discretionary that the fund is to be considered as the beneficial owner of the dividend under Article 8 of the tax treaty.

In its previous practice, the Norwegian Tax Administration has assumed that RICs do not meet the condition of being «beneficial owners» and are therefore not entitled to a reduced rate under Article 8. Previous decisions from the Tax Administration seem to be based on the fact that the RICs in practice distribute received dividends and thus usually pay little or no corporate tax in the USA.

However, the Tax Appeal Board corrects its previous practice and applies the correct assessment basis according to the OECD’s comments, i.e. whether the recipient «has a legal obligation to redistribute». According to international practice, this is a strict assessment basis that must be understood according to its wording. In our opinion, the tax Appeal Board’s correction of the state of the law is therefore in accordance with the OECD Model Tax Convention and international case law related to the concept of «beneficial owner».

It is worth noting that the Tax Appeal Board’s style of interpretation is dynamic in the sense that more recent developments and comments relating to the Model Tax Convention are given weight when interpreting a treaty that was concluded quite some time ago (the treaty with the USA was signed on 3 December 1971).

Article 20 of the tax treaty between the USA and Norway sets out a Limitation on benefits clause, which excludes certain investment and holding companies’ right to reduced withholding tax under Articles 8, 9, 10 and 12, if the following two cumulative conditions are met:

1. the tax burden for the investment or holding company must, according to certain special measures, be substantially lower than the tax normally imposed on company profits; and
2. 25 percent or more of the capital in the fund must be directly or indirectly owned by one or more persons who are not resident in the tax treaty states.

According to the wording of letter (a), when a substantially lower tax is imposed than that which otherwise applies to company profits, it is not sufficient that this is a result of ordinary rules. It must be the result of «special measures». In other words, rules that follow from the ordinary tax system are not sufficient to make Article 20 applicable.

The purpose of this provision is to disqualify companies that are subject to particularly favorable tax regimes as a result of «special measures» in their home countries in order to avoid such companies being used as flow-through companies by persons resident in third countries in order to obtain lower withholding tax on outgoing dividends from companies in Norway or the USA. The provision thus aims to limit treaty shopping.

The provision in Article 20 of the tax treaty is atypical and is unlikely to be found in any of Norway’s other tax treaties. The limitation on benefit clause is based on a U.S. tax treaty standard that was first applied in the tax treaty between Luxembourg and the USA in 1962 and, for a period of time, for other U.S. tax treaties, including the tax treaties with the Netherlands and Norway.

The Tax Appeal Board concluded that the condition in Article 20(a) was not met. The RIC fund was not subject to «special measures» that result in it being «subject to a substantially lower tax» by the USA than the tax normally imposed on company profits in the USA.

As Article 20 of the tax treaty between Norway and the USA is based on the U.S. tax treaty standard, the Tax Appeal Board justified its conclusion based on, among other things, the motives for the standard provision.

The Tax Appeal Board placed decisive emphasis on the memorandum prepared by the staff of the Joint Committee on Internal Revenue Taxation, submitted to the Senate on Foreign Relations Committee and included in the Executive Report 92-30 (8 August 1972, p. 5 et seq. on pp. 15-16). The memorandum states that, when the tax treaty was ratified in 1972, neither Norway nor the USA granted investment and holding companies such tax benefits that would make it relevant to apply Article 20. The RIC regime has existed in the USA since 1942, i.e. since before the tax treaty was signed. The connection between the taxation of mutual funds and unitholders in the USA, as reflected in the taxation of RICs, was thus not considered to be a special measure by the USA at the time when the tax treaty was concluded and ratified in the early 1970s.

The Tax Appeal Board finds that the understanding in the above memorandum is not compatible with the Ministry of Finance’s circular R-56/72 from the fall of 1972. The Ministry of Finance assumed that Norway may levy, pursuant to Article 20, a 25 percent withholding tax rate on outgoing dividends from Norwegian companies to American investment or holding companies without prejudice to the rules in Article 8(2). The reason was said to be that «special tax measures in U.S. legislation apply to the companies in question». The circular did not mention which tax measures were referred to.

As the conditions in Article 20 are cumulative, it was not necessary for the Tax Appeal Board to decide whether the ownership requirement in letter b was met.

The Tax Appeal Board’s decision makes it clear that RICs will generally be entitled to reduced withholding tax based on the treaty with the USA. The RICs will be beneficial owners to dividends from Norway and they will also avoid the cut-off of benefits under the LOB clause.

Presumably, a similar right to reduced deduction must apply to corresponding foreign companies that are treated in the same way as Norwegian mutual funds and other undertakings for collective investment in transferable securities in Europe (UCITS) under tax law. The right of deduction for distributions from mutual funds is a method of ensuring tax neutral treatment of income from collective investment undertakings compared to income from direct investments. In this way, mutual funds can be used for collective investments in a cost-effective manner.

Norwegian tax treaties with other states lack a LOB clause or are very diverse in the design of their LOB clauses. The design of the LOB clause in the USA/Norway tax treaty deviates from the OECD Model as set out in Article 29 (1-7) according to the OECD commentaries.

Each tax treaty should therefore be examined thoroughly to clarify the content of any LOB clause. In addition, many tax treaties will contain a so-called Principal Purpose Test (PPT) rule, which may supplement any LOB clause. Although the PPT rule is designed as a general anti-tax avoidance rule (GAAR), while the LOB clause is more standardized (SAAR), the provisions will have a scope of application that is partly overlapping when it comes to establishments that lack substance.

The Tax Administration has recently applied the PPT rule and denied reduced withholding tax deductions in tax treaty cases involving the establishment of intermediate holding companies. If such intermediate holding companies have a weak connection to the state where the company is established, there is a risk that the PPT rule may apply.

Presumably, as practice has developed, a distinction must be made between companies with the status of «corporation» on the one hand, and partnerships, estates and trusts on the other hand, see the Tax Appeal Board in Grand Chamber 01 NS 90/2019. This distinction has an impact on whether the undertaking is granted treaty protection as a resident under Article 3(1) of the U.S. treaty. For RICs covered by Article 3(1)(b)(i), it is, as mentioned, sufficient to be liable to tax, while for partnerships, estates and trusts it is necessary to actually pay taxes («subject to tax») in the home state.

It follows from previous practice that U.S. pension funds organized as a U.S. «group trust arrangement» are not resident under Article 3 (b) (ii) of the tax treaty with the USA. This is because such organizational forms are subject to tax and the income received by the trust is not subject to tax in the USA. Taxation does not occur until the distribution of pensions or other welfare benefits from the (pension) trust is carried out. It is true that the «subject to tax» condition can be met by the underlying beneficiaries paying the tax, but it will generally not be met for pension funds that distribute pensions. The dividend has then changed its character to pension and can no longer be considered as dividend income under the tax treaty. This understanding is based on agreements between competent authorities and statements from the Norwegian Ministry of Finance. The Tax Appeal Board has confirmed that such pension funds organized as trusts are not granted tax treaty protection. This stands in contrast to the RICs, which have the status of «corporations» under U.S. law, cf. Article 3 clause 1 b) (i) of the tax treaty between Norway and the USA.