November 30, 2009
By Electronic Delivery
Ms. Judith Herdin-Winter
Deputy Head of Division
International Tax Law, Division IV/4
Federal Ministry of Finance
RE: Treaty Eligibility for RICs under Austria-U.S. Tax Convention
Thank you for the time you spent with me recently discussing collective investment vehicles (“CIVs”) organized in the U.S. as regulated investment companies (“RICs”) and whether RICs are eligible, as entities, for reduced withholding tax rates under the Austria-U.S. income tax convention. It always is a pleasure to see you. This letter follows up on our discussions regarding “tax transparency” and why the Investment Company Institute 1 submits that RICs, as beneficial owners, should not be required to include the attestation of holdings with reclaims filed after 2007.
As discussed in my April letter to you (attached), RICs are corporations for U.S. federal income tax purposes; RIC investors are not taxed as if they own the RIC’s underlying assets directly. For all of the reasons described in the April letter, RICs are not tax transparent. Among the many differences between the taxation of RIC shareholders and investors in a pass-through vehicle (such as a partnership) are:
- RIC investors are taxed based upon the distributions that they receive – which are based upon their proportionate interests in the RIC on the date the RIC distributes its income (rather than their interests on the dates that the income is received by the RIC); investors in pass-through vehicles, in contrast, effectively are taxed based upon their proportionate interests on the date the income is received, because (unlike RIC shareholders) investors in pass-through vehicles are treated as owning directly their proportionate interests in the underlying assets;
- all income distributed by a RIC to its shareholders is taxable as a corporate dividend except to the extent that a specific provision of Subchapter M of the U.S. Internal Revenue Code provides for character retention; in contrast, the tax character of income is retained in the hands of investors in pass-through vehicles;
- all RIC income not distributed is taxed at the entity level; in contrast, pass-through vehicles’ income never is taxed at the vehicle level;
- RICs cannot flow through net operating losses nor net capital losses to their shareholders; in contrast, these losses always flow through pass-through vehicles to their investors;
All of these differences, the Institute submits, are attributable to the different legal rights of the investors in these different investment vehicles. RIC investors, for the reasons discussed above, simply are not the beneficial owners of a RIC’s income; the RIC itself is the beneficial owner.
Two foreign tax credit considerations provide further support for treating the RIC as the beneficial owner of its income. The first consideration involves the different conditions under which a foreign tax credit is available to investors in RICs compared to investors in pass-through vehicles. The second consideration involves the differences in how the foreign tax credit rules are applied to RIC shareholders depending on whether or not they are U.S. residents.
No RIC shareholder has any possibility of claiming a foreign tax credit on the RIC’s income unless two conditions are satisfied. First, under Subchapter M, a RIC must hold more than half of its assets in the stock or securities of foreign corporations to be eligible to flow through the foreign tax credit. If the RIC is ineligible, it deducts the foreign taxes as an expense in determining its distributable income. Second, if the RIC is eligible to flow through the credit, it must elect to do so; if the election is not made, the RIC deducts the foreign taxes as an expense.
Investors in pass-through vehicles, in contrast, may claim the foreign tax credit without regard to the pass-through vehicles’ holdings or elections. U.S. residents investing in pass-through vehicles always may claim credits for foreign taxes paid on income received by the pass-through vehicle. Foreign investors likewise should be entitled to claim foreign tax credits in their residence countries on non-U.S. withholding taxes paid on the foreign income received by the pass-through vehicle; so long as the investor’s country of residence treats the U.S. pass-through vehicle as tax transparent (as the pass-through vehicle is treated for U.S. tax purposes), the foreign taxes should be treated as paid directly by the investor in the pass-through vehicle and creditable as such.
The second consideration – the treatment of RIC shareholders who are U.S. residents and those shareholders who are not – further supports the position that the RIC beneficially owns its income. Specifically, as illustrated below, a RIC shareholder eligible to claim a credit for foreign taxes paid by the RIC will be deemed to have additional taxable income equal to the amount of the creditable taxes allocated to that shareholder. A RIC shareholder who is neither a citizen nor resident of the U.S. is not treated as having any additional taxable income and is not provided a credit against U.S. withholding tax for the foreign taxes paid by the RIC.
To illustrate, assume a RIC that invests only in foreign securities all of which pay dividends subject to foreign withholding taxes at a 15 percent rate. Further assume two RIC shareholders who each receive a cash dividend of $85 on their proportionate interest in the RIC on the date that it distributes its income for the year. If the RIC elects to flow through the foreign tax credit, the first shareholder (a U. S. resident) will be treated as having received $100 of income (the $85 cash dividend and an additional deemed distribution of $15, which is equal to the amount of creditable foreign taxes allocated to that shareholder based upon the shares held on the date the RIC distributes its income). Thus, the U.S. resident shareholder effectively gets the “benefit” of the foreign taxes paid by the RIC because the foreign taxes paid will offset the shareholder’s U.S. tax liability on a dollar-for-dollar basis.
The second shareholder (the foreign nonresident) receives only $85; U.S. withholding tax is imposed upon this amount. The only credit for foreign taxes that a foreign shareholder in a RIC may claim is a credit in the shareholder’s residence country for the U.S. withholding tax on the amount actually distributed by the RIC ($85 in this example).
For the reasons discussed above and explained in more detail in my April letter to you, the ICI submits that a RIC is the beneficial owner of its income. Consequently, RICs should not be required to complete the attestation of holdings to receive the benefits of the Austria-U.S. income tax convention.
If I can provide you with additional information regarding the taxation of RICs, or any related matter, please do not hesitate to contact me at 001-202-326-5832 or firstname.lastname@example.org. Thank you again, Judith, for the thoughtful consideration you have given already to this request. I look forward to speaking with you again soon.
Senior Counsel – Tax Law
Stephen E. Shay