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March, 2011 Volume 85, No. 3
Will Malta Become the “New” Ireland in International Tax Planning?
by Jeffrey Rubinger
Page 32
Historically, U.S. taxpayers setting up operations in Europe (or elsewhere outside of the United States) have looked to Ireland as a result of its highly skilled workforce, its developed infrastructure, and membership in the European Union (EU). Perhaps even more important, however, were the tax benefits afforded to U.S. multinationals, including a 12.5 percent corporate income tax rate on active ( i.e.. “trading”) income and lack of transfer pricing rules for related party transactions. 1
The recent ratification of the U.S.-Malta income tax treaty (effective January 1, 2011), however, along with a 5 (and possibly zero) percent effective corporate income tax rate on active income (the lowest corporate income tax rate in the European Union), a new favorable regime for the tax treatment of intellectual property, and lack of transfer pricing rules, has clearly made Malta one of the most attractive jurisdictions from an income tax perspective with respect to inbound investments to, and outbound investments from, the United States. This article will discuss the U.S. tax planning opportunities available with Maltese corporations that have become more attractive given these recent developments.
U.S. International Tax Regime, in General
The U.S. federal income tax treatment of a corporation depends on whether such corporation is domestic or foreign. For this purpose, a corporation is treated as domestic if it is incorporated under the law of the U.S. or of any U.S. state. 2 All other corporations ( i.e.. those incorporated under the laws of foreign countries) are treated as foreign corporations. 3
• U.S. Federal Income Taxation of Domestic Corporations — The United States employs a “worldwide” tax system with respect to U.S. persons, under which U.S. taxpayers generally are taxed on all their worldwide income, regardless of whether the income is derived from U.S. or foreign sources. In order to mitigate the double taxation that may arise from taxing the foreign-source income of a U.S. person, a foreign tax credit for income taxes paid to foreign countries is available to reduce or eliminate the U.S. taxes on such income, subject to certain limitations.
Income earned by a U.S. taxpayer from foreign operations conducted by foreign corporate entities generally is only subject to U.S. federal income tax when the income is distributed as a dividend to the U.S. shareholder. Until that time, U.S. federal income tax on the income is generally deferred. Nevertheless, anti-deferral regimes, such as the controlled foreign corporation (CFC) rules under Subpart F (§§951-965) and the passive foreign investment company (PFIC) rules (§§1291-1298), may cause the U.S. shareholders of a foreign corporation to be taxed on a current basis in the U.S. with respect to certain categories of passive income earned by its foreign subsidiaries, regardless of whether the income has been distributed. A foreign tax credit may be available to offset, in whole or in part, the U.S. federal income tax owed on this foreign-source income, whether repatriated as an actual dividend or included under one of the anti-deferral regimes. 4
• U.S. Federal Income Taxation of Foreign Corporations — With respect to active business income, the United States taxes foreign corporations only on income that is “effectively connected” with the conduct of a U.S. trade or business. 5 Such “effectively connected income” is taxed in the same manner and at the same rates as the income of a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. federal income tax on business operations of a foreign corporation to cases in which the business is conducted through a “permanent establishment” in the United States.
In addition, foreign corporations are generally subject to a gross-basis U.S. tax at a flat 30 percent rate on U.S. source income that is classified as fixed, determinable, annual, or periodical (FDAP) income, including interest, dividends, rents, royalties, and certain similar types of income, subject to certain exceptions. 6 The tax generally is collected by means of withholding by the payer of the income. The withholding rate on FDAP income is often reduced or eliminated by treaty.
Maltese Corporate Income Tax Regime, in General
Similar to the U.S. corporate income tax system, a company incorporated under the laws of Malta will be subject to corporate income tax in Malta on its worldwide income, regardless of the source of such income. The corporate income tax rate in Malta is currently 35 percent. Companies that are incorporated in Malta are considered “ordinarily resident and domiciled” in Malta and are eligible for benefits under Malta’s expansive income treaty network.
A company that is incorporated outside of Malta but that is “managed and controlled” 7 in Malta will be treated as a Maltese “resident” corporation and subject to Maltese corporate income tax on a “remittance” basis only. Essentially, this means that Maltese resident corporations will only be subject to corporate income tax on 1) income that arises in Malta, or 2) income that arises from outside of Malta if such income is remitted into Malta ( i.e., paid to a Maltese bank account). Therefore, Maltese resident corporations are not subject to Maltese corporate income on income that arises outside of Malta, so long as such income is not remitted into Malta. Furthermore, capital gains arising outside of Malta will not be subject to corporate income tax by a Maltese resident corporation, even if remitted to Malta. Notably, Maltese resident corporations are eligible for treaty benefits under Malta’s expansive treaty network (including the recently ratified treaty with the United States), regardless of the fact that the income of such company may be completely exempt from corporate income tax in Malta because it is never remitted into Malta.
• Imputation System — As noted above, the corporate income tax rate in Malta is generally 35 percent. However, Malta applies an “imputation system” whereby the corporate income tax paid by the company is refunded to the shareholders when distributions are made to them. 8 The amount of the refund depends on the type of income earned by the company. In particular, when dividends are paid by a Maltese company engaged in active business operations ( i.e.. a trading company), the shareholders become entitled to claim refunds of 6/7 of the Maltese corporate income tax paid. This results in an effective corporate income tax rate of 5 percent on trading companies. If, on the other hand, dividends are paid by Maltese companies out of profits earned from passive interest and royalties, the shareholders are entitled to claim a refund of 5/7 of the Maltese corporate income tax paid. This results in an effective corporate income tax of 10 percent on these types of passive income. 9
• Treatment of Intangible Property — As noted above, royalties generally are subject to an effective corporate income tax rate of 10 percent in Malta. As of January 1, 2010, however, Malta completely exempts from corporate income tax royalties derived from patents on inventions, regardless of where the patent is registered or where the underlying research and development was carried out. Furthermore, a Maltese resident corporation ( i.e.. a corporation that is formed outside of Malta, but that is managed and controlled in Malta) will be completely exempt from corporate income tax on all types of royalties (not just royalties derived from patented intangibles) as long as the royalties are derived from outside of Malta and are not remitted into Malta.
• Other Corporate Income Tax Benefits in Malta — In addition to the benefits mentioned above, the corporate income tax regime in Malta also has other significant tax benefits. Malta does not impose withholding tax on interest, dividends, or royalties paid to foreign persons, and Malta has no transfer pricing rules that apply to related-party transactions, no thin capitalization ( i.e.. minimum debt-to-equity ratios) rules, and no CFC rules.
U.S.-Malta Income Tax Treaty
An important development that will likely lead to additional tax planning opportunities with Malta, in both the inbound and outbound context, is the ratification of the U.S.-Malta income tax treaty. The treaty, which entered into force on November 23, 2010, is effective for amounts paid or credited on or after January 1, 2011. In general, the treaty reduces the U.S. withholding tax rate on 1) dividends from 30 percent to either 5 or 15 percent; 10 2) interest from 30 percent to 10 percent; 11 and 3) royalties from 30 percent to 10 percent. 12
For a Maltese company to be eligible for treaty benefits, such company needs to be treated as a resident of the treaty, as well as satisfy the treaty’s limitation on benefits (LOB) provision. For this purpose, a resident of the treaty is defined as “any person who, under the laws of that [s]tate, is liable to tax therein by reason of his [or her] domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.” 13
Regarding the LOB provision, one of the most common manners of satisfying this provision is under the so-called “ownership and base erosion test.” In general, pursuant to the treaty, a Maltese company can qualify under this test only if on at least half of the days of the taxable year at least 75 percent of each class of shares in the company is owned directly or indirectly by residents of Malta, and less than 25 percent of the company’s gross income is paid or accrued to residents of a country other than the United States or Malta. 14
Similar to many other recently enacted income tax treaties, however, the LOB provision of the treaty also contains a “derivative benefits” article, which essentially allows residents from certain third countries to own the shares of a Maltese company without disqualifying the Maltese company from obtaining treaty benefits. Under this provision, a Maltese company can qualify for treaty benefits if at least 95 percent of each class of the company’s shares are owned, directly or indirectly, by seven or fewer persons who are “equivalent beneficiaries,” and less than 25 percent of the company’s gross income is paid or accrued, directly or indirectly, to persons who are not equivalent beneficiaries. 15
For this purpose, an equivalent beneficiary is defined as a resident of a member state of the EU or European Economic Area (EEA) 16 state or of Australia or of a party to NAFTA, but only if that resident would be entitled to all the benefits of a comprehensive income tax treaty between its home country jurisdiction and the United States, and with respect to dividends, interest, or royalties, would be entitled under such treaty to a rate of tax with respect to the particular class of income for which benefits are being claimed at least as low as the rate applicable under the treaty. 17 An example of the use of this provision is discussed below.
• Qualified Dividends — In addition to the benefits made available to Maltese companies investing in the United States under the treaty, another significant benefit resulting from the ratification of the treaty is the potential ability of U.S. individual taxpayers to receive “qualified dividends” from a Maltese corporation. Section 1(h)(11) provides for a 15 percent maximum tax rate on “qualified dividend income” received by individuals and other taxpayers subject to tax under §1. 18 Section 1(h)(11) accomplishes this result by taxing qualified dividend income at the same rate as long-term capital gains.
To be eligible for this reduced rate, the dividends must be received from either a domestic corporation or a qualified foreign corporation (QFC). A QFC is defined as any foreign corporation that is, among other things, eligible for benefits of a comprehensive income tax treaty with the United States which the Secretary of Treasury determines is satisfactory for this purpose and which contains an exchange of information provision. To be a QFC, the foreign corporation must also be a resident within the meaning of such term under the relevant treaty and must satisfy any other requirements of that treaty, including the requirements under any applicable LOB provision. 19
In Notice 2006-101, the IRS published a list of jurisdictions that have concluded with the United States “satisfactory comprehensive” income tax treaties that contain an exchange of information provision. Although Notice 2006-101 provides that the Treasury and IRS intend to update the list, as appropriate, when, for example, new treaties are enacted or existing treaties are amended or renegotiated, the notice also makes it clear that any changes to the list of income tax treaties that meet the requirements of §1(h)(11) will apply only to dividends paid after the date of publication of the revised list.
Inbound Planning
With the recent ratification of the treaty and the use of Maltese resident (but nondomiciled) corporations, certain non-U.S. taxpayers interested in investing in the United States can obtain significant tax benefits by investing through a Maltese corporation. For example, assume taxpayers resident in Spain (or another high-tax jurisdiction) would like to lend money to finance the operations of, as well as license intellectual property to, a U.S. business owned by a related corporation. If those residents formed a company in Spain for this purpose, any U.S.-source interest or royalties paid to the Spanish corporation would be eligible for reduced withholding tax rates under the U.S.-Spain income tax treaty ( i.e.. 10 percent in both cases) but would be subject to corporate income tax rates in Spain at a 30 percent rate. 20
If, on the other hand, the same Spanish investors formed a company in the Cayman Islands, but moved the management and control of such company to Malta, the company would be treated as a Maltese resident corporation. Under the treaty, a Maltese resident corporation is eligible for treaty benefits, because it is treated as a “person who, under the laws of [Malta], is liable to tax therein by reason of [its] place of management.” 21 Therefore, any U.S.-source interest or royalties paid to such corporation would be eligible for reduced withholding tax rates under the treaty ( i.e.. 10 percent), so long as the payments are remitted into Malta. 22
Furthermore, the LOB provision of the treaty will be satisfied in this case, despite the fact that the Maltese resident corporation is owned by residents of a third country ( i.e.. Spain) because of the derivative benefits article of such provision. The Maltese resident corporation would be 95 percent owned by seven or fewer residents of the EU, and the withholding tax rate on the U.S.-source interest or royalties would be at least as low under the U.S.-Spain treaty ( i.e.. 10 percent) as it would under the treaty ( i.e.. 10 percent).
If, however, the owners of the Maltese company were resident in a country outside of the EU, EEA, Australia, Canada, or Mexico, or were resident in a jurisdiction whose income tax treaty with the United States provided for higher rates of withholding on the U.S.-source interest or royalties than the 10 percent rate provided for under the treaty, then the derivatives benefits article of the LOB provision would not be satisfied. As a result, no treaty benefits would be allowed in such a situation. For example, if the Maltese company was owned by residents of Israel, the derivative benefits article of the LOB provision would not be satisfied and, therefore, treaty benefits would not be available unless another article of the LOB provision were satisfied.
Outbound Planning
In the outbound context, the use of a Maltese resident corporation can also result in significant tax savings in certain situations. For example, assume U.S. taxpayers that are conducting an operating business through an S corporation or a partnership decide to expand their business abroad. Also assume that they decide to expand their operations in a low-tax jurisdiction that does not have a comprehensive income tax treaty with the United States ( e.g., Hong Kong, Singapore, Cayman Islands, etc.). Under this scenario, any dividends repatriated to the United States from the operating company would not be eligible for qualified dividend rates (currently 15 percent) in the hands of the ultimate beneficial U.S. shareholders, because of the lack of income tax treaty between the United States and the operating company’s jurisdiction. Instead, such dividends would be subject to U.S. federal income tax at ordinary income rates (currently 35 percent).
If, on the other hand, the shareholders formed a Maltese corporation to conduct their business operations, any dividends repatriated to the United States should be eligible for qualified dividend income treatment (once the IRS updates the list provided in Notice 2006-101 to include Malta as a jurisdiction that has a comprehensive income tax treaty with the United States). Therefore, the profits can be repatriated to the United States at a 15 percent rate instead of a 35 percent rate. Moreover, as noted above, companies engaged in an active trade or business in Malta are subject to an effective corporate income tax rate of only 5 percent, which is the lowest corporate income tax rate in the EU.
Conclusion
The recent ratification of the U.S.-Malta income tax treaty, along with the lowest corporate income tax rates in the EU, a favorable regime for the tax treatment of intellectual property, and lack of transfer pricing rules, clearly makes Malta one of the most attractive jurisdictions from an income tax perspective with respect to inbound investments to, and outbound investments from, the United States. These benefits will become even more significant once the IRS makes it clear that dividends received by Maltese corporations are eligible for qualified dividend income treatment.
1 Ireland introduced transfer pricing rules, which basically endorse OECD transfer pricing guidelines. These rules are effective for accounting periods commencing on or after January 1, 2011, in relation to any arrangement entered into on or after July, 1, 2010.
2 I.R.C. §7701(a)(4). All references to “section” refer to sections of the Internal Revenue Code (I.R.C.) of 1986, as amended, and the Treasury Regulations promulgated thereunder.
3 I.R.C. §7701(a)(5).
4 See I.R.C. §§902 and 960.
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5 I.R.C. §882.
6 I.R.C. §881.
7 The Maltese income tax act does not define the concept of management and control within the context of the Maltese tax system. Instead it is a facts and circumstances test with the following factors being the most relevant: 1) directors are resident in Malta; 2) head office of the company is located in Malta; 3) minutes of the board meetings show that the most important decisions occurred in Malta; 4) management decisions were taken in Malta; 5) the company operates a Maltese bank account; and 6) financial statements are audited by a Maltese auditor.
8 The refunds are payable within 14 days from the last day of the month in which the request is made to the Maltese tax authorities.
9 It should be noted that the refund is reduced to 2/3 of the corporate income tax paid if the dividend is paid out of profits from which the company has claimed treaty benefits pursuant to an income tax treaty with Malta.
10 Art. 10(2)(a) of the treaty. The rate is reduced to 5 percent if the beneficial owner is a company that owns at least 10 percent of the voting stock. The 15 percent rate applies in all other cases. The withholding tax rate on dividends is eliminated entirely if the beneficial owner of the dividend is a pension fund that is a resident of the other treaty jurisdiction and such dividend is not derived from the carrying on of a trade or business. See Art. 10(3) of the treaty.
11 Art. 11 of the treaty. Contingent interest is taxed at a 15 percent rate under the treaty. See Art. 11(3)(a).
12 Art. 12.
13 Art. 4.
14 Art. 22(2)(f).
15 Art. 22(3).
16 The EEA includes all of the members of the EU plus Iceland, Norway, and Liechtenstein.
17 Art. 22(8)(d).
18 The 15 percent rate on qualified dividends was recently extended for another two years until the end of 2012 under the 2010 Tax Relief Act.
19 See Notice 2006-101, 2006-2 C.B. 930.
20 It is assumed that the portfolio interest exemption would not be available in this case because of the relationship between the parties. See §881(c)(3)(B).
21 Art. 4(1).
22 Art. 22(7) of the U.S.-Malta Treaty would deny treaty benefits if the payments are not remitted into Malta.
Jeffrey L. Rubinger is a tax partner in Holland & Knight’s Ft. Lauderdale office and is head of its South Florida tax practice. He received his J.D. from the University of Florida School of Law and an LL.M. in taxation from New York University School of Law. Mr. Rubinger is admitted to the Florida and New York bars and is a certified public accountant.
This column is submitted on behalf of the Tax Section, Guy E. Whitesman, chair, and Michael D. Miller and Benjamin Jablow, editors.