Rev. Rul. 77-435

Advice has been requested whether, under the circumstances described below, a dividend paid to a Netherlands Antilles corporation qualifies for the 5 percent withholding rate as provided in the withholding regulations for Article VII(1) of the Income Tax Convention of April 28, 1948, between the United States and the Netherlands, T.D. 5778, 1950-1 C.B. 92, as extended to the Netherlands Antilles by the Protocol of June 15, 1955, T.D. 6153, 1955-2 C.B. 777, (the Convention), and as modified and supplemented by the Protocol of October 23, 1963, 1965-1 C.B. 624, (the Protocol).

P, a foreign corporation organized under the laws of the Netherlands Antilles (the Antilles), owns 100 percent of the stock of domestic corporation S-1, which, in tum, owns 100 percent of the stock of domestic corporation S-2. P is a holding company entitled to the special tax benefits provided under Article 14 of the Netherlands Antilles' National Ordinance on Profits Tax of 1940, as in effect on and after September 1, 1963. P, S-1, and S-2 all use the calendar year for accounting purposes. S-1 and S-2 did not file consolidated returns in the years in question.

In 1975 S-1 paid a dividend to P. In connection with this dividend, S-1 filed with the Commissioner of Internal Revenue the information required by section 505.302(c) (2) of the Convention withholding regulations and claimed the 5 percent withholding rate on the dividend as provided in those regulations for Article VII(l) of the Convention.

The information filed by S-1 with the Commissioner pursuant to Rev. Proc. 66-40, 1966-2 C.B. 1245, indicated that for the 3-year period, 1972 through 1974, 34 percent of S-I's aggregate gross income for such period was derived from manufacturing with the remainder consisting of portfolio investment dividends (25 percent) and intercorporate dividends from S-2 (41 percent). However, in 1972, 70 percent of S-I's gross income consisted of dividends from portfolio investments with the remainder consisting of manufacturing income (20 percent) and intercorporate dividends from S-2 (10 percent).

Article II (2) of the Convention provides, in part, that when the United States applies the provisions of the Convention, any term not specifically defined therein shall, unless the context otherwise requires, have the same meaning as the term has under the Internal Revenue Code of 1954.

Article VII(L) of the Convention, as it applies to dividends paid to Antilles corporations, provides, in part, for a United States rate of tax not to exceed 5 percent if the Antilles corporation controls, directly or indirectly, at least 95 percent of the entire voting power in the corporation paying the dividends, and not more than 25 percent of the gross income of the paying corporation is derived from interest and dividends, other than interest and dividends from its own subsidiary corporation.

Section 505.302(c) (1) of the Convention withholding regulations, for purposes of withholding at source on dividends paid to an Antilles corporation, provides, in part, that a United States source dividend paid to an Antilles corporation shall riot be taxed at a rate in excess of 5 percent if not more than 25 percent of the gross income of the paying corporation for the 3-year period immediately preceding the taxable year in which the dividend is paid consists of dividends and interest (other than dividends and interest received by such paying corporation from its own subsidiary corporations, if any).

Section 505.302(c) (2) (iv) of the Convention withholding regulations provides, in part, that any domestic corporation claiming that dividends paid or to be paid by it are subject to a rate of tax not in excess of 5 percent shall file with the Commissioner of Internal Revenue the amounts by years (for the 3-year period immediately preceding the taxable year in which the dividend is paid) of the gross income of the domestic corporation, of the interest and dividends included in such gross income, and of the interest and dividends received by the domestic corporation from its own subsidiary corporations, if any.

Article (I) (1) of the Protocol provides, in part, that Article VII(1) of the Convention does not apply to income derived from sources within the United States by any holding company entitled to any of the special tax benefits provided under Article 13, Article 14, or Article 14A of the Netherlands Antilles National Ordinance on Profits Tax of 1940, as in effect on and after September 1, 1963.

Article I (2) (a) of the Protocol provides, in part, that Article VII(1) of the Convention shall continue to apply to United States source dividends even when received by an Antilles corporation entitled to the above special tax benefits if the payor corporation is a United States corporation (other than a United States corporation, 60 percent or more of the gross income of which is derived from dividends, royalties, rents from real property, gain from the sale or other disposition of stock, securities, or real property, or interest except to the extent derived by a corporation the principal business of which is the making of loans).

The specific issues considered in the instant case relate to the effect of the 60 percent gross income test in Article 1(2) (a) of the Protocol on S-I's claim to the 5 percent withholding rate on the 1975 dividend to P, pursuant to the Convention withholding regulations for Article VII(1) of the Convention.

Issue 1:

The first question is what period of measurement is to be used for the 60 percent gross income test in Article I(2) (a) of the Protocol.

Although Article I(2) (a) of the Protocol does not specify a period of measurement for the 60 percent gross income test, section 505.302(c) (2) (iv) of the Convention withholding regulations, in part, requires that, for purposes of measurement for the 25 percent test in Article VII of the Convention, the information described in the section be filed "for the 3-year period immediately preceding the taxable year in which the dividend is Sections 2(b) (1) (iii) and (5) Rev. Proc. 66-40 require a domestic corporation to file information th the Commissioner with respect the 60 percent test comparable to hat required by section 505.302(c) (2) (iv) with respect to the 25 percent test.

Accordingly, the measuring period for the 60 percent test in Article I (2) (a) of the Protocol is the 3-year period immediately preceding the taxable year in which the dividend is paid.

Issue 2:

The next question is whether the 60 percent gross income test in Article I (2) (a) of the Protocol is to be applied on a year-by-year or an aggregate basis for the 3-year period. Because neither the Convention, its regulations, nor the Protocol defines the term "3 year period," that temi will have the same meaning as it has under the Code, pursuant to Article II (2) of the Convention.

Rev. Rul. 65-260, 1965-2 C.B. 243, holds that the term "3-year period," referred to in sections 921 (1) and 931 (a) of the Code means a period of 36 months immediately preceding the close of the taxable year. Sections 921 (1) and 931 (a) contain 3-year period gross income tests substantially similar to the 60 percent and 25 percent gross income tests in Article I(2) (a) of the Protocol and Article VII(L) of the Convention. See also, Rev. Rul. 74-275, 1974-1 C.B. 376.

Accordingly, the 60 percent gross income test in Article I(2)(a) of the Protocol is applied on an aggregate basis for the 36-month period preceding the year of payment of the dividend to an Antilles corporation. Thus, the fact that 70 percent of S-l's gross income in 1972 consisted of dividends from portfolio investments does not, in itself, prevent S-1 from satisfying the 60 percent test of Article I(2)(a).

Issue 3:

The remaining question is whether S-2's dividends to S-1 are included in the computation of the 60 percent gross income test in Article I(2)(a) of the Protocol.

Article I(2)(a) of the Protocol does not specifically define, nor does it exclude intercorporate dividends from, the term "dividends" for purposes of the 60 percent test. Although intercorporate dividends are expressly excluded from the term dividends under Article VII(1) of the Convention for purposes of the 25 percent test, this test is separate from the 60 percent test and does not control the meaning of dividends for purposes of the 60 percent test. Also, no general definition for the term dividends is provided by the Convention. Because Article II(2) of the Convention requires that undefined terms in the Convention have the same meaning as those terms have under the Code and because under the Code the term dividends ordinarily includes intercorporate dividends, the term dividends as used in Artide I(2)(a) of the Protocol includes intercorporate dividends. See section 61(a)(7) of the Code, which provides that gross income means all income from whatever source derived, including, but not limited to, dividends; and section 1.61-9(a) of the Income Tax Regulations, which provides, that unless otherwise specifically provided, dividends are includible in gross income under section 61.

Accordingly, intercorporate dividends are considered dividends for purposes of the computation of the 60 percent gross income test in Article I(2)(a) of the Protocol. Since 66 percent of S-l's gross income for the 1972-74 3-year period consisted Of portfolio investment dividends (25 percent) and dividends from S-2 (41 percent), S-1 does not satisfy the 60 percent gross income test in Article I(2)(a), and thus cannot qualify for the 5-percent withholding rate under the witholding [sic] regulations for Article VII(1) of the Convention.