Rev. Rul. 84-152

ISSUE

Whether the exemption provided by Article VIII(1) of the United States-Netherlands Income Tax Convention (the Convention), T.D. 5778, 1950-1 C.B. 92, as supplemented by the Protocol of June 15, 1955 and extended on November 10, 1955 to the Netherlands Antilles (Antilles), 1956-2 C.B. 1116, and as modified and supplemented by the Protocol of October 23, 1963 (1963 Protocol), 1965-1 C.B. 624, is applicable to interest payments made by a domestic corporation to an Antilles corporation under the circumstances described below.

FACTS

P, a corporation organized under the laws of Switzerland, owns 100 percent of the stock of S, a corporation organized under the laws of the Antilles and engaged in business there. P also owns 100 percent of the voting stock and voting power of R, a domestic corporation engaged in manufacturing in the United States.

R required a significant increase in working capital for purposes of upgrading its production capabilities. On August 1, 1984, P agreed to lend to S an amount approximating the funds required by R at an annual interest rate of 10 percent. S shortly thereafter reloaned the proceeds of this loan to R at an annual interest rate of 11 percent. S is not sufficiently liquid to make the loan to R out of funds other than those obtained from P.

Thereafter, R made timely interest payments to S, and S made timely interest payments to P. Any excess revenue after expenses with respect to the financing arrangement was retained by S. Neither R nor S was thinly capitalized.

S is not entitled to any of the special tax benefits provided under Articles 13, 14, or 14A of the Netherlands Antilles' National Ordinance on Profit Tax of 1940, as in effect on September 1, 1963, or to substantially similar tax benefits granted under any law of the Antilles enacted after that date.

Neither P nor S is engaged in a trade or business within the United States through a permanent establishment.

LAW AND ANALYSIS

Section 881(a)(1) of the Internal Revenue Code, except as provided in the portfolio interest exemption in new subsection (c) (added to section 881 by section 127 of the Tax Reform Act of 1984) generally imposes a 30 percent tax on any interest received by a foreign corporation from sources within the United States, to the extent such interest is not effectively connected with the conduct of a trade or business within the United States. Section 1442(a) provides generally that such tax is to be deducted and withheld at the source of the income.

Under section 881(c) of the Code, the 30 percent tax under section 881(a)(1) or (3) is not imposed on portfolio interest received by a foreign corporation from sources within the United States.

Section 881(c)(3)(B) of the Code provides, in part, that for purposes of that subsection the term `portfolio interest` shall not include any portfolio interest which is received by 10-percent shareholder (within the meaning of section 871(h)(3)(B)).

Section 127(g)(1) of the Tax Reform Act provides that, except as otherwise provided in subsection (g), the amendments made by section 127 (including the addition of section 881(c) of the Code) shall apply to interest received after the date of the enactment of the Act (July 18, 1984) with respect to obligations issued after such date, in taxable years ending after such date.

Section 894(a) of the Code, provides that income of any kind, to the extent required by any treaty obligation of the United States, shall not be included in gross income and shall be exempt from income taxation.

Article VIII(1) of the Convention, as extended to the Antilles, provides generally that interest (other than mortgage interest) derived from sources within the United States by a resident or corporation of the Antilles not engaged in a trade or business in the United States through a permanent establishment shall be exempt from United States tax. Article I of the 1963 Protocol, which limits the applicability of Article VII(1) of the Convention, does not apply because S is not entitled to any of the special tax benefits provided under Articles 13, 14, or 14A of the Netherlands Antilles' National Ordinance on Profit Tax of 1940, as in effect on September 1, 1963, or to substantially similar tax benefits granted under any law of the Antilles enacted after that date.

Article VII(1) of the United States-Switzerland Income Tax Convention (Swiss Treaty). T.D. 6149, 1955-2 C.B. 814, provides that the tax imposed by the United States on interest derived from sources within the United States by a resident or corporation of Switzerland not having a permanent establishment in the United States shall not exceed 5 percent.

Under the facts presented here, in order for the interest exemption under Article VIII(1) of the Convention to apply to interest paid by R, such interest must be `derived . . . by` S from R. The words `derived . . . by` refer not merely to S's temporarily obtaining physical possession of the interest paid by R, but to S's obtaining complete dominion and control over such interest payments. See Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971), acq. on another issue, 1972-2 C.B. 1. In substance, S, while a valid Antilles corporation, never had such dominion and control over R's interest payments but rather was merely a conduit for the passage of R's interest payments to P. The primary purpose for involving S in the borrowing transaction was to attempt to obtain the benefits of the Article VIII(1) interest exemption for interest paid in form by R, a domestic corporation, to S, an Antilles corporation, thus, resulting in the avoidance of United States tax. This use of S lacks sufficient business or economic purpose to overcome the conduit nature of the transaction, even though it can be demonstrated that the transaction may serve some business or economic purpose. See Gregory v. Helvering, 293 U.S. 465 (1935), and Aiken Industries, Inc. v. Commissioner, supra. Thus, for purposes of the interest exemption in Article VIII(1) of the Convention, the interest payments by R will be considered to be `derived . . . by` P and not by S.

Section 881(c) of the Code does not apply to the interest payments by R because P owns 100 percent of the voting stock and voting power of R, and is considered to derive the interest paid by R. See section 881(c)(3)(B).

HOLDING

Under the facts of this case, the interest payments by R are not exempt from taxation by the United States under Article VIII(1) of the Convention, as extended to the Antilles. Further, such interest payments will be subject to a 5 percent United States withholding tax under Article VII(1) of the Swiss Treaty.

See Rev. Rul. 84-153, this page, this Bulletin, which considers the United States income tax consequences of using an Antilles subsidiary to obtain overseas financing for a domestic subsidiary of a United States parent corporation.