In Jnet 2013 Issue 1, KPMG discussed the potential FIRPTA implications of the New Protocol to the U.S.-Japan Income Tax Treaty ("the proposed Protocol") signed on January 24, 2013 by the governments of the United States and Japan. The proposed Protocol, when ratified, would amend the 2003 United States-Japan Income Tax Convention, as previously amended (the "2003 Treaty"), to bring that agreement into closer conformity with the current tax treaty policies of both the United States and Japan. 1
Another notable change to the 2003 Treaty that would be made by the proposed Protocol is the elimination of withholding tax on interest paid to non-financial institutions.2 Under the provisions of the current 2003 Treaty such interest is subject to a 10 percent withholding tax rate.
The proposed Protocol will not take effect until the Governments of both the U.S. and Japan complete their respective ratification processes and exchange instruments of ratification. The general consensus is that it is unlikely that the U.S. Senate will ratify the proposed Protocol before than the end of 2013. Once the proposed Protocol is ratified and instruments of ratification exchanged, the withholding tax provisions in the proposed Protocol (including withholding on interest) will be effective for amounts "paid or credited" on or after the first day of the third month following the date on which the proposed Protocol enters into force.3 Thus, for example, if the proposed Protocol enters into force on January 1, of a year, then no withholding tax would apply to interest paid or credited on or after April 1, of that year.
Given the anticipated reduction in the withholding tax rate for interest, multinational corporations that have intercompany loans outstanding between their U.S. and Japanese affiliates may be inclined to consider deferring the payment of interest until the new withholding tax rates under the proposed Protocol take effect. This article provides an overview of certain U.S. and Japanese tax considerations related to deferring interest payments on inter-company loans.
Whether it may be possible to qualify for the zero percent withholding rate under the proposed Protocol by deferring U.S. source interest payments on a loan from a Japanese company to a U.S. affiliate until after the effective date of the proposed Protocol depends on the specific facts.
As noted above, the proposed Protocol, once ratified, will be effective for amounts "paid or credited" on or after the effective date. Whether an amount of interest is treated as paid or credited by a U.S. person for purposes of the 2003 Treaty and proposed Protocol is determined under U.S. law.4
Under its domestic tax rules, the United States imposes withholding tax on fixed or determinable annual or periodic income when a payment of an amount subject to withholding is made to a foreign person.5 A payment is considered made when the amount would be includible in the income of the beneficial owner under the U.S. tax principles governing the cash method of accounting6 , which tax the income when it is actually or constructively received by the taxpayer.7
Based on U.S. tax rules and the proposed Protocol, if interest is not paid or credited to the taxpayer's account until after the proposed Protocol enters into force, it may qualify for the zero percent withholding rate. Depending on the terms of the loan agreement, however, interest may be treated as constructively received prior to the date of actual payment. Income is to be included in gross income for the taxable year in which it is actually or constructively received.8 Income is treated as constructively received when it is "credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given."9 For example, if the loan agreement provides for interest payments on specific dates (e.g. quarterly payments), the lender could be deemed to be in constructive receipt of these payments on the specified dates even if the lender instructed the borrower to delay payment, and the constructive receipt would trigger withholding tax liability.
If a loan agreement provides for interest payments on specified dates, the parties may want to consider significantly modifying the agreement such that it might be treated as a new loan. The new loan then could provide for interest accruals but not specify payment dates. In general, a modification of a loan instrument is a significant modification if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.10 For example, changes in the amount of interest under a loan agreement11 or the deferral of scheduled payments12 can qualify as a significant modification. To the extent there is a significant modification and a new loan issued, then gain or loss may also need to be realized from the exchange.13
If an interest payment can be deferred and thus qualify for the zero percent withholding rate under the proposed Protocol, for example because the loan agreement does not provide for specific payment dates or because it can be significantly modified to not provide specific payment dates, a U.S. corporation also must consider the collateral consequences of deferring interest payments to Japan. For example, Internal Revenue Code ("IRC") §267 may apply to defer a deduction for accrued interest until the interest is actually considered to be paid for withholding tax purposes.14 The regulations provide an exception that makes this general matching rule inapplicable for amounts exempt from tax under a treaty, but interest payments are expressly excluded from this regulation.15 As a result, if a U.S. company defers interest payments to its Japanese affiliate, it may also be required to defer its interest expense deduction until the year in which interest is actually paid.
Further, IRC §163(j) limits the deductibility of interest expense where a taxpayer has "excess interest expense" in a taxable year. If a U.S. corporation defers interest payments on a loan to a Japanese affiliate until the proposed Protocol is effective, it may have two or more years of interest expense all reported in a single tax year. For purposes of determining the limitation on deductibility of interest by the U.S. subsidiary under IRC §163(j), such interest will be taken into account in the year it is paid, and not in the year accrued.16 Thus, for example, if the proposed Protocol were to enter into force in 2014, and if the U.S. subsidiary defers the payment of interest accrued in 2013 until after the proposed Protocol entered into force in 2014, for purposes of IRC §163(j) limitation calculation, such interest will be viewed as paid or accrued in 2014 along with any interest related to 2014 that is paid during 2014. With its interest expense in 2014 being approximately double the amount of what it would generally have, the U.S. subsidiary may be in an excess interest position for 2014. However, given that its 2013 interest expense was reduced by the same amount of the deferred interest, it may also have excess limitation carryover from 2013 to 201417 to help offset its 2014 excess interest. Thus, the U.S. subsidiary could find itself neutral from an IRC §163(j) perspective.
In the context of Japanese source interest paid on a loan from a U.S. company to a Japanese affiliate, Japanese law controls whether deferring interest payments by the Japanese affiliate until the proposed Protocol enters into force would achieve a Japanese withholding tax rate reduction. We express no view on how Japanese law would apply.
We note, however, that the 2003 Treaty includes separate effective dates for U.S. and Japanese purposes for the interest withholding tax provisions in the 2003 Treaty.18 While the United States applied the 2003 Treaty to amounts paid or credited after the effective date, Japan applied the 2003 Treaty to amounts "due to be received" on the effective date.19 In other words, the United States adopted a cash basis approach while Japan appeared to have adopted an accrual basis approach. The proposed Protocol, in contrast, does not include different entry into force provisions for the United States and Japan, and instead requires both countries to apply the new withholding tax rates introduced by the proposed Protocol to amounts "paid and credited" on or after the effective date. It is unclear if the U.S. and Japan intended the proposed Protocol to have different entry into force provisions than those in the 2003 Treaty, whether the proposed Protocol may be amended to eliminate this difference.
Assuming that deferral of interest payments is possible in Japan, we next consider the potential impact on the U.S. lender under the entry into force provisions of the proposed Protocol as released. First, a U.S. corporation that uses the accrual method of accounting would be required to include accrued interest in its U.S. taxable income on an accrual basis, regardless of the payment date.20 Assuming the accrued interest is foreign source income of the U.S. corporation there are at least two reasons the U.S. corporation may not have foreign tax credits available to offset U.S. tax on the interest income. First, assuming that liability for withholding tax does not accrue under Japanese law until actual payment (we express no view on how Japanese law would actually apply), there would be no foreign taxes paid or accrued at the time the accrued interest is taken into account. Second, when actual payment is made, there would be no withholding tax imposed assuming payment is made after the proposed Protocol is effective.
If the earnings of the Japanese subsidiary are of relevance for U.S. tax purposes (such as when the Japanese subsidiary is treated as a controlled foreign corporation21), the interest expense of the Japanese subsidiary may be allowed as a deduction in calculating its earnings and profits, assuming the U.S. parent includes the corresponding interest income in its taxable income on accrual basis.22
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE U.S.ED, AND CANNOT BE U.S.ED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
1. Protocol Amending the Convention Between the Government of the United States of America and the Government of Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (January 24, 2013) ("proposed Protocol").
2. Proposed Protocol, Article IV.
3. See Article XV, paragraph 2(a) of the proposed Protocol.
4. See Announcement 2004-60, 2004-2 C.B. 43 (providing guidance on effective dates under the 2003 Treaty).
5. Treas. Reg §1.1441-1(b)(1). See also IRC§ 881 (defining fixed or determinable annual or periodic income earned by a corporation).
6. Treas. Reg. §1.1441-2(e)(1)
7. Treas. Reg. §1.446-1(c)(1)(i). Under Treas. Reg. §1.451-2(a), the taxpayer is deemed to be in constructive receipt of income when "it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions."
8. Treas. Reg. §1.451-1(a).
9. Treas. Reg. §1.451-2(a).
10. Treas. Reg. §1.1001-3(e)(1).
11. Treas. Reg. §1.1001-3(e)(2) (Changes in the yield of a debt instrument constitutes a substantial modification if the yield is modified by more than the greater of (i) 25 basis points, or (ii) 5 percent of the annual yield of the original instrument).
12. Treas. Reg. §1.1001-3(e)(3) (Deferral of scheduled payments for a period equal to the lesser of five years or 50 percent of the loan agreement's original term constitutes a substantial modification).
13. Treas. Reg. §1.1001-3(a)(1) (referring to Treas. Reg. §1.1001-1(a)).
14. Treas. Reg. §1.267(a)-3(b)(1).
15. Treas. Reg. §1.267(a)-3(c)(2).
16. Prop. Reg. §1.163(j)-7(b)(2).
17. Per IRC §163(j)(2)(B)(ii), the taxpayer can carry forward the excess limitation to the following three taxable years to offset any excess interest in such years.
18. 2003 Treaty Art. 30. See also Announcement 2004-60, 2004-2 C.B. 43 (providing guidance on effective dates under the 2003 Treaty).
19. See Article 30, paragraph 2(a) of the 2003 Treaty.
20. Treas. Reg. §1.451-1(a).
21. Within the meaning of IRC §957(a).
22. Treas. Reg. §1.964-1(a) (earnings and profits of a foreign corporation computed substantially as if a domestic corporation); IRC §267(a)(2). Note that IRC §267(a)(3) (which defers interest deductions until actual payment) only applies to payments made to foreign corporations.