When a foreign corporation receives dividends from U.S. sources, the income is generally subject to tax at 30%. To avoid double taxation and encourage cross-border investments, the U.S. has entered into bilateral tax treaties with numerous countries. The bilateral tax treaty between the U.S. and Switzerland entitles Swiss-resident entities to a reduction in the tax rate applied to dividends received from U.S. sources provided it meets the criteria enumerated in the treaty. If none of the requirements listed in treaty are satisfied, the U.S. Competent Authority (“CA”) may authorize a lower rate if it determines the Swiss entity was not established for the principal purpose of obtaining treaty benefits (the CA is the official within the Treasury Department who is authorized to interpret provisions of bilateral tax treaties). The principal purpose test is designed to prevent business from establishing tax residency in a country primarily to obtain treaty benefits (i.e. treaty shopping).
Starr’s Request for Treaty Benefits
Starr International Company Inc. (“Starr”), a Swiss resident company, was once the largest shareholder of the insurance giant AIG. In 2007, Starr, which did not meet any of the criteria for the reduced dividend tax rate in the U.S.-Swiss tax treaty, petitioned the IRS for a discretionary reduction in the tax rate applicable to approximately $191 million in dividends Starr received from AIG in 2007. The CA denied Starr’s request for treaty benefits because it concluded that obtaining Swiss treaty benefits was a principal purpose of Starr’s recent relocation to Switzerland. The CA pointed to Starr’s history in low-tax jurisdictions as suggesting that it sought to avoid U.S. tax: it initially incorporated in Panama, it was first managed and controlled from Bermuda, it briefly relocated to Ireland and finally settled in Switzerland.
Starr challenged the decision, but the U.S. District Court for the District of Columbia upheld the CA’s denial of treaty benefits (see Starr International Company Inc. v. U.S. (120 AFTR 2d 2017-5488 (DC Dist Col, 8/14/2017)). Starr argued that it was not treaty shopping because Starr was a resident of Switzerland and treaty shopping always involves a resident of a country not party to the relevant tax treaty. However, the District Court rejected Starr’s definition of treaty shopping as narrow because Starr did not differentiate between “on paper” residency and bona fide residency required by the treaty. “On paper” residency is based on objective factors like domicile, nationality and place of management whereas bona fide residency is based on a substance-over-form determination that a taxpayer has a genuine connection to its “on paper” residence. Starr conceded that it was not a bona fide resident of Switzerland before it made its decision to establish residency in Switzerland and, according to the Court, in applying the principal purpose test, the CA properly looked beyond the objective factors of residency and properly concluded that Starr’s motivation for establishing bona fide residency was primarily motivated by obtaining the benefits of the U.S.-Swiss tax treaty.
Starr also argued that even if the CA applied the correct residency standard, it did not benefit from choosing Switzerland over Ireland or over its other finalists. However, the Court explained that the analysis is not limited to whether a company’s current jurisdiction is more favorable than its previous one, but rather why a company chose to establish itself in Switzerland over any other jurisdiction (a totality of the circumstances inquiry). In addition, the Court concluded that tax considerations were obviously important because Starr acknowledged that U.S. tax was one of four key criteria that the company analyzed in its decision to establish tax residency in Switzerland.