In this long-read, we’ll break down the key aspects of the Tax Treaty between the Netherlands and the United States (“NL-US Tax Treaty”). We’ll explain how it functions, its purpose, and the process for claiming treaty benefits.
Tax treaties exist to divide taxing rights, preventing situations where the same income is taxed twice if two countries apply their domestic tax laws on the same item of income. If such double taxation wouldn’t be prevented, international economic traffic would be highly discouraged.
In essence, a tax treaty as a referee, determining which country has the right to tax specific income, while the other must provide relief to eliminate double taxation. However, it’s important to note that tax treaties do not create taxing rights, but merely divide taxing rights.
A common example of overlapping taxation between the US and the Netherlands arises from their respective tax systems. The US taxes individuals based on nationality, whereas the Netherlands taxes based on residency. Without the NL-US Tax Treaty, a US national residing in the Netherlands could face the situation where both countries would subject this person to Personal Income Tax.
This example clearly illustrates the importance of claiming tax treaty benefits:
The purpose of the double tax agreement
The purpose of a tax treaty plays a crucial role in interpreting its provisions, as it provides context and guidance for resolving ambiguities. Historically, tax treaties were primarily established to prevent double taxation on income, ensuring that individuals and businesses operating abroad were not taxed twice on the same item of income. This objective was particularly important for encouraging international trade and investment.
However, starting in the 1990s and continuing into the 2000s, increased public scrutiny and debate over international tax avoidance and evasion led to significant changes in the design of tax treaties. A second objective of tax treaties was prompted: the prevention of tax avoidance and evasion.
The dual purpose of tax treaties – both preventing double taxation and combating tax avoidance and evasion – has been incorporated into most tax treaties, including the NL-US tax treaty:
“THE PRESIDENT: I have the honor to submit to you, with a view to its transmission to the Senate for advice and consent to ratification, the Convention Between the Government of the United States of America and the Government of the Kingdom of the Netherlands for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, signed at Washington on December 18, 1992. The Convention would replace the 1948 income tax convention between the United States and the Netherlands, which was last amended in 19651.”
Any treaty’s basic building blocks will look like this:
And for more background on how Tax Treaties work, check out our primer blog post:
Tax residency
When assessing tax residency for tax treaty purposes, it is important to distinguish between individuals and entities, as the criteria and tie-breaker rules differ for each.
Individuals
The starting point for tax residency is the domestic law of both countries involved. If both countries consider the induvial a tax resident under their respective domestic laws, a set of tie-breaker rules is applied to resolve the ‘conflict’:
- Permanent home: the individual is deemed a tax resident of the country where he has a permanent home available.
- Centre of vital interests: if a permanent home is held in both countries, residency is determined based on the individual’s strongest personal and economic ties.
- Habitual abode: if the centre of vital interests cannot be determined, tax residency is determined based on where the individual regularly resides.
- Nationality: if the habitual abode test is also inconclusive, nationality becomes the deciding factor.
- Mutual agreement: if the individual is a national of both or neither countries, the authorities of both countries will have to decide by mutual agreement.
Entities
Typically, a corporate entity is tax resident in the country where it is liable to tax on the basis of domestic law by reason of its domicile, residence, place of management or place of incorporation. Where an entity is considered a tax resident in both countries under the respective domestic laws, its tax residency must be determined by the authorities on the basis of mutual agreement. In this determination, the authorities take into account several factors, including:
- Place of effective management: the location where key business decisions and strategic control are regularly exercised.
- Place of incorporation: the country where the entity was originally incorporated.
- Other relevant factors: any additional elements that may help determine the entity’s tax residency status.
Real Estate
Income from real estate is typically taxed on the basis of the situs principle, meaning that taxing rights are assigned to the country where the property is physically located. This approach ensures the country with the closest economic connection to the property retains its rights to impose taxes on the income derived from it. The other country has to eliminate double taxation.
Business Income / Permanent Establishment
Business income is generally taxed in the country where the enterprise is resident, unless the enterprise has a so-called permanent establishment in the other country. This rule applies equally to businesses operated by individuals and corporate entities, as tax treaties do not distinguish between them in this context.
Permanent establishment
A permanent establishment for corporate income tax purposes is defined as a ‘fixed place of business’. However, in practice, this concept is far more complex and entire readings have been published to interpreting its nuances. Historically, the term permanent establishment was designed to address traditional business models where a company from one country established a physical presence – such as a store, office, or factory in the other country. However, in today’s digital and global economy, the concept of a permanent establishment has evolved to include a far broader range of business activities such as (conditions apply):
- Data centers
- Storage and distribution facilities
- Pop-up and flagship stores
- Online business operations
It goes beyond the scope of this article to provide a full overview of the definition of a permanent establishment, but the key take-away is that when an enterprise has physical presence in another country, it may also have a taxable presence in that country. If so, the enterprise may have an obligation to file tax returns and pay taxes in that country.
Claiming tax treaty benefits to avoid double taxation
To prevent double taxation, businesses that are taxed on their foreign income should seek tax treaty relief in their country of residence.
It is essential to take timely action, as claiming tax treaty benefits may be subject to statutes of limitations in the residence country. Delays in compliance could result in tax interest charges and penalties in the country where the permanent establishment is constituted. Thus, businesses engaged in cross-border operations should proactively assess their tax obligations to ensure compliance and optimize tax treaty benefits.
Dividends / Interest / Royalties
Many countries impose a withholding tax on outbound cross-border payments of dividends, interest and royalties. This means that the country where the payment originates has the right to withhold taxes before the funds are transferred to the recipient [levy at source].
For example, where a company distributes dividends to a shareholder abroad, it must first withhold and remit tax in the country where the distributing company is located. As a result, the recipient receives a net dividend after withholding tax as been deducted, reducing the actual amount of income received.
Double taxation risks
At the same time, the gross amount of dividends (i.e., before withholding tax) is often considered taxable income in the recipient’s country of residence. Without treaty relief, this could lead to double taxation – once at the source where the payment is made and again in the recipient’s country of residence.
US-NL tax treaty relief
To mitigate double taxation, tax treaties often establish limits on withholding tax rates and provide mechanisms for tax relief. Under the US-NL tax treaty, the withholding tax on dividends paid to individuals for instance, is capped at 15%.
Additionally, while the recipient’s country of residence retains the right to tax dividend income, it must grant a tax credit for the withholding tax already paid. This ensures that the total tax burden on the dividend does not exceed what would be due if the income were earned domestically.
By reducing withholding tax rates and allowing for tax credits, treaties like the US-NL tax treaty help facilitate cross-border investment.
Income from employment
As a starting point, income from employment is taxed in the country of residence of the employee, unless the employment is exercised in the other country. In the latter case, the work state is allowed to tax the employment income.
Tax treaties often include provisions to prevent (excessive) taxation of short-term work assignments abroad. The country of residency retains the exclusive right to tax employment income if all the following conditions are met:
- Limited presence in the work state: the employee’s physical presence in the work state does not exceed 183 days within the tax year.
- Employer location: the remuneration is not paid by (or on behalf of) an employer in the work state; and
- No permanent establishment: the remuneration is not borne by a permanent establishment of the employer in the work state.
If the above conditions are met, the work state is not permitted to tax the employment income. The country that loses its taxing right has to eliminate the double taxation.
Limitation on benefits clause
The Limitation on Benefits (LOB) clause in the NL-US tax treaty is designed to prevent treaty shopping, where companies from third countries try to gain undue benefits from the treaty. The clause ensures that only legitimate residents of the Netherlands or the US can access the treaty’s reduced tax rates and other advantages. Not meeting the LOB clause results in tax treaty benefits being denied.
Key Elements of the LOB Clause
Qualifying Persons
The treaty lists categories of persons and entities that automatically qualify for treaty benefits, such as:
- Individuals who are tax residents.
- Governments and government entities.
- Publicly traded companies meeting certain listing and ownership requirements.
- Certain non-profit organizations and pension funds.
Ownership and Base Erosion Tests
If an entity is not automatically qualified, it may still be eligible if:
- At least 50% of its shares are owned by qualified residents.
- It does not significantly erode its taxable base by making deductible payments (e.g., interest, royalties) to non-residents.
Active Business Test
A company engaged in an active trade or business in its country of residence can claim treaty benefits, provided:
- The income it seeks treaty benefits for is connected to its business activities.
- The business is substantial relative to the income-generating activities.
Derivative Benefits Test
A company may qualify if it is at least 95% owned by residents of countries with comparable tax treaties with the US or the Netherlands.
Discretionary Relief
If a company does not meet the above tests, it can request the tax authorities for discretionary relief by proving that its structure and operations have a valid economic reasons, not including tax benefits.
Methods to eliminate double taxation
To prevent double taxation, the US-NL tax treaty applies one of two methods:
- Exemption method: the foreign income is entirely exempt from taxation in the residence country.
- Tax credit method: the residence country includes the foreign income in taxable income but grants a tax credit for taxes already paid abroad.
Economic differences: capital import vs. capital export neutrality
The choice between both methods of double taxation relief:
- Exemption method & capital import neutrality: under this method, the tax rate of the source country (i.e., where the income is earned) determines the total tax burden. This ensures that all businesses operating in that market – whether domestic or foreign – are taxed at the same rate, promoting a level playing field.
- Tax credit method & capital export neutrality: the tax rate of the residence country remains decisive. This ensures that all business operating from the same country of residence face the same tax rates.
Policy choices: the Netherlands vs the US
Different (types of) economies have different priorities when structuring their international tax policies.
The Netherlands, as a small open economy, typically favours the exemption method. This approach ensures that Dutch businesses expanding internationally do not face fiscal barriers, allowing them to compete effectively in foreign markets.
The US, with its large domestic market, on the other hand, more commonly applies the exemption method. This approach ensures that US businesses, whether operating domestically or internationally, remain subject to comparable tax treatment.
Numerically, this looks as follows:
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The Tax Treaty between the Netherlands and the United States is one of the world’s most heavy traffic treaties. However, it is also one of the most compliacted ones, deviating significantly from the OECD-Model Template. If you’d like to discuss whether you can invoke its benefits, and how it may apply – book a slot! We’re geeks for this after al, so we’re happy to help.
