On August 14, 2017, the United States District Court for the District of Columbia (DC District Court) decided Starr International Company, Inc. v. United States. In Starr International, the DC District Court held that the Internal Revenue Service (IRS) was not arbitrary or capricious in finding at least one of the taxpayer’s principal purposes for moving its residency to Switzerland was to obtain tax benefits under the US-Swiss Treaty.
Before discussing the facts and holding in Starr International, it is helpful to set the stage for the dispute. The United States has a bilateral tax treaty with a number of nations to avoid double taxation and encourage cross-border investments. Bilateral tax treaties provide benefits to residents of the two contracting states. The United States has a bilateral tax treaty with Switzerland (the US-Swiss Treaty). Treaty benefits under the US-Swiss Treaty are generally desirable for qualified taxpayers because treaty coverage reduces the tax on certain types of transactions, such as US-source dividend income for Swiss residents.
Article 1 of the US-Swiss Treaty provides, except as otherwise provided, the Treaty shall apply to persons who are residents of Switzerland. A person generally is treated as a resident of Switzerland if that person, under Swiss law, is liable to tax therein by reason of his domicile, residence or other similar criteria. However, Article 22, Limitation on Benefits, provides additional criteria to claim benefits provided for in the US-Swiss Treaty.
The Limitation on Benefits provision of the US-Swiss Treaty contains multiple objective tests to claim benefits provided for in the US-Swiss Treaty. All the tests provided in Article 22 aim to identify entities with legitimate, non-tax purposes for residency in Switzerland. This provision intends to stop taxpayers from “treaty shopping” and establishing residency in Switzerland with the principal purpose of obtaining benefits of the US-Swiss Treaty.
Turning now to the Starr International case. The taxpayer was based in Bermuda until approximately 2004, when it relocated to Ireland. Roughly a year after relocating to Ireland, the taxpayer sought to relocate yet again, claiming Ireland was not amenable to its charitable objectives and its assets were not sufficiently insulated from litigation in Ireland. The taxpayer and its new charitable arm were Swiss residents by the end of 2006. Subsequently, the taxpayer filed a request for treaty benefits under Article 22(6) of the US-Swiss Treaty in 2007. While waiting for a decision from the IRS, the taxpayer filed tax refund claims for the difference between the US dividend rate and the lower treaty dividend rate for the 2007 and 2008 tax years. The IRS issued a refund for 2008, but denied a refund for 2007, which prompted Starr to file a tax refund suit. The court dismissed Starr’s complaint without prejudice and permitted Starr to bring a claim under the Administrative Procedure Act (APA). In 2010, the IRS ultimately issued a final determination denying the taxpayer’s request for treaty benefits. This denial led the taxpayer to bring a claim under the APA alleging that the IRS acted arbitrary or capricious in denying treaty benefits under Article 22(6).
The taxpayer alleged treaty shopping was the legal standard the IRS is required to apply when implementing Article 22(6), meaning all entities must be awarded benefits so long as they are not treaty shopping. It argued the proper definition of treaty shopping under the Technical Explanations of the US-Swiss Treaty (Technical Explanations) requires that an entity must have a principal purpose of obtaining treaty benefits and it must be owned or established by a third-country resident. The court rejected this argument for a multitude of reasons. First, the court dismissed the taxpayer’s claim that residency merely refers to “on-paper” residency. Residency does not simply rely on the place of incorporation or location of the entity, but also considers an entity’s sufficient nexus to the contracting state and consider substance-over-form principles. Second, the court pointed out that if the taxpayer’s third-country rule for treaty shopping was valid, it would be stated as another mechanical test in Article 22. Additionally, the taxpayer’s proposed test clashed with the nature of the discretionary provision in Article 22 because it would take away any room for discretion from the Competent Authority to deny treaty benefits. The taxpayer’s reading of the provision would destroy the nature of the provision. Further, the court found that the taxpayer’s test would unduly narrow the definition of treaty shopping.
The taxpayer also argued that the Competent Authority’s determination was arbitrary and capricious because the Competent Authority overlooked essential information that would have been demanded a different result and heeded irrelevant or incorrect facts, which led to unreasonable conclusions. To support these contentions, the taxpayer provided alternative reasons for relocating to Switzerland besides low dividends tax rates under the US-Swiss Treaty. Particularly, the taxpayer argued tax considerations could not have been a primary reason for relocating to Switzerland because the treaty benefits were not guaranteed to it. The court was not moved by this argument and found US tax considerations to be a top priority for the taxpayer in relocating to Switzerland. The court also disagreed with the taxpayer’s challenge of the four sets of facts and circumstances the Competent Authority could not reconcile when deciding to grant treaty benefits to the entity. The court stated it was reasonable, not capricious, to consider the taxpayer’s previous history of residence and incorporation.
Ultimately, the court did not find anything arbitrary or capricious in the Competent Authority’s findings that one of the principal purposes for the taxpayer’s relocation to Switzerland was to obtain tax benefits under the US-Swiss Treaty.
Practice point: Taxpayers who move residency to another country should be aware of this recent case because it provides an in-depth analysis for limitation on benefits provisions, particularly in regards to Switzerland. Taxpayers should be aware of the discretion granted to the IRS in determining whether an entity qualifies under the Limitation of Benefits provision.