company tests must have acquired shares representing 80 percent or more of the voting stock of
the company paying the dividends prior to October 1, 1998. This restriction supplements those
imposed under Article 17 (Limitation on Benefits), and is necessary because of the increased
pressure on the Limitation on Benefits tests resulting from the fact that the Convention is one of
the first U.S. tax treaties to provide for a zero rate of withholding tax on intercompany dividends.
The test is intended to prevent companies from re-organizing in order to become eligible for the
zero rate of withholding tax in circumstances where the Limitation on Benefits provision does
not provide sufficient protection against treaty-shopping.
For example, assume that ThirdCo is a company resident in a third state. ThirdCo owns
directly 100% of the issued and outstanding voting stock of USCo, a U.S. company, and of
MEXCo, a Mexican company. MEXCo is a substantial company that manufactures widgets;
USCo distributes those widgets in the United States. If ThirdCo contributes to MEXCo all the
stock of USCo, dividends paid by USCo to MEXCo would qualify for treaty benefits under the
active trade or business test of subparagraph (c) of paragraph 1 of Article 17. However, allowing
ThirdCo to qualify for the zero rate of withholding tax, which is not available to it under the third
state’s tax treaty with the United States (if any), would encourage treaty-shopping.
In order to prevent this type of treaty-shopping, the Convention imposes an additional
holding requirement on companies that qualify for benefits only under paragraphs 1(c) (the
active trade or business test), 1(d)(iii) (the subsidiaries of a publicly traded NAFTA company
test) or 1(f) (the ownership-base erosion test) of Article 17. For those companies, the zero rate of
withholding tax is available only with respect to dividends received from companies that the
recipient company owned, directly or indirectly, prior to October 1, 1998.
Accordingly, in the example above, MEXCo will not qualify for the zero rate of
withholding tax on dividends unless it owned USCo before October 1, 1998. If it did own USCo
before October 1, 1998, then it will continue to qualify for the zero rate of withholding tax on
dividends so long as it qualifies for benefits under at least one of the tests of Article 17. So, for
example, if ThirdCo decided to get out of the widget business and sold its stock in MEXCo to
FWCo, a company that is resident in a country with which the United States does not have a tax
treaty, MEXCo would continue to qualify for the zero rate of withholding tax on dividends so
long as it continued to meet the requirements of the active trade or business test of Article
17(1)(c) or, possibly, the competent authority discretionary test of Article 17(2).
The results would be different under the “ownership-base erosion” test of Article
17(1)(f). For example, assume MEXCo is a passive holding company owned by Mexican
individuals, which was established in 1996 to hold the shares of USCo. MEXCo qualifies for
benefits only under the ownership-base erosion test of Article 17(1)(f). If the Mexican
individuals sold their stock in MEXCo to FWCo, MEXCo would lose all the benefits accorded to
residents of Mexico under the Convention (including the zero rate of withholding tax on
dividends) because the company would not longer qualify for benefits under Article 17 (unless,
of course, the U.S. competent authority were to grant benefits under Article 17(2)).
Other methods of qualifying under Limitation on Benefits do not raise the same concerns.
Accordingly, a resident of a Contracting State that satisfies Limitation on Benefits by virtue of
9