The United States has a tax treaty crisis on its hands caused by Congress’s failure to ratify any new bilateral tax treaties or update existing ones since 2010. It sounds unbelievable, but nearly a decade has passed since the United States last changed its tax treaties. Other countries consistently revisit their treaties while creating new ones to protect their tax bases in the competitive international tax environment.
U.S. tax treaties are also mired in controversy because of the Tax Cuts and Jobs Act (P.L. 115-97). There is concern that TCJA protectionist international tax provisions could violate U.S. tax treaty nondiscrimination provisions and the OECD model tax convention, preventing taxpayers from receiving full foreign tax credits. Primary concerns lie with the base erosion and antiabuse tax and the global intangible low-taxed income tax, both of which impose minimum taxes on different kinds of foreign-source income.
Conflicts and discrepancies are inevitable in an undertaking as large as tax reform. But in this latest effort, international uncertainties have been exacerbated by Congress’s silence on whether it intended tax reform provisions to overtake conflicting treaty provisions. Lawmakers aren’t done cleaning up the current bill — regulations and a purported “phase 2” of the reform plan are pending and could address these treaty concerns. If not, there are workarounds that could be a realistic solution.
Tax Treaties and the Savings Clause
There are several rules of engagement attached to U.S. tax treaties. Like many countries, the United States applies a savings clause to its treaties that generally preserves the right of each treaty partner to tax its residents and citizens under domestic law as if the treaty did not exist (U.S. model income tax convention, article 1(4)). There are some exceptions — the savings clause doesn’t override the nondiscrimination provisions in any treaty, an important point regarding the TCJA and the BEAT.
The nondiscrimination provision in article 24 of the U.S. model treaty blocks the United States from imposing taxes on entities in the treaty partner’s jurisdiction that are more burdensome than those the IRS would impose on domestic entities. The same applies to treaty partners and their treatment of U.S. taxpayers. Both sides must also treat interest, royalty payments, and other disbursements in a nondiscriminatory manner, subject to some exceptions. A payment made by a U.S. company to a company in a treaty country must be deductible as if it was paid to a U.S. company, and vice versa. Article 24 of the OECD model tax convention addresses similar nondiscrimination concerns.
What happens if a tax treaty conflicts with a U.S. statute? The surface-level answer is clear-cut. The deeper explanation is murkier. The clear-cut answer is that under IRC section 7852(d), neither one has preferential status over the other. But in a battle of wills, one must prevail. In fact, a so-called last-in-time rule engineered by the courts applies, facilitating application of the most recent provision.
While Congress and the courts try to harmonize U.S. tax statutes with treaties, the last-in-time rule allows Congress to pave over existing treaties and change the rules by passing conflicting legislation. The last time lawmakers overhauled the tax system, they made it clear that the branch profits tax, strongly divisive at the time, did not supersede the country’s bilateral tax treaties. This time around, Congress implemented international tax reform without mentioning whether it meant to override existing treaties.
Several tax practitioners have pointed out that this raises a whole host of questions that make a sensitive issue even more thorny. They are asking whether Congress forgot to address potential conflicts in the TCJA, or just thought they didn’t exist. Furthermore, according to panelists at the American Bar Association’s 2018 May tax meeting, it is unclear whether the later-in-time rule applies if Congress does not recognize that there is a conflict between treaty and law.
GILTI and FDII Questions
Section 951A imposes a minimum tax on GILTI earned by U.S. shareholders of controlled foreign corporations. Broadly speaking, it is calculated by taking a shareholder’s net CFC-tested income and dividing it by the shareholder’s net deemed tangible income return. U.S. CFC shareholders must include their pro rata share of GILTI in current income, but shareholders that are C corporations can get a deduction — up to 50 percent of their GILTI amount. This means that C corporation shareholders are taxed on their GILTI income at a 10.5 percent rate, increasing to 13.125 percent in 2026.
Noncorporate shareholders are not so lucky — they do not receive a deduction. The good news is that taxpayers can receive a foreign tax credit for GILTI taxes paid. GILTI goes in its own limitations basket and cannot be carried forward or backward. The bad news is that the credit is limited to 80 percent of those payments, instead of a full 100 percent.
The new foreign-derived intangible income (FDII) deduction in section 250 works in tandem with GILTI, giving U.S. corporations a deduction on income derived from selling goods and services to foreign customers. Eligible taxpayers can receive a 37.5 percent corporate income tax deduction, decreasing to 21.875 percent after 2025.
There has been fear that GILTI violates article 7 of U.S. tax treaties, relating to business profits. However, this may not be the case. Article 7 says that business profits of an entity cannot be taxed by the treaty partner unless the entity does business there through a permanent establishment. Back in January, Reuven S. Avi-Yonah of the University of Michigan Law School argued in a working paper that GILTI is imposed on the U.S. related party, and that the savings clause generally gives the United States the right to tax its residents under domestic law, knocking out any potential claims. Others have made this argument as well. Lately the discussion has centered on whether the 80 percent tax credit conflicts with tax treaties that give full credit for foreign taxes.
As for FDII, some think the United States is playing unfair. Shortly before the TCJA was signed into law, finance ministers from Europe’s top five economies sent a letter to Treasury Secretary Steven Mnuchin voicing their concerns with the international provisions of the reform package, including several concerns about FDII and its interplay with established treaty norms. They argued that FDII and the resulting reduced corporate income tax rate would subsidize U.S. exports and could be subject to challenge before the WTO.
“The design of the regime is notably different from accepted [intellectual property] regimes by providing a deduction for income derived from intangible assets other than patents and copyright software, such as branding, market power, and market-related intangibles,” they said. “It would not be compatible with the [base erosion and profit shifting] consensus that has been approved by more than 100 states and jurisdictions worldwide. Furthermore, in deviation of the agreed nexus approach, the proposal will provide benefits to income from IP assets that are in no direct connection with [research and development] activity.”
BEAT Concerns
At the heart of the TCJA treaty-related questions is the BEAT, section 59A. Lawmakers created the BEAT to level the tax playing field between U.S.-owned and foreign-owned U.S. corporations, and to combat earnings stripping. It applies a 10 percent minimum tax on domestic C corporations and foreign corporations with business in the United States that have more than $500 million in gross receipts and exceed a specific number of deductible payments — like interest and royalties payments, and specific payments for services — made to a foreign related party. Financial institutions including banks and securities dealers are subject to the BEAT if 2 percent of those payments are made to foreign entities. Other entities have a 3 percent threshold.
The BEAT is calculated by taking a statutory percentage of the taxpayer’s income (including the deductible payments made to foreign related parties) and dividing that by the taxpayer’s regular liability, minus specific tax credits. The BEAT is 5 percent for the 2018 tax year, but will jump to 10 percent in 2019 and 12.5 percent in 2026.
The BEAT may violate the nondiscrimination provisions of U.S. tax treaties because it treats transactions involving foreign related parties differently from those involving domestic related parties. The BEAT essentially penalizes deductions involving foreign parties that would not be taxed if both sides were domestic companies. This appears to directly conflict with article 24, which generally says that interest, royalties, and other payments made by an enterprise in one treaty state to a resident of the other treaty state must be deductible as if they had been paid to a domestic entity. Furthermore, the United States can’t rely on the savings clause to walk itself out of BEAT-related nondiscrimination claims, because nondiscrimination provisions are exempted from the clause.
Europe’s finance ministers are worried that the BEAT will hurt international banking and insurance, because cross-border, intragroup financial transactions would not be deductible under the new law and would be subject to taxation. They say that foreign financial institutions already have strict limits on the amount of borrowing they can conduct in the United States and will be affected when undertaking genuine payments to foreign entities.
Finally, there’s the last-in-time principle. Given that the recently enacted BEAT seems to conflict with existing U.S. treaties, it ostensibly supersedes them. Yet Congress historically likes to harmonize tax statutes with tax treaties, unless it explicitly states otherwise. It never said that it meant — or did not mean — for the BEAT to overrule established treaties, leaving the issue in limbo.
Not all are convinced that the BEAT does in fact violate U.S. tax treaties, however. According to Avi-Yonah, discrimination arguments do not work against the BEAT because U.S. parties are involved on both sides, with one foreign-owned. Beyond that, the BEAT does not deny deductions, which would be a violation of article 24, according to Avi-Yonah. If anything, the BEAT is conceptually similar to broadly applied thin capitalization rules, and thin capitalization rules historically have not been identified by the OECD as discriminatory, he said. The BEAT is an attempt to protect the U.S. tax base, just as other countries are doing with diverted profit taxes and other measures.
Possible Changes and Renegotiations
Treaty concerns notwithstanding, tax reform isn’t done: Congress is still analyzing the international provisions and is working on new tax legislation — a phase 2 bill. Beyond that, Treasury’s GILTI regulations are due to be released soon. Potential conflicts may be addressed via either of these avenues.
The last time Congress implemented tax reform, it ushered in a series of updates to existing tax treaties. So the precedent certainly is there, even though Congress’s current track record on addressing tax treaties is abysmal. If lawmakers remain silent on the TCJA and treaties, there are several ways the issue can be handled.
One option is the courts, and challengers may ask the judiciary to determine whether provisions in the TCJA override existing tax treaties. A legal sidebar released by the Congressional Research Service in December mused that the TCJA would likely be favored over an existing tax treaty, based on prior Supreme Court, D.C. Circuit Court of Appeals, and Tax Court rulings. But the reality is that the United States would face international political fallout from a wholesale treaty override.
That takes us to treaty renegotiations. Congress is at a standstill on treaties — it hasn’t approved any tax treaties or treaty updates since 2010, leaving countries like Chile, Hungary, and Spain in limbo. Meanwhile, Taiwan reportedly wants to enter into a treaty with the United States, and Armenia is pushing for a renegotiation to replace its former Soviet Union treaty. Others like Ireland are in renegotiations behind the scenes.
Even though the system is clogged, tax treaty policy isn’t static, and conflicts have generally been addressed in one form or another. Commentators at the May ABA meeting pointed out that over the years, tax treaty policy has been altered because of rule changes and policy shifts from Treasury. Even in the trade context, U.S. tax rules violating trade obligations have generally taken a back seat to treaties.
Given that there are countries already seeking renegotiations, compromises on TCJA international provisions not addressed in upcoming legislation or regulations could occur in discussions. In a November 2017 draft paper, Itai Grinberg of Georgetown Law pointed out that the United States could agree to give up some of the taxing jurisdiction asserted by the BEAT in exchange for agreements that promote greater international tax stability, like agreements that stabilize residence or destination taxation.
There’s also the threat of foreign retaliation, which, depending on who you talk to, is either real or overblown. Under international norms, either partner may pull the plug on a treaty it thinks is unsatisfactory, but Grinberg says that international overrides would be difficult because tax treaties supersede domestic statutes in many countries, and such overrides generally are not the norm.
“For one reason or another, tax treaty overrides are difficult (or impossible) to achieve without abrogating the entire tax treaty,” Grinberg said. “The legal systems that prohibit tax treaty overrides include the Chinese, Dutch, French, Italian, Japanese, Spanish, and Swiss legal systems. In countries where tax treaties cannot be overridden, the likelihood of responding to the BEAT with certain types of changes within their income tax are low.”