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Why Aren’t U.S. States Subject to International Tax Treaties?

Posted on Mar. 8, 2021

Steven N.J. Wlodychak is the former indirect (state and local) tax policy leader for EY’s Americas tax policy and a retired principal in EY’s National Tax Department in Washington.

In this installment of The Hissing Goose, Wlodychak examines the Switzerland-U.S. tax treaty in considering why states are not included in the international tax treaty system.

Here’s a question for you: What governments in the world are not subject to any of the global rules of income taxation? Renegade nations, global competitors of the United States, or tax havens might first come to mind. In actuality, look closer to home: U.S. state and local governments.

How can it be that any governmental system of taxation, let alone a subnational government like a U.S. state, is completely outside the international tax treaty system? The answer is found right in the text of the treaties themselves. As a demonstration that the states are not subject to these treaties, one U.S. income treaty is worth reviewing first — that between Switzerland and the United States.1

Why kick off with that one? What could Switzerland and the United States possibly have in common that is useful to this discussion? Despite that the United States is a huge nation that spans an entire continent and Switzerland is a small, landlocked nation covering a spectacular mountainous region in the center of Europe, from a governmental structure perspective, the two nations actually have a great deal in common: Both are organized as constitutional federations consisting of a centralized federal government with subnational governments sharing broad powers of sovereignty and self-government. Just as the United States is a federation of states that have a shared sovereignty with its federal government, the corresponding subnational units of the Swiss government are its cantons. Swiss cantons, like the states, have separate sovereign powers of government and impose, collect, and administer their own taxes.2

Regarding the conduct of foreign affairs, just like the United States under its Constitution, the Swiss national government has the power to enter into treaties with foreign governments.3 Unlike the U.S. states,4 however, the Swiss cantons have separate constitutional authority to negotiate treaties with foreign nations and even subnational governments if these powers are not otherwise limited by actions of the Swiss national government.5 The U.S. Constitution, on the other hand, expressly prohibits the states from entering into agreements with foreign governments without the consent of Congress.6 It grants sole authority to the executive branch to negotiate treaties with foreign governments, subject to approval by a vote of two-thirds of the Senate, which, as I’ll discuss later, may be one of the structural reasons U.S. international tax treaties have never been extended to the states.7 You’d think that when the two national federal governments, with so much in common, join in an income tax treaty, they would mutually agree to extend the treaty protections to the income taxes levied by their subnational governments, right?

Well, they didn’t. Take a look at section 2 of article 2 of the Switzerland-U.S. treaty describing the taxes covered. The Swiss side of the treaty says: “The existing taxes to which the Convention [the Switzerland-U.S. treaty] shall apply are: a) in Switzerland: the federal, cantonal and communal taxes on income (total income, earned income, income from property, business profits, etc.)” (emphasis added).

Thus, not only are the Swiss federal income taxes covered by the treaty but so are the income taxes imposed by the Swiss cantons and Swiss “communal” (basically, municipal) taxes.

The corresponding U.S. side of the treaty, also found in article 2, section 2 says: “The existing taxes to which the Convention [the Switzerland-U.S. treaty] shall apply are . . . b) in the United States: the Federal income taxes imposed by the Internal Revenue Code and the excise taxes imposed on insurance premiums paid to foreign insurers and with respect to private foundations” (emphasis added).

A quick comparison of the two sides of this treaty makes obvious that while the Swiss side includes the subnational income taxes levied by its cantons, the treaty, by its terms, only applies to the U.S. federal income taxes. By its silence, the Switzerland-U.S. treaty does not apply to the states. Moreover, it is not just a clear reading of the Switzerland-U.S. treaty that reaches that conclusion. The U.S. Supreme Court in considering other international bilateral treaties on taxation has, on several occasions, concluded that these treaties do not extend to the states.8

The one exception to the general inapplicability of the treaty to U.S. state taxation is in the nondiscrimination provisions of article 24.9 These provisions generally provide that the nationals of both countries are not subject to tax either by the “contracting state” (a term of art meaning the national government entering into the treaty, which does not include a U.S. state, for example) or “its political subdivisions or local authorities” that is more burdensome than the taxes imposed on its own nationals.10 In other words, the nationals of the nonresident country can’t be subject to taxation or requirements relating to those taxes that are any worse than those imposed on the country’s own residents. However, this clause by itself does not regulate or moderate the taxes that are imposed at the subnational level.

The Switzerland-U.S. treaty is just one example of the extent to which the U.S. states are not bound by international tax treaties. The same language in that treaty appears in article 2 of the U.S. model tax treaty, upon which every U.S. international tax treaty is based. Significantly, this model treaty is generally aligned with the text of a model tax treaty published by the OECD.11 Thus, based on the model treaty, U.S. international tax treaties consistently exclude the state income taxes from their coverage.

The next question is, why is this important in the context of state taxation? Nations enter tax treaties to facilitate trade and encourage investment through establishing some certainty on the taxation of transactions and businesses engaged in activities in both jurisdictions. As a threshold matter, these treaties seem to address two issues: first, when a taxing jurisdiction will impose a tax and, second, when a potential for overlap of tax by both the resident state and the nonresident state exists (a “double tax” situation), which universal standards apply to determine what income will be subject to tax by which jurisdiction.

As to the first issue, a general agreement exists that a nonresident is not subject to tax unless it has a permanent establishment in the taxing jurisdiction. Absent a PE, the nations of the world have generally agreed that they cannot impose an income tax on that individual or business. The U.S. model tax treaty defines a PE generally as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.”12 In essence, it establishes a physical presence test with clear, bright-line standards.

As to the second issue, and perhaps even more important, the international tax treaties contain clearly defined rules on double taxation. In fact, by their very names, the tax treaties emphasize the importance of dealing with problems of double taxation of each nation’s respective citizens.13 The treaties recognize the sovereign power of each nation to tax all the income of its residents. They also have rules to determine what constitutes residency for both individuals and businesses. But they acknowledge that in a mobile world, those residents could be subject to tax in the other jurisdiction based on income source. The tax treaties establish rules to avoid double taxation by providing reciprocal arrangements to enable their citizens to understand their taxing obligations to each government. Taking the Switzerland-U.S. treaty as an example, “double taxation is avoided” in Switzerland through deductions and exemptions from Swiss taxes for income subject to tax in the United States.14 In the United States, double taxation is avoided through the provision of tax credits for taxes paid in Switzerland.15 The treaty provides a mechanism for instances in which double taxation may still apply through the “competent authority” procedure, which allows an appeal to both jurisdictions to negotiate and alleviate the potential for double tax.

These standards are uniform, well understood, and replicated not only in the U.S. treaties with the rest of the world but also among the nations in their own bilateral tax treaties with other nations based on the OECD model. Certainly, the standards are imperfect, even so much so that they are undergoing a substantial review as part of the OECD’s base erosion and profit-shifting projects.16 But in contrast to the limitations on the U.S. states’ authority to impose their income taxes, at least they are understandable, relatively uniform, and predictable.

Instead, state or local individual and business taxpayers, regardless of whether they are U.S. residents, are subject to a hodgepodge of arcane, sometimes unwritten, rules that exist in no other country in the world (and sometimes, in no other state). Starting with the power to tax, and with few exceptions,17 the only outside limits on a state or local government’s ability to tax a nonresident is an ephemeral concept of nexus, which hasn’t been derived through a mutual agreement among the states or by a uniform standard established by Congress or by the rules of the global tax system. Instead, it has been established through judicial interpretations of vague language in the Constitution’s commerce and due process clauses, which don’t even use the word “tax.” Good or bad, defined concepts of PE and limits on double taxation in the international tax treaties applicable to the taxes levied by nations (and at least the Swiss cantons) protect U.S. individuals and businesses from taxation by other nations. The protections for nonresidents from state taxation are contained in “uniform” laws that are hardly uniform and — at least according to some courts — weren’t even binding on the states anyway.18 Other meager protections include judicial dicta such as “four prong tests”19 and obtuse rulings that the Constitution does not mandate a physical presence test, without actually holding whether the statute in question is constitutional.20

Even the courts appear exhausted and increasingly reluctant to arbitrate obvious double taxation matters by the states. From the far ends of the judicial spectrum, conservative and liberal, the members of the U.S. Supreme Court also appear uninterested and increasingly skeptical of their authority to impose judicial solutions to multistate tax problems. Nowhere was this more evident than in the Court’s 2015 opinion in Wynne, in which conservative Justices Clarence Thomas and Antonin Scalia admonished the Court’s dormant commerce clause jurisprudence21 as “imaginary” and providing “imaginary benefits.”22 Liberal Justice Ruth Bader Ginsburg later said the states have no obligation to provide a tax credit for the taxes paid to other states and that doing so is merely a matter of “policy.”23

Perhaps one of the reasons the U.S. international tax treaties have never been extended to the states is the process by which the treaties are ratified. Under the Constitution, the executive branch has the power to enter into treaties with the advice and consent of two-thirds of the Senate.24 Further, states are precluded from entering into treaties on their own without congressional consent.25 That doesn’t mean states can’t be subject to international tax treaties if the federal government wants them to be — even in the existing international treaties, the federal government has bound the states to their nondiscrimination provisions.

So, why would it be that the operative PE and double taxation provisions of the international tax system have not been extended to the states, like the Swiss did to its cantons? From a purely domestic political perspective, it seems likely that elected U.S. senators see no benefit to ratifying actions that restrict state taxing powers. One can easily imagine the political calculus of a senator considering a vote to ratify an international tax treaty. For example, an electoral challenger could suggest — true or not — that an international tax treaty that limited the state’s authority to tax nonresidents resulted in the loss of state tax revenues that had to be made up by tax increases on in-state voters. Clearly, the number of local voters who might be affected by the provisions extending treaty protections would be small. After all, the nexus and double taxation rules would primarily benefit either nonresidents who want to do business in and compete with in-state residents or a small, but growing, number of in-state residents who are looking for tax credits to offset the nonresident state taxes they would otherwise pay at home. At the end of the day, it seems obvious that it is better to impose a tax liability on someone who can’t vote than on someone who can, and excluding U.S. states as a condition to vote for ratification of an international tax treaty is the expedient answer.

As a smaller nation that is more reliant on imports and exports, Swiss voters likely view the applicability of international tax treaties through a different lens than American voters. It is also likely that the United States has been able to get its way and exclude the states from the treaty restrictions for so long because of its superior negotiating position as the world’s largest economy and one historically less reliant on foreign trade than other nations. It could also be that the foreign governments recognize that, for most of their residents and businesses seeking to do business in the United States, the low state tax rates and the fact that they could be deducted from federal income tax liabilities (and, as in Germany, could be used to compute their foreign tax credits against their domestic taxes) have made the extension of tax treaties to the states just not worth fighting over.

It is not as if other countries have not tried. Canada26 and the United Kingdom,27 likely to be considered the United States’ strongest trading partners and international allies, have continued to vigorously object to state worldwide combined reporting. Other important U.S. trading partners have regularly interceded in state tax actions they perceive as adversely affecting their nationals by filing objections to state tax laws as they are being developed28 or by filing briefs in judicial actions challenging state taxes imposed on international transactions.29

I don’t want to say that these international rules are ideal, but at least they establish a common boundary of (relatively) understandable rules compared with the lack of any consistent rules on the taxation of nonresidents by the states or equitably resolve double taxation problems through legislation or mutual state agreements and not, as Ginsburg suggested, merely as a matter of “policy.” The states are untethered from all of them, and the Court, perhaps rightly so, is reluctant to interfere in issues that ought to be resolved through federal legislation or agreements among the states themselves.

As the world economy globalizes and digital technology makes it easier to collaborate from remote locations, developing at least some universal, agreed upon rules on the limits of state tax authority on residents and nonresidents alike can only help to alleviate the many problems that we face without them. Perhaps the migration from some states to others because of the COVID-19 emergency has accelerated the desperate need for more uniform standards of multistate taxation. At the very least, the international tax treaties demonstrate that, although far from perfect, sovereign powers can come together and settle the key matters to avoid double taxation. Right now, at least in the context of individual multistate taxation, we have virtually no legal boundaries. Maybe it is time we do.


2 Compare the Federal Constitution of the Swiss Confederation of 18 April 1999, article 3 (“The Cantons are sovereign except to the extent that their sovereignty is limited by the Federal Constitution. They exercise all rights that are not vested in the Confederation”) and articles 127 to 135 (expressly regulating Swiss federal, cantonal, and communal taxes) with the U.S. Constitution’s 10th Amendment (“The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.”); Article I, section 10 (limits on state actions, including the import and export clause, and on state agreements with other state and foreign governments without congressional consent); and Article I, section 8, cl. 3 (commerce clause) and the 14th Amendment (the equal protection and due process clauses as applied to state action).

3 See Swiss Constitution, article 184 (granting Federal Council (which has executive authority of the Swiss Confederation (see Swiss Constitution, article 174 et seq.)) the responsibility for foreign relations and the power to sign and ratify international treaties subject to approval by the Federal Assembly (which has legislative authority of the Swiss Confederation (see Swiss Constitution, articles 148 to 155)); and Swiss Constitution article 141 and article 141a (allowing for an optional public referendum on the approval of international tax treaties to which the U.S. Constitution has no similar analog).

4 U.S. Constitution, Article I, section 10, cl. 1 (“No State shall enter into any Treaty, Alliance, or Confederation”) and cl. 3 (“No State shall, without the Consent of Congress . . . enter into any Agreement or Compact with another State, or with a foreign Power”).

5 Swiss Constitution, article 56 (“1. A Canton may conclude treaties with foreign states on matters that lie within the scope of its powers. 2. Such treaties must not conflict with the law or the interests of the Confederation, or with the law of any other Cantons. The Canton must inform the Confederation before concluding such a treaty. 3. A Canton may deal directly with lower ranking foreign authorities; in other cases, the Confederation shall conduct relations with foreign states on behalf of a Canton.”).

6 U.S. Constitution, Article I, section 10, cl. 1 and cl. 3.

7 U.S. Constitution, Article II, section 2, cl. 1 (The president “shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur”).

8 See, e.g., Container Corp. of America v. Franchise Tax Board, 463 U.S. 159, 196 (1983) (“the tax treaties into which the United States has entered do not generally cover the taxing activities of subnational governmental units such as States”); see also Barclays Bank PLC v. Franchise Tax Board, 512 U.S. 298, 321-328 (1994) for a discussion of the United Kingdom’s attempts to limit state taxation through amendments to the tax treaty between it and the United States. For additional history, see California Franchise Board, Water’s-Edge Manual, ch. 1(a)(4)(b).

9 Switzerland-U.S. treaty, article 24, cl. 5 (“The provisions of this Article shall, notwithstanding paragraph 2 of Article 2 (Taxes Covered), apply to taxes of every kind and description imposed by a Contracting State or a political subdivision or local authority thereof.” (emphasis added)).

10 Id. at article 24, cl. 1 (“Nationals of a Contracting State shall not be subjected in the other Contracting State [i.e., either the U.S. federal government or the Swiss Confederation] to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances are or may be subjected.”).

11 Compare generally the U.S. model tax treaty with the OECD Model Tax Convention on Income and on Capital: Full Version, 2017. See also United States Model Technical Explanation Accompanying the United States Model Income Tax Convention, Nov. 15, 2006 (“Negotiations also took into account the Model Tax Convention on Income and on Capital, published by the Organisation for Economic Cooperation and Development (the ‘OECD Model’).”).

12 U.S. model tax treaty, article 5, section 1.

13 See title of the Switzerland-U.S. treaty, at 17-18 (“Convention . . . for the avoidance of double taxation with respect to taxes on income” (emphasis added)).

14 Switzerland-U.S. treaty, article 23, section 1, Relief From Double Taxation.

15 Id. at sections 2 (U.S. residents or citizens for taxes paid to Switzerland) and 3 (Swiss residents who are citizens of the U.S.).

16 See, e.g., OECD, Action 1 Tax Challenges Arising From Digitalisation (Pillar 1 — the reallocation of taxing rights: addresses lack of physical presence, where tax should be paid and on what basis, and what portion of profits could or should be taxed in which jurisdictions); and Action 7 Permanent Establishment Status (“Tax treaties generally provide that the business profits of a foreign enterprise are taxable in a jurisdiction only to the extent that the enterprise has in that jurisdiction a permanent establishment to which the profits are attributable. The definition of permanent establishment included in tax treaties is therefore crucial.”).

17 Some examples: P.L. 86-272 (federal law limiting imposition of a net income tax on a business engaged in sales solicitation in the state); 4 U.S.C. section 114 (federal law prohibiting taxation of “qualified retirement income” (e.g., IRAs and 401(k) plans) by any state other than the recipient’s state of residence); 49 U.S.C. section 40116 (federal law limiting taxation of air commerce and the pay of employees engaged in air commerce); and the Internet Tax Freedom Act (P.L. 105-277), as made permanent by the Trade Facilitation and Trade Enforcement Act of 2015 and codified at 47 U.S.C. section 151 note (prohibiting state taxation of internet access services and discriminatory state taxes on business conducted on the internet).

18 Several courts expressly concluded that the Multistate Tax Compact adopted by many states, which included limitations on state apportionment modeled after the Uniform Division of Income for State Tax Purposes, was not binding on the states. See, e.g., Graphic Packaging Corp. v. Hegar, 538 S.W.3d 89, 101 (Texas 2017) (the “compact is not a binding regulatory compact”); Gillette Co. v. Franchise Tax Board, 363 P.3d 94, 99-103 (Calif. 2015), cert. denied, 137 S. Ct. 294, 196 L. Ed. 2d 238 (2016) (holding that the compact does not contractually bar states from overriding its apportionment provisions); Kimberly-Clark Corp. v. Commissioner of Revenue, 880 N.W.2d 844, 848-52 (Minn. 2016), cert. denied, 137 S. Ct. 598 (2016) (holding that the legislature did not violate the contract clause when repealing articles III and IV of the compact and that if the apportionment election were a contractual obligation, it would violate Minnesota’s constitutional prohibition against contractual suspensions of the taxing power); Gillette Commercial Operations N. Am. & Subsidiaries v. Department of Treasury, 878 N.W.2d 891, 902-06 (Mich. Ct. App. 2015), appeal denied, 499 Mich. 960 (2016) (holding that the compact is not a binding contract under Michigan law); and Health Net Inc. v. Department of Revenue, 362 Ore. 700 (2018) (holding that the compact is not contractually binding and, even if it were, Oregon’s statute overriding the compact’s apportionment provisions would not violate the contract clause).

19 See Complete Auto Transit Inc. v. Brady, 430 U.S. 274, 279 (1977) (establishing a commerce clause test based on whether a tax “is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State”).

20 See South Dakota v. Wayfair Inc., 535 U.S. ___, 138 S. Ct. 2080, 2092 (2018) (“the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause.”) and at 2099 (“The question remains whether some other principle in the Court’s Commerce Clause doctrine might invalidate the [South Dakota remote seller sales tax] Act. Because the Quill physical presence rule was an obvious barrier to the Act’s validity, these issues have not yet been litigated or briefed, and so the Court need not resolve them here.”).

21 Comptroller of the Treasury v. Wynne, 135 S. Ct. 1787, 1811 (2015) (Thomas, J., dissenting) (“I continue to adhere to my view that the negative Commerce Clause has no basis in the text of the Constitution, makes little sense, and has proved virtually unworkable in application, and, consequently, cannot serve as a basis for striking down a state statute.”) (citations omitted).

22 Id. at 1811 (Scalia, J., dissenting) (“Then again, it is only fitting that the Imaginary Commerce Clause would lead to imaginary benefits.”).

23 Id. at 1814 (Ginsburg, J., dissenting) (“States often offer their residents credits for income taxes paid to other States, as Maryland does for state income tax purposes. States do so, however, as a matter of tax ‘policy,’ [citation omitted] . . ., not because the Constitution compels that course.”).

24 U.S. Constitution, Article II, section 2, cl. 2.

25 U.S. Constitution, Article I, section 10, cl. 1.

26 See Note of Exchange from Allan J. MacEachern, deputy prime minister and minister of finance of Canada to G. William Miller, secretary of the U.S. Treasury (Sept. 26, 1980) (“It is the position of Canada that the so-called ‘unitary apportionment’ method used by certain states of the United States to allocate income to United States offices or subsidiaries of Canadian companies results in inequitable taxation and imposes excessive administrative burdens on Canadian companies doing business in those states. Under that method the profit of a Canadian company on its United States business is not determined on the basis of arm’s-length relations but is derived from a formula taking account of the income of the Canadian company and its worldwide subsidiaries as well as the assets, payroll and sales of all such companies. For a Canadian multinational company with many subsidiaries in different countries to have to submit its books and records for all of these companies to a state of the United States imposes a costly burden.”).

27 See Barclays Bank PLC, 512 U.S. at 324, n.22 (“Barclays has also directed our attention to a series of diplomatic notes similarly protesting the [California worldwide combined reporting] tax. . . . see also . . . (letter from Secretary of State George Shultz to California Governor George Deukmejian (Jan. 30, 1986)) (‘The Department of State has received diplomatic notes complaining about state use of the worldwide unitary method of taxation from virtually every developed country in the world.’) The British Parliament has gone further, enacting retaliatory legislation that would, if implemented, tax United States corporations on dividends they receive from their United Kingdom subsidiaries. See Finance Act 1985, pt. 2, ch. 1, [section] 54, and sch. 13, 5 (Eng.), reenacted in Income and Corporation Taxes Act 1988, pt. 18, ch. 3, [section] 812 and sch. 30, 20, 21 (Eng.)”).

28 See, e.g., Maria Koklanaris, “D.C. Council Chair to Introduce Legislation to Repeal Tax Havens List,” Tax Notes Today State, Nov. 2, 2015 (recounting an interview with Phil Mendelson, chair of the Council of the District of Columbia, regarding complaints from countries listed in a District tax havens bill. “‘I got some letters, I got some phone calls, my staff got some phone calls, and they got some visits,’ Mendelson said.”); see also Bill 21-0396 (Dec. 29, 2015).

29 For example, in Barclays Bank PLC, the United Kingdom and the member states of the European Community submitted amici briefs to the U.S. Supreme Court objecting to California’s worldwide combined reporting method. See Barclays Bank PLC, 512 U.S. at 300 (fn.) and at 324, fn. 22 (“The governments of many of our trading partners have expressed their strong disapproval of California’s method of taxation, as demonstrated by the amici briefs in support of Barclays from the Government of the United Kingdom, and from the Member States of the European Communities . . . and the governments of Australia, Austria, Canada, Finland, Japan, Norway, Sweden, and Switzerland.”)


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