Clarification Requested on Exemption of Distributions From Nonqualified Plans

January 3, 2019

Quyen Huynh
Deputy International Tax Counsel for Treaty Affairs
Office of the International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Room 3058
Washington DC 20220

Re: Distributions from Nonqualified Pension Plans under pre-1966 U.S. Income Tax Treaties

Dear Ms. Huynh:

Morgan Lewis represents a U.S. corporation that is a member of a multinational group of corporations and that sponsors for certain of its retired employees a nonqualified retirement plan ("NQP"), that is, a plan that does not enjoy any special tax treatment under the Internal Revenue Code.¹ Certain of the beneficiaries are both nonresident aliens ("NRAs"² under the Code and residents of countries with which the United States entered into an income tax treaty prior to 1996 that is still in force (the "pre-1996 treaties"). Under the pension articles of the pre-1996 treaties, the beneficiaries are plainly entitled to exemption from U.S. tax on distributions from the NQPs. Because the Internal Revenue Service (the "Service" or the "IRS") appears to be taking the blanket position that none of the pre-l 996 treaties exempt the beneficiaries from withholding tax in respect to such distributions, its client has asked Morgan Lewis to seek written clarification from the Government that the treaties do indeed provide this benefit and, as a consequence, withholding should not be required and tax should not be imposed.

The Service's position raises fundamental issues regarding not only the scope of the pension article but also the meaning of undefined terms in the treaties and the roles of Treasury's model income tax treaty and its technical explanation. For this reason we believe that it is appropriate for the Treasury Department, as the steward of the U.S. treaty program, to consider the Service's position. It should also be noted that the U.S. corporation that seeks the Treasury Department's assistance in this matter is not doing so for its own benefit but to secure relief for its former employees and similarly situated individuals.

In our client's case the issue first arose when an IRS examining agent informed the financial institution that disburses the plan's distributions and that acts as a withholding agent³ with respect to the distributions (and distributions from similar plans sponsored by many U.S. businesses) that it must, irrespective of the treaty language, withhold under Section 1441 of the Code at the 30 percent statutory rate⁴ on all distributions from U.S.-sponsored NQPs to residents of treaty jurisdictions that have a pre-1996 treaty with the United States, unless the Service's National Office provided otherwise in writing. In response and on behalf of its client, Morgan Lewis therefore asked the Service's Office of Associate Chief Counsel (International) ("ACCI") if it would entertain the issuance of a ruling to the effect that the pension articles of particular pre-1996 treaties exempt the distributions from NQPs from withholding and tax. For the reasons discussed below, ACCI refused even to consider the issuance of such guidance.

Like any withholding agent, the financial institution is liable for any tax required to be withheld that was not withheld.⁵ Given the positions of the examining agent and ACCI, the institution has therefore understandably decided to withhold at the statutory rate on all distributions from NQPs to NRAs, even though, for the reasons set forth below, the beneficiaries are clearly entitled to exemption from withholding and tax under the relevant pre-1996 treaty. As the institution is one of the very largest providers of withholding and related services to NQPs, and ACCI's position has presumably been communicated not only to this institution's examining agent but to all examining agents that audit distributions from NQPs, it is highly likely, moreover, that the withholding agents for the NQPs sponsored by many U.S, businesses are being forced to withhold on pension distributions even if the applicable treaties provide otherwise.

It should be emphasized that in many cases the recipients of the distributions are foreign retirees living on fixed incomes who had previously received pension distributions U.S. tax-free on the basis of their treaty entitlements. Perhaps needless to say, it is extraordinarily distressing and perplexing to these individuals to experience without any explanation from the Service (and thus from the sponsor or custodian) an unexpected 30 percent cut in their retirement income. The Service's position is working a particular hardship since the countries where these individuals now reside may tax the distributions for the simple reason that they view them, in accordance with the plain language of the treaties, as "pensions" taxable only by such countries and not by the United States.

Part I of the discussion below addresses the domestic law and treaty background. Part II demonstrates that many of the pension articles in pre-1996 treaties by their terms cover distributions from NQPs and that those that are ambiguous should, in light of the relevant model income tax treaty of the Organization for Economic Cooperation and Development (the "OECD" and "the OECD Model") and commentary on the OECD Model ("the Commentary"), be viewed as covering such distributions. Part III summarizes ACCI's position. Part IV explains why ACCI's position is legally unsupportable. Part V shows that, even if it were appropriate to interpret the pre-1996 treaties by reference to later U.S. treaty and domestic law, that law would not support denying the pension article's coverage to distributions from NQPs unless the particular treaty or associated Treasury Department technical explanation ("TE") specifically so provides.

I. Domestic Law and Treaty Background

In this part we provide the background to this issue. The first section is the statutory and regulatory background. The second is the treaty background, in particular the relationship to other treaty articles of the pension article, insofar as it covers pension distributions to retirees in respect of their former employment.

As factual background, note that the situation of the affected retirees is not uniform. In addressing this issue, however, Treasury should consider the typical circumstances, that is, a beneficiary who is a resident alien under the Code in the taxable year in which he or she performs services for the U.S. corporation in the United States. In the taxable year or years in which the individual receives the NQP distribution or distributions, he or she is an NRA not engaged in a trade or business within the United States ("ETB") under Section 864 of the Code. For one reason or another, the distributions are not subject to tax under Section 877, a provision which in certain circumstances subjects to net basis taxation income earned by an NRA who was formerly a resident alien.

A. Statutory and Regulatory Background

As indicated above, the examining agent and apparently ACCI believe that it is appropriate to require the financial institution to withhold tax at the 30 percent statutory rate under Section 1441 on NQP distributions to such an NRA. Given that the pension distributions at issue constitute deferred compensation for the performance of personal services as an employee, and leaving aside the tax treaty issue, it is not obvious why this position is correct as a matter of internal domestic law. Specifically, Section 1441 provides that the tax does not apply to compensation for personal services (which the pension distributions constitute) if the compensation is subject to the withholding tax on employee "wages" imposed by Section 3402⁶ and the compensation is income effectively connected with the conduct of a trade or business within the United States ("ECI").⁷ Thus, in order to reach its conclusion that Section 1441 applies to the distributions, the Service must have concluded that the pension distributions are not wages subject to the Section 3402 tax, are not ECI, or are not either.

It evidently has concluded — correctly, we believe — that they are not either. Section 3401(a) broadly defines "wages" to include, with statutory exceptions, "all remuneration . . . for services performed by an employee for his employer; regulations interpret such remuneration to include "pensions . . . and retired pay . . . if paid as compensation for services performed by the employee for his employer."⁸ One of the statutory exceptions to the definition of "wages" is "remuneration paid for . . . services performed by a nonresident alien individual, as may be designated by regulations prescribed by the Secretary.⁹ Pursuant to this authority, the regulations exclude from the definition of "wages" remuneration paid for services performed by an NRA that "otherwise constitutes wages" under the general rule in the regulations cited above¹⁰ but that is not "effectively connected with the conduct of a trade or business within the United States."¹¹

As a general matter, the income taken into account by an NRA or a foreign corporation in a taxable year is ECI only if the NRA or foreign corporation is "engaged in [a] trade or business within the United States during the taxable year."¹² As an individual on the cash receipts and disbursements method of accounting, an NRA takes the pension distribution into account when he or she receives it. And, as indicated above, the NRAs whose tax situation is addressed here are not ETB in the years in which they receive the distributions. Accordingly, the distributions are not ECI and for that reason are not wages under Section 3401. Since they are therefore not subject to Section 3402 withholding, they are, unless a treaty exemption applies, subject to Section 1441 withholding.

Since the Service has concluded that the distributions are subject to Section 1441 withholding, it must have therefore adopted this reasoning and concluded that the distributions are not ECI. We believe this conclusion is correct for the reason described in the immediately preceding paragraph, viz., that the beneficiaries are not ETB in the years in which the NRAs receive the distributions.

Since the Service has concluded that the distributions are not ECI, it evidently must also believe — correctly, again — that the application of Section 864(c)(6) does not alter this conclusion. That provision treats as ECI certain income that would not otherwise constitute ECI. If Section 864(c)(6) did apply, the distributions would be ECI and therefore wage withholding and not 30 percent withholding would apply.

Yet Section 864(c)(6) merits some discussion because, as indicated at the end of this section, informal, unpublished advice issued by the Service many years ago could be construed to apply Section 864(c)(6) in a situation such as the instant one.

Section 864(c)(6) states in pertinent part:

For purposes of this title, in the case of any income or gain of a nonresident alien individual . . . which (A) is taken into account for any taxable year, but (B) is attributable to a sale or exchange of property or the performance of services (or any other transaction) in any other taxable year, the determination of whether such income or gain is taxable under section 871(b) . . . shall be made as if such income or gain were taken into account in such other taxable year and without regard to the requirement that the taxpayer be engaged in a trade or business within the United States during the taxable year referred to in subparagraph (A).

Section 871(b)(1) provides that an NRA ETB "during the taxable year" shall be taxable as provided in Section 1 on his taxable income which is ECI. The evident purpose of Section 864(c)(6) is to prevent an NRA from avoiding the Section 871(b)(1) tax by deferring the receipt of income that would have been taxed in the year earned, when the NRA was ETB, to a year in which he or she is not ETB and thus is not, absent the application of Section 864(c)(6), subject to the Section 871(b)(1) tax.

The legislative materials confirm this intent. The Report of the Staff of the Joint Committee on Taxation, for example, provides in pertinent part:

Under prior law, foreign taxpayers could avoid U.S. tax by receiving income that was earned by a U.S. trade or business in a year after the trade or business had ceased to exist. For example, the business could sell property and accept an installment obligation as payment. By recognizing the gain on the installment basis, the taxpayer could defer the income to a later taxable year. If the taxpayer had no U.S. trade or business in that year, then the income recognized in that year was not treated as effectively connected with a U.S. trade or business. Congress believed that income earned by a foreign person's U.S. trade or business should be taxed as such, regardless of whether recognition of that income is deferred until a later taxable year. Similarly, Congress believed that foreign persons should not be able to avoid U.S. tax on their income from the performance of services in the United States where payment of the income is deferred until a subsequent year in which the individual is not present in the United States.¹³

Neither the statutory language nor the provision's purpose applies to the instant situation, in which a resident alien earns deferred compensation and, as an NRA in a later year, receives the compensation in the form of a pension distribution. The subject of the provision is "the determination of whether . . . income or gain is taxable under section 871(b)." In making this determination, the reader is asked to hypothesize that the income was taken into account in the year in which earned. The provision asks: Would the income have been taxed under Section 871(b) in that year? If so, it is subject to tax under Section 871(b) in the year received, notwithstanding that, contrary to one of the requisites for taxation under Section 871(b), the taxpayer is not ETB in that year. If, however, the income were in the instant case taken into account in the year in which it was earned, it would not have been taxable under Section 871(b) since the taxpayer was a resident alien in that year and Section 871(b) does not apply to resident aliens.¹⁴

As to purpose, the Joint Committee extract makes clear that the provision is aimed at deferral by "foreign taxpayers" of income "earned by a u.S. trade or business." A resident alien is not a "foreign taxpayer" within the extract's meaning; he or she is a "U.S. taxpayer" in the sense that he or she is subject to u.s. tax on the same basis as a U.s. citizen. Specifically, a resident alien, like a U.S. citizen, is not taxed on income "earned by a U.S. trade or business"; he or she is taxed on all his or her worldwide income. Quite simply, the statute does not address a resident alien's (or indeed a U.S. citizen's) intentional or unintentional deferral of income to a year in which he or she would not otherwise be subject to tax on the income because the individual is then an NRA not ETB. Section 877 is the provision that addresses such deferred income, in addition to other income earned by an NRA who was formerly a resident alien or a U.S. citizen.

As indicated, the Service has not always taken the position that Section 864(c)(6) does not apply to income paid to an NRA that was deferred from a year in which the individual was a resident alien. With one or two exceptions, the guidance (in the form of a private letter ruling or field service advice) is bereft of analysis and thus not very illuminating. In some situations, moreover, the advice suggests Section 864(c)(6) might apply to a former resident alien but ultimately concludes that a tax treaty prevents its application or that Section 864(c)(6) does not apply for a reason other than the individual's former status as a resident alien;¹⁵ thus the statements on Section 864(c)(6) are only dicta. Yet there is a handful of items of informal guidance issued before 1996 in which the Service appears to have applied Section 864( c)(6) to a former resident alien.¹⁶ Consistent with its position in this matter, however, the Service's more recent items of guidance have either repudiated a prior position that Section 864(c)(6) applies in a particular situation¹⁷ or have set forth the statute without applying it.¹⁸

B. Treaty Background

The primary treaty article addressing employment compensation is the "dependent personal services" article. The first paragraph in that article in the 1977 version of the Model, on which the dependent personal services article of many of the pre-1996 treaties is based, provides:

Subject to the provisions of Articles 16, 18 [the pension article] and 19, salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State.¹⁹

The associated provision in the Commentary states: "Paragraph 1 establishes the general rule as to the taxation of income from employment (other than pensions), namely, that such income is taxable in the State where the employment is actually exercised."

Like all iterations of the Treasury Department's model income tax treaty,²⁰ the 1977 version (and all subsequent versions) of the OECD Model reserves the jurisdiction to tax pension distributions to the residence State: "[P]ensions and other similar remuneration paid to a resident of a Contracting State in consideration of past employment shall be taxable only in that State."²¹

Two points are clear from the above extracts. First, "pensions and other similar remuneration" in respect of employment, as described in the pension article, is a species of "remuneration . . . in respect of an employment" as described in the dependent personal services article: By its terms the first paragraph of the dependent personal services article applies "subject to" the pension article; the Commentary states that such paragraph applies to employment income "other than pensions." Second, because the pension article reserves to the residence State the exclusive right to tax "pensions and other similar remuneration," and the dependent personal services article reserves to the source State the exclusive right to tax "remuneration in respect of an employment" other than "pensions and other similar remuneration," the failure of employment remuneration to qualify as a pension means that the source rather than the residence State has exclusive taxing jurisdiction.²²

II. Pre-1996 Treaties

The pension articles of a number of pre-1996 treaties plainly cover distributions from NQPs. The U.S.-Israel treaty (1975), for example, defines the term "pensions and other similar remuneration," in pertinent part, as "periodic payments other than social security payments . . . made . . . by reason of retirement or death and in consideration for services rendered."²³ The U.S.-Australia treaty (1982) contains a virtually identical definition.²⁴ Clearly a pension distribution from an NQP can constitute a "periodic payment . . . made . . . by reason of retirement or death and in consideration for services rendered."

A very early pre-1996 treaty, the U.S.-Greece treaty (1950) treaty, defines a "pension" in pertinent part as "periodic payments made in consideration for services rendered."²⁵

The U. S.-France treaty (1994) originally provided that "pensions and other remuneration, including distributions from pension and other retirement arrangements derived and beneficially owned by a resident of a Contracting State in consideration of past employment . . . shall be taxable only in that State."²⁶ Whatever the meaning of the term "pension," it cannot be seriously contended that an NQP benefitting retirees is not a "retirement arrangement." In 2004 the treaty partners amended the pension article to clarify the inclusion of payments under social security legislation. In the course of this amendment, they struck the clause "including distributions from pension and other retirement arrangements," but indicated that "pension distributions and other similar remuneration" arising in a Contracting State, to which the amended article applied and continues to apply when paid to a resident of the other Contracting State, include "pension distributions and other similar remuneration . . . paid by a pension or other retirement arrangement established in that State," thereby retaining the coverage of NQPs.²⁷

Rather than the treaties themselves, the TEs of other pre-1996 treaties make the coverage clear. The TE to the U.S.-Canada treaty (1980), for example, provides that "[t]he term 'pensions' also would include amounts paid by other retirement plans or arrangements, whether or not they are qualified plans under U.S. domestic law."²⁸

Many pre-1996 U.S. income tax treaties do not define the terms "pension" or "pension or other similar remuneration" although they use these terms or similar terminology.²⁹ According to their respective TEs, all the post-1977 treaties among this group (with a few exceptions, all the pre-1996 treaties) are based on, and often adopt in their pension article the language of, the 1977 or 1992 version of the OECD Model. Like the pre-1996 tax treaties, the early versions of the OECD Model do not define the term "pension" or "pension or other similar remuneration." The entirety of the OECD's pension article during this period provided:

Subject to the provisions of paragraph 2 of Article 19 [relating to pensions in respect of Government service], pensions and other similar remuneration paid to a resident of a Contracting State in consideration of past employment shall be taxable only in that State.

Although the Commentary to the OECD Model during this period likewise did not define the term, it explained the article's scope: "The provision also covers widows' and orphans' pensions and other similar payments such as annuities paid in respect of past employment."³⁰ "Annuities in respect of past employment" is a non-technical term that does not necessarily suggest any limitation to amounts provided to retirees on a non-discriminatory basis or any other common criterion of payments from a "qualified" pension plan.³¹ The Commentary's indication that the treaty language "pensions and other similar remuneration" includes annuities in respect of past employment therefore strongly suggests that the treaty term itself is not limited to payments from a qualified plan. According to the evidence, therefore, the pension articles of the pre-1996 treaties based on the 1977 or 1992 versions of the OECD Model that do not define the terms "pension" or "pensions and other similar remuneration" should be construed to include distributions from NQPs as well as qualified plans.

No pre-1996 treaty or associated TE remotely suggests that a "pension" or similar term is limited to a distribution from a qualified plan.

In summary, based on their explicit language, the discussion in the associated TE, and/or the relevant OECD Model and Commentary, all the pre-1996 treaties that use the terms "pension," "pensions and other similar remuneration" or similar terms should be read to encompass distributions from an NQP.

To the extent the Service has addressed the issue in writing, it has indeed agreed with our position. A 2004 private letter ruling³² under the U.S.-Australia treaty³³ specifically holds that a distribution by a U.S.-based NQP to an NRA and a resident of Australia for purposes of the treaty was exempt from U.S. tax under that treaty's pension article where, as in this case, the taxpayer earned the distribution while working in the United States as a resident alien. Although the ruling therefore considers a factual situation indistinguishable from the paradigm case considered here, the Service has not explained in writing why the ruling's logic does not apply. In other areas, such as in the Section 355 or rescission areas, the Service has typically sought public comment or at least justified its action before adopting a no-rule policy with respect to an issue on which it has previously ruled favorably. Here the Service not only has in contrast changed its position without any opportunity for taxpayer input but has exacerbated the unfairness and surprise by instructing its examining agents to require the collection of the newly-imposed tax at source.

III. ACCl's Position

ACCI has indicated orally that it will not issue a favorable ruling because it believes that, under the Treasury Department's TEs of the pension article in the 1996 and 2006 United States Model Income Tax Conventions (the "1996 Model" and the "2006 Model" (together with the 2016 United States Model Income Tax Convention (the "2016 Model"), the "U.S. Models") and the TEs relating thereto (the "1996 TE" and the "2006 TE" and, together, the "Model TEs"), the article does not apply to distributions from NQPs even where the treaty containing the article, such as the pre-1996 treaties at issue here, entered into force before the TEs were issued. The position apparently applies even to those pension articles, such as the one in the U.S.-Australia treaty,³⁴ which contain language clearly including NQP distributions.

ACCI points out that all or virtually all of the pre-1996 treaties (usually in Article 3(2)) refer to the internal law of the taxing State for the definition of a term not defined by the treaty itself (the "Article 3(2) provisions"). The U.S.-Spain treaty typically provides:

As regards the application of the Convention by a Contracting State any term not defined therein shall, unless the context otherwise requires, and subject to the provisions of Article 26 (Mutual Agreement Procedure), have the meaning which it has under the laws of that State concerning the taxes to which the Convention applies.³⁵

Second, although none of the U.S. Models, including the most recent one, the 2016 U.S. Model, define the terms "pension," "pensions and other similar remuneration," or a similar term, the U.S. Model TEs contain the following language:

The phrase "pension distributions and other similar remuneration" is intended to encompass payments made by private retirement plans and arrangements in consideration of past employment. In the United States, the plans encompassed by Paragraph 1 include: qualified plans under section 401(a), individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies section 408(k), individual retirement accounts and section 408(p) accounts), nondiscriminatory section 457 plans, section 403(a) qualified annuity plans, and section 403(b) plans. The Competent Authorities may agree that distributions from other plans that generally meet similar criteria to those applicable to other plans established under their respective laws also qualify for the benefits of Paragraph 1. In the United States, these criteria are as follows:

(a) The plan must be written;

(b) In the case of an employer-maintained plan, the plan must be nondiscriminatory insofar as it (alone or in combination with other comparable plans) must cover a wide range of employees. including rank and file employees, and actually provide significant benefits for the entire range of covered employees;

(c) In the case of an employer-maintained plan the plan must contain provisions that severely limit the employees' ability to use plan assets for purposes other than retirement, and in all cases be subject to tax provisions that discourage participants from using the assets for purposes other than retirement; and

(d) The plan must provide for payment of a reasonable level of benefits at death, a stated age, or an event related to work status, and otherwise require minimum distributions under rules designed to ensure that any death benefits provided to the participants' survivors are merely incidental to the retirement benefits provided to the participants.

In addition, certain distribution requirements must be met before distributions from these plans would fall under paragraph I. To qualify as a pension distribution or similar remuneration from a U.S. plan the employee must have been either employed by the same employer for five years or be at least 62 years old at the time of the distribution. In addition, the distribution must be made either

(A) on account of death or disability,

(B) as part of a series of substantially equal payments over the employee's life expectancy (or over the joint life expectancy of the employee and a beneficiary), or

(C) after the employee attained the age of 55.

Finally, the distribution must be made either after separation from service or on or after attainment of age 65. A distribution from a pension plan solely due to termination of the pension plan is not a distribution falling under paragraph I.

Clearly many NQPs will not satisfy all the requirements in the Model TEs set forth above, in particular the nondiscrimination requirement. According to ACCl, then, where a pre-1996 treaty does not define the term "pension"or a similar term used in its pension article, reference must be made, under a provision like that in the U.S.-Spain treaty, to the internal law of the taxing State, here the United States. Since the law of United States includes the Model TEs, where the NQP in question does not satisfy their requirements; the pre-1996 treaty's pension article does not apply to the NQP distribution. This position apparently applies even to pre-1996 treaties which do define a pension to include an NQP distribution.

IV. Response to ACCl's Position

There are a number of responses to ACCI's position.

A. Pre-1996 Treaties That Define the Term "Pension" or a Similar Term

As indicated in Part ll, a number of pre-1996 treaties, either in the treaty language itself or in the accompanying TE, define the term "pension" or a similar term. The Article 3(2) provisions on which ACCI's position rests apply only to "any term not defined" in the treaty. Accordingly, this position is meritless with respect to treaties that do define a "pension" or similar term.

B. "Ambulatory" Approaches to Treaty Interpretation

ACCI argues that, even though the treaty negotiators of the respective pre-1996 treaty agreed to its Article 3(2) provision before 1996, the provision refers to the laws of the taxing State in effect when it would apply those laws, not to such laws in effect at the time the treaty was agreed. The Article 3(2) provisions in the pre-1996 treaties, however, do not clearly support this "ambulatory" approach to the incorporation of domestic law concepts into a treaty. Typical of the Article 3(2) provisions in the pre-1996 treaties, Article 3(2) of the U.S.-Spain treaty provides: "As regards the application of the Convention by a Contracting State any term not defined therein shall, unless the context otherwise requires . . . have the meaning which it has under the laws of that State concerning the taxes to which the Convention applies." Arguably, this provision's declaration that an undefined term "shall . . . have the meaning which it has under the laws" of the taxing State suggests, if anything, that in the future, that is, when the treaty is being applied, an undefined term shall have the meaning which it currently has, that is, at the time the treaty is concluded.

The 1996 Model introduced a new Section 3(2) provision stating: "As regards the application of the Convention at any time by a Contracting State any term not defined therein shall . . . have the meaning which it has at that time." (Emphasis supplied.) In explaining this explicit adoption of the ambulatory approach, the 1996 TE asserted without any support:

It has been understood implicitly in previous U.S. Models and in the OECD Model that the reference in paragraph 2 to the internal law of a Contracting State means the law in effect at the time the treaty is being applied, not the law as in effect at the time the treaty was signed. This use of "ambulatory definitions" has been clarified in the text of this Model.

Although the Article 3(2) provision in the 2006 Model is identical to that in the 1996 U.S. Model, the 2006 TE dropped the assertion that the U.S. approach to Article 3(2) provisions had always been ambulatory. The 2006 TE thus inferentially supports the position that, while undefined terms in a U.S. tax treaty using the 1996 Model language have the meaning they have in the taxing State's law at the time it applies the treaty, undefined terms in U.S. tax treaties that lack the same or similar language, including the pre-1996 treaties, have the meaning assigned them in the taxing State's law at the time the treaty was signed. If this position is correct, then the language in the TEs and any U.S. law adopted after the execution of a pre-1996 treaty restricting the scope of the term "pension" to distributions from a qualified plan is irrelevant to the interpretation of the that treaty's pension article.

Even if an ambulatory approach generally applies in discerning the meaning of undefined terms in a pre-1996 treaty, there are two reasons why it should not be deemed to incorporate the Model TEs' definition of a "pension." First, all the Article 3(2) provisions, including those in pre-1996 treaties, disregard meanings assigned by the taxing State's internal law where the "context otherwise requires." In explaining this exception, the 1996 TE states:

The use of an ambulatory definition . . . may lead to results that are at variance with the intentions of the negotiators and of the Contracting States when the treaty was negotiated and ratified. The reference in both paragraphs 1 [the paragraph setting forth the definitions of certain terms used in the treaty] and 2 to the "context otherwise requiring" a definition different from the treaty definition, in paragraph 1, or from the internal law definition of the Contracting State whose tax is being imposed, under paragraph 2, refers to a circumstance where the result intended by the Contracting States is different from the result that would obtain under either the paragraph 1 definition or the statutory definition.

As shown in Part II, the intent of the negotiators of the pre-1996 treaties appears to have been to include distributions from NQPs in the pension article. Even if the term "pension" has a meaning under current law that excludes such distributions, the reference to the "context otherwise requiring" mandates rejection of that meaning in applying pre-1996 treaties since to accept it would thwart the negotiators' intent in a significant way.

Second, whatever the legitimacy of the ambulatory approach in general, such U.S. case law as exists strongly disapproves of, in the interpretation of a treaty, the use of treaty materials issued after the adoption of the treaty. In National Westminster Bank, PLC v. United States,³⁶ the U.S. Court of Appeals for the Federal Circuit rejected the Government's contention that, as applied to NatWest, Section 1.882-5 of the Treasury Regulations, issued in 1980, was consistent with the business profits atticle of the 1975 income tax treaty between the United States and the United Kingdom.

In computing the net income attributable to its U.S. trade or business that the United States could tax consistent with the treaty's business profits article, NatWest claimed deductions for interest paid on borrowings by the trade or business from NatWest's head office, a deduction expressly prohibited by the Section 1.882-5.³⁷

The article provided that the profits to be attributed to a U.S. permanent establishment of a U.K. enterprise, and thus the enterprise's income that the United States could tax, were

the profits which it [the permanent establishment] might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.³⁸

The article further provided that, in determining the attributed profits,

there shall be allowed as deductions those expenses which are incurred for the purposes of the permanent establishment, . . . whether incurred in the State in which the permanent establishment is situated or elsewhere.³⁹

In concluding that NatWest was entitled to attribute interbranch interest expense to the permanent establishment, the Court noted that if the branch had been a separately incorporated U.S. subsidiary — a comparison to the tax results of which the "distinct and separate" enterprise formulation seemed to require — it would have been allowed a deduction for interest on borrowings from its parent.

As further support for its position, and as most relevant in this context, the Court pointed to the business profits article in the 1963 version of the OECD Model, on which, the TE indicated, the U.K. treaty article was based, and, in particular, the Commentary associated with it. That Commentary allowed deductions for "payments of interest made by different parts of a financial enterprise (e.g. a bank) to each other on advances, etc., (as distinct from capital allotted to them)."⁴⁰

The Government noted that an OECD report issued in 1984 indicated that the United States viewed Section 1.882-5 as consistent with the treaty and thus undercut the taxpayer's reliance on the 1963 Commentary. Dismissing this argument, the Court stated:

The 1984 OECD Report is . . . the earliest indication in the record of the Treasury's belief in the consistency between § 1.882-5 and the 1975 Treaty. Given the nine-year gap between the signing of the 1975 Treaty and the issuance of the 1984 OECD Report (and the four-year gap between the implementation of the 1975 Treaty and the issuance of the 1984 Report), the consistent position of the Treasury as of 1984 can hardly be read as dispositive of the issue of the intent ofthe United States and the United Kingdom in 1975 when the Treaty was signed — especially when considering that § 1.882-5 was not even proposed until February 27, 1980.⁴¹

Explicitly relying on the 1963 Commentary, the Court concluded that "the Government's current interpretation of the 1975 Treaty is entitled to minimal deference where it contravenes the treaty's language and negotiation history, as well as the contemporaneous expectations of the United Kingdom."⁴²

NatWest addressed OECD materials, not a TE, but it did so only to discern the Treasury Department's understanding of a U.S. treaty provision, which of course a TE also expresses. It thus strongly suggests that, in interpreting treaty language, a U.S. court⁴³ will not accord much deference to a position in a TE inconsistent with the history and language of the treaty, where, as is the case of the Model TEs, the TE was not issued before the treaty's execution or contemporaneously with it.

C. Status of the Model TEs

The Treasury since 1996 (as shown above) and the OECD since 1995⁴⁴ have taken the position that undefined treaty terms generally have the meanings assigned them in the laws of the taxing State in effect when that State applies those laws. Despite this position, the U.S. courts have not taken into account, in interpreting a treaty, technical explanations, commentaries, and other non-binding materials issued after the treaty's execution, presumably because they are not "laws of [the taxing] State" to which Article 3(2) refers for the meaning of undefined terms.

At least OECD pronouncements represent the consensus view of many sovereign states. TEs express the view of only the U.S. Treasury Department, the agency charged with negotiating tax treaties on behalf of the United States. Despite the significance of TEs for informing the U.S. Senate's review of a proposed treaty⁴⁵ and the fact that U.S. courts sometimes refer to them in interpreting a treaty, their legal status depends on the principles of treaty interpretation. Under the Vienna Convention of the Law of Treaties,⁴⁶ other documents can be referenced to interpret the text of a treaty if they constitute an "agreement relating to the treaty which was made between all the parties in connection with the conclusion of the treaty," or an "instrument which was made by one or more parties in connection with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty."⁴⁷ By contrast, TEs are prepared without consulting the other country and without seeking that country's approval,⁴⁸ unless, on rare occasions,⁴⁹ they are developed jointly with and agreed to by the other treaty country, as with the 2007 Protocol to the U.S.-Canada Income Tax Treaty.⁵⁰ U.S. case law therefore supports a degree of wariness in using TEs to interpret U.S. tax treaties.⁵¹

According to the Treasury Department itself, the U.S. Model and, by extension, the Model TEs are even less helpful in interpreting a particular bilateral treaty. In the introduction to the 1996 TE, the Department explained the purpose of the U.S. Model as follows:

[T]he Model is not intended to represent an ideal United States income tax treaty. Rather, a principal function of the Model is to facilitate negotiations by helping the negotiators identify differences between income tax policies in the two countries. In this regard, the Model can be especially valuable with respect to the many countries that are conversant with the OECD Model. Such countries can compare the Model with the OECD Model and very quickly identify issues for discussion during tax treaty negotiations. By helping to identify legal and policy differences between the two treaty partners, the Model will facilitate the negotiations by enabling the negotiators to move more quickly to the most important issues that must be resolved. Reconciling these differences will lead to an agreed text that will differ from the Model in numerous respects. Another purpose of the Model and the Technical Explanation is to provide a basic explanation of U.S. treaty policy for all interested parties, regardless of whether they are prospective treaty partners. . . . Since the Model is intended to facilitate negotiations and not to provide a text that the United States would propose that the treaty partner accept without variation, it should not be assumed that a departure from the Model text in an actual treaty represents an undesirable departure from U.S. treaty policy.⁵²

Thus, according to the Treasury's own description, the function of the U.S. Model treaties and the Model TEs is not, as ACC} contends, to shed light on the meaning of bilateral treaties, let alone treaties executed before the relevant provision in the U.S. Model treaty or Model TE was adopted. Instead, they are designed to provide an explanation of general U.S. treaty policy and to facilitate discussion with another country of a new treaty or protocol, discussion of which the Treasury expects will lead to variations from both the U.S. Model and the Model TE. Given this function of the U.S. Model treaties and the Model TEs, even if the discussion of the pension article in the 1996 TE had appeared before the execution of a particular pre-1996 treaty, the existence of that discussion would not have meant that the negotiators of that treaty had accepted that discussion as authoritative in determining the meaning and scope of that treaty's pension article. Indeed, as shown in the next Part, since the issuance of the 1996 TE, the Treasury Department has concluded many treaty provisions and TEs that do not follow that discussion.

D. Summary

To summarize, ACCl's use of the Model TEs to interpret the pension articles in pre-1996 treaties is misguided for a number of reasons. The Article 3(2) provisions on which ACCI bases its argument apply only to terms not defined in the treaty, and a number of pre-1996 treaties do define a "pension" or similar term. Even where the particular pre-1996 treaty does not define the term, the respective Article 3(2) provision should not be read to incorporate by reference the meaning assigned by the Model TEs for several reasons. There is considerable doubt whether the Article 3(2) provisions in the pre-1996 treaties refer to the taxing State's law at the time the State would apply such law rather than at the time the treaty was concluded; because the "context otherwise requires," the meaning of a "pension" or similar term should not be gleaned from the domestic law of the taxing State; the U.S. courts have rejected, in the interpretation of a treaty, the use of non-binding materials, such as TEs and OECD commentaries, issued after the treaty's conclusion; and the Model TEs are not law and not even, according to the Treasury Department itself, authoritative in interpreting a particular bilateral treaty.

V. Sources of Domestic Law

As far as we know, ACCI bases its position on the language of the Model TEs concerning the pension article. As shown above, the Model TEs should not be viewed as relevant domestic law for purposes of the Article 3(2) provisions in the pre-1996 treaties. The question therefore arises whether there are other sources of current, or at least post-1995, domestic law whose incorporation by the relevant Article 3(2) provisions would lead to the same conclusion as the Model TEs' incorporation.

A. Statute, Regulations, and Case Law

Section 61(a)(11) provides that gross income includes "pensions." Currently effective regulations under this provision state:

Pensions and retirement allowances paid either by the Government or by private persons constitute gross income unless excluded by law. Usually, where the taxpayer did not contribute to the cost of a pension and was not taxable on his employer's contributions, the full amount of the pension is to be included in his gross income. But see sections 72, 402, and 403, and the regulations thereunder.⁵³

Consistent with the statute, the regulation's general rule is that pensions, like other forms of compensation for services, are included in gross income. Sections 72 (in part), 402, and 403 provide special tax rules for annuities associated with qualified employer plans. By contrasting taxation under those provisions with taxation under the general rule, the regulations unmistakably imply that the general rule applies to a "pension" that is not associated with a qualified plan. Consistent with this regulations, under case law a "pension" includes a distribution from an NQP.⁵⁴

B. Post-1995 Treaties

Notwithstanding the position in the 1996 TE, a number of treaties (the "post-1995 treaties") adopted contemporaneously with or after the 1996 TE's release and/or such treaties' associated TEs provide that a "pension" includes a distribution from an NQP. As discussed above, in 2004 the pension articles in the U.S.-France treaty⁵⁵ and in 2007 the U.S.-Canada treaty⁵⁶ were substantially amended, but not in any way suggesting the negotiators intended to renounce those articles' pre-existing coverage of distributions from NQPs. In addition, TEs issued with respect to the U.s.-Luxembourg (1996), U.S.-Austria (1996), U.S.-Switzerland (1996), and U.S.-Ireland (1996) treaties all state that "'pensions and other similar remuneration' includes amounts paid by all private retirement plans and arrangements in consideration of past employment, regardless of whether they are qualified plans under U.S. law." Implicitly acknowledging the intended divergence, the TEs to the U.S.-Switzerland (issued on October 7, 1997) and U.S.-Ireland (issued on September 19, 1996) treaties indicate that the drafters took into account current treaty policy, presumably as reflected in the contemporaneous 1996 TE (issued on September 20, 1996).⁵⁷ Somewhat later, the TE to the U.S.-Japan treaty (2003) provides that the term "pension and other similar remunerations" includes distributions from qualified plans and "any other payment made by private retirement plans and arrangements in consideration of past employment."⁵⁸ The TE further provides that the negotiations took into account "the U.S. Department of the Treasury's current tax treaty policy and the Treasury Department's [1996] Model Income Tax Convention."⁵⁹ Again, aware of the position of the 1996 TE on NQPs, the negotiators nevertheless took a different path.

There is in fact only one treaty⁶⁰ that itself appears to exclude qualified plans from the pension article's coverage and only seven TEs with respect to post-1995 treaties (themselves, like the U.S. Models, silent on the issue) with respect to such treaties that use the same restrictive language as the 1996 TE or similar language.⁶¹ The remaining TEs⁶² provide that the pension article "includes" or "encompasses" NQPs but may leave open the possibility that NQPs might be covered as well.

Thus, of the approximately 17 pension articles that were adopted or substantially revised contemporaneously with or after the publication of the 1996 TE, seven appear to cover NQPs, eight appear to exclude them, and two are ambiguous. Even if, under the authority of an Article 3(2) provision, it were legitimate to look to treaties that the United States subsequently entered into with third countries in order to divine the meaning of terms used by a pension article in a pre-1996 treaty, those third-country treaties would provide little guidance.

C. The Impact of OECD Developments

Surely one of the reasons that Treasury has had, in its recent bilateral treaty negotiations, only qualified success in permitting source-based taxation of NQP distributions is that, to the extent there has ever been any doubt that the OECD Model's pension article applied to such distributions, the 2005 additions to the Commentary, to which the United States agreed,⁶³ eliminated it. One such addition provides that the "article applies regardless of the tax treatment of the scheme under which the relevant payments are made."⁶⁴ Another, similar addition made in 2017 provides that "the Article applies regardless of whether or not the relevant payments are made from a 'recognised pension fund,'"⁶⁵defined as an entity likely to be a qualified fund.⁶⁶ Since, for a variety of policy reasons,⁶⁷ the OECD Model, like the U.S. Models, provides for exclusive residence-based taxation of amounts subject to the pension article, it is understandable that U.S. treaty partners, especially those partners that are OEeD members, would resist source-based taxation of any pensions, including distributions from NQPs.

The Commentary to the OECD Model does note that the article's exclusive residence-based taxation rule could lead to international double taxation or non-taxation. The Model provides as an example of the latter a situation in which the source State permits the employer a deduction for a contribution to a pension plan and the residence State does not tax the recipient on the receipt of a distribution from the plan. Because of potential international double non-taxation, the Commentary notes that some States may wish to provide some type of source-based taxation instead of the exclusive residence-based taxation provided by the OECD Model.⁶⁸

Because of the complex interactions between the treaty partners' schemes for taxing the income from retirement, the Commentary cautions, however, that they should be addressed through bilateral negotiation: "The issues arising from all these differences [in tax systems] need to be fully considered in the course of bilateral negotiations, in particular to avoid double taxation or non-taxation, and, where appropriate, addressed through specific provisions."⁶⁹

ACCI's incorporation by reference into the pre-1996 treaties of the Model TEs' exclusion of NQPs from the pension article's scope is not merely illegal. As an effectively unilateral amendment of the treaties it ignores the policy need, as expressed in the Commentary and as recognized by the United States in its agreement to the Commentary, to address cross-border flows of retirement income bilaterally and not to treat NQPs differently than qualified plans.

VI. Conclusion

For the above reasons, ACCl is legally incorrect in asserting that distributions from NQPs do not qualify as "pensions" covered by the pension articles in the pre-1996 treaties. In fact, as demonstrated above, all of those articles cover distributions from NQPs as well as qualified plans and do not distinguish between them. We suggest that the Service issue a notice or some other type of guidance indicating that withholding and taxation will not be required if the pension article of the relevant pre-1996 treaty generally reserves to the residence State taxing jurisdiction with respect to pensions paid by a U.S.-based plan, whether or not the plan is qualified, and, in the meantime, direct examining agents to refrain from requiring withholding.

We request a meeting with you and any other appropriate Treasury and Service officials to discuss these issues.

Sincerely yours,

Peter M. Daub

Mary B. Hevener

Morgan Lewis
Washington, DC

cc:
David Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave., NW, Room 3120
Washington, DC 20220
David.kautter@treasury.gov

Lafayette Halier
Deputy Assistant Secretary for International Tax Affairs
Department of the Treasury
1500 Pennsylvania Avenue, NW, Room 3058
Washington, DC 20220
LafayetteChip.Harter@treasury.gov

Douglas Poms
International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW, Room 3058
Washington, DC 20220
Douglas.Poms@treasury.gov

Krishna Vallabhaneni
Acting Tax Legislative Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW, Room 3044
Washington DC 20220
Krishna.Vallabhaneni@treasury.gov

Carol Weiser
Acting Benefits Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW, Room 3044
Washington, DC 20220
Carol.weiser@treasury.gov