CRS REPORT FAVORS TREATY OVERRIDE ARTICLES IN FUTURE CONVENTIONS.

Harry G. Gourevitch Senior Specialist in Taxation and Fiscal Policy Office of Senior Specialists

March 25, 1993

SUMMARY

Since about 1980 Congress has with increasing frequency enacted tax laws containing provisions that override U.S. tax treaties with other countries. A treaty override occurs when an act of Congress overturns or modifies a tax benefit granted to foreign investors by a tax treaty. While before 1980 tax legislation also overrode tax treaties from time to time, as in the Revenue Act of 1962 and the Tax Reduction Act of 1975, those occasions were relatively infrequent. Treaty overrides were contained in tax legislation enacted in 1980, 1984, 1986 and 1988. An earnings stripping provision enacted in 1989 was challenged by commentators as violating tax treaty non- discrimination provisions. In 1992 a bill (H.R. 5270) to reform the international tax rules was introduced for discussion purposes. The bill, which was not brought to a vote in either chamber, contained provisions that would have overridden tax treaties.

This report examines the Supreme Court's later in time rule which holds that under the Constitution's Supremacy Clause whenever an international agreement and an act of Congress conflict the one later in time shall prevail. Accordingly, an act of Congress prevails over a conflicting prior treaty, just as a treaty prevails over a conflicting prior act of Congress.

The growing number of conflicts between acts of Congress and tax treaties are attributed to Congress' Constitutional role in setting tax policy, its increased interest in recent years in the tax rules governing international business and investment transactions, and to the expanding scope of tax treaties. The potential for conflict arises because, while the Congress enacts tax legislation, it has limited input into the contents of tax treaties which are negotiated by the executive branch. Conflicts between tax treaties and legislation may also have been aggravated by the fact that during the nineteen eighties the U.S. government changed domestic tax laws at an accelerated pace. To renegotiate a tax treaty in order to reflect changes in tax policy generally is very time consuming and may be difficult to achieve.

Recent conflicts between tax legislation and tax treaties are reviewed and the views of some commentators on legislative overrides of tax treaties are noted. While as a matter of constitutional law a later act of Congress may override a conflicting prior treaty, the United States remains obligated under international law to perform its commitments under the treaty. Thus, a legislative override of a tax treaty may place the United States in the position of violating its obligations under international law.

Some possible approaches to the problem of congressional overrides of tax treaties are discussed, including an override article now included in four recent U.S. tax treaties in which an overriding party pledges that it will enter into negotiations or consultations to modify the treaty if its legislative override has decreased the other party's treaty benefits. This novel treaty provision may find itself in other new tax treaties or protocols and in the Draft Model U.S. income tax treaty now under revision, and while it will not eliminate congressional overrides of tax treaties, it may help to reduce the international friction such overrides tend to create with our treaty partners.

TABLE OF CONTENTS

INTRODUCTION

RECENT LEGISLATIVE OVERRIDES OF U.S. TAX TREATIES

     The Foreign Investment in Real Property Tax Act of 1980

THE UNITED STATES' OBLIGATIONS UNDER INTERNATIONAL LAW TO PERFORM TREATIES

POSSIBLE APPROACHES TO RESOLVING CONFLICTS BETWEEN TAX TREATIES AND TAX LEGISLATION

CONCLUSION

I am indebted to Raymond Celada for helpful comments.

TAX TREATIES: THE LEGISLATIVE OVERRIDE PROBLEM

INTRODUCTION

Congress was particularly active during the 1980s in formulating and reformulating tax policy, enacting major tax statutes almost yearly. A number of these contained provisions overriding tax treaties. The executive branch, in particular the Treasury Department, maintains an active program of negotiating bilateral income tax conventions, and some estate tax conventions, with other countries and approximately forty income tax conventions are now in force. Under the Constitution, as interpreted by the Supreme Court, whenever an act of Congress and an international agreement conflict the one later in time prevails. For example, when in the Foreign Investment in Real Property Tax Act of 1980 Congress decided to tax foreigners on their gains from dispositions of stock in U.S. real property holding companies, the tax conflicted with many U.S. tax treaties which at the time exempted foreign investors resident in the other treaty country from tax on stock gains. Congress directed that the tax apply notwithstanding conflicting treaties. Rather than overriding the tax treaties immediately, however, Congress adopted a five year delayed effective date for those investors who were protected by a treaty exemption in order to give the Treasury Department time to renegotiate the treaties and to remove the exemption. At the end of the five years FIRPTA was to prevail over, that is, to override, those tax treaty exemptions that had not been renegotiated by then.

Tax treaty overrides can cause friction with our treaty partners because, while a later act of Congress may override a prior treaty as a matter of domestic law, the United States remains obligated under international law to perform its treaty obligations in good faith. Some actual or threatened legislative overrides of treaties are more significant than others, as some may be technical in nature, or interpretative or inadvertent, without going to the heart of the benefits exchanged, while other overrides can be more serious. In recent years foreign governments have become more vocal about protesting actual or proposed congressional overrides of tax treaties, and in some cases they have threatened retaliatory measures aimed at the foreign operations of American corporations within their borders.

Conflicts between tax treaties and domestic tax legislation ultimately arise from the Constitutional separation of powers between Congress and the executive branch, the one to make tax policy, the other to enter into treaties with the advice and consent of the Senate. Congress, especially the House of Representatives, has less input into the contents of tax treaties than the contents of domestic tax legislation. Tax treaties are negotiated and drafted by the Treasury Department and its foreign government counterparts, and then submitted as completed texts to the Senate for its advice and consent. Prior to that time congressional involvement is limited to its periodic contacts with the Treasury Department, which fall short of the detailed negotiating and drafting process that characterizes the hammering out of domestic tax legislation. After submission of a treaty to the Senate, it can either approve or reject a treaty in its entirety, with only very limited opportunity to place its imprint on a treaty by means of reservations or understandings. It is possible that some conflicts between tax legislation and tax treaties in recent years would not have occurred had the legislative branch been controlled by the same political party as the executive branch. However, the delayed treaty override in FIRPTA was enacted in 1980 when the same political party controlled Congress and the executive branch.

Since conflicts between tax legislation and tax treaties are the inevitable consequence of the separate Constitutional roles of Congress and the Executive it is not at all clear such conflicts can be eliminated altogether. But it may be possible to reduce the friction with our treaty partners that overrides can cause by including an override article in U.S. tax treaties. Such an article commits the overriding treaty partner to enter into negotiations or consultations to modify the treaty if a legislative override has reduced the other partner's treaty benefits.

RECENT LEGISLATIVE OVERRIDES OF U.S. TAX TREATIES

The Treasury Department conducts an active program of negotiating bilateral income tax treaties, including a few estate and gift tax treaties, with other countries. To date the United States has entered into approximately forty bilateral income tax treaties. Tax treaties are designed primarily to avoid double taxation and to prevent tax evasion. For example, under U.S. tax treaties dividends paid by a domestic corporation to a shareholder resident in the other treaty country are taxed at rates as low as 5 percent, whereas under the Internal Revenue Code the applicable rate is 30 percent (Code sections 871(a)(1)(A), 881(a)(1)). While the United States and other countries already have rules in their domestic laws to reduce or eliminate unilaterally double taxation on foreign source income, tax treaties serve to adapt and refine these rules. Tax treaties serve to prevent tax evasion by providing for the exchange of tax information between tax administrations.

As the Treasury Department has expanded its treaty program to include an increasing number of countries, the scope of tax treaties being negotiated appears to have expanded as well. Congress for its part has in recent years taken an increasing interest in the formulation and reformulation of tax policy, including the tax rules applying to international business and investment transactions. In a number of tax statutes enacted during the 1980s Congress determined that existing tax treaty provisions in certain particulars failed to reflect congressional tax policy. As to a few of the areas of conflict it declared that treaties should prevail over inconsistent legislation, but as to others it declared that the legislation should prevail over inconsistent treaty provisions.

THE FOREIGN INVESTMENT IN REAL PROPERTY TAX ACT OF 1980

Prior to 1980 instances of legislative overrides of tax treaties were relatively rare, though they did occur from time to time, as with the Revenue Act of 1962. Starting with the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) such overrides became more common. FIRPTA imposed taxes on foreigners' gains from the sale of stock in U.S. corporations that primarily invested in U.S. real estate, but as most tax treaties at the time exempted all stock gains from tax, FIRPTA expressly provided that it would apply notwithstanding any conflicting treaty provisions. FIRPTA also provided, however, that for investors protected by a treaty exemption the taxation of foreigners' stock gains would not go into effect until five years after the law's enactment. The five year delayed effective date was intended to give the Treasury Department time to renegotiate and remove the tax treaty exemption. If after five years such treaty exemption had not been removed, it was automatically overridden. One commentator was critical of this prospective treaty override and favored scrapping FIRPTA altogether. ¹ A prospective treaty override was not a reasonable solution, he argued, as treaty partners were faced with a situation they could not change. He recognized, however, that there may be no satisfactory solution to the problem that arises whenever Congress makes a policy shift that conflicts with existing tax treaties.

THE DEFICIT REDUCTION ACT OF 1984

In the Deficit Reduction Act of 1984 (the 1984 act) Congress enacted Code section 269B on stapled stock entities taxing a stapled foreign corporation as a domestic corporation. ² As this change was in conflict with tax treaties that exempt from U.S. tax a corporation resident in a treaty partner unless it has a U.S. permanent establishment, Congress expressly decided that inconsistent treaties were to be overridden except as they applied to any foreign corporation stapled to a domestic corporation on June 30, 1983. ³ The 1984 act also enacted as Code section 7701(b) a statutory definition of the circumstances under which an alien individual is to be taxed as a U.S. resident. This provision was also in conflict with tax treaties, as an individual might be a U.S. resident under the statutory definition and a resident of a treaty partner under tax treaty "tie breaker" rules, but this time Congress decided that inconsistent treaties were to prevail over the statutory definition. ⁴ On occasion, a tax statute conflicts with a tax treaty without Congress being aware of it. This appears to have happened with the 1984 act which contained a provision making certain U.S. owned foreign corporations subject to the accumulated earnings tax. It was later discovered, that this provision conflicted with an exemption from the U.S. accumulated earnings tax in the income tax treaty with Jamaica. The 1984 act also enacted another provision, Code section 904(g), that conflicted with certain tax treaties. Section 904(g) provided that interest, dividends and certain other payments by a U.S. owned foreign corporation are to be treated in the hands of the recipient as U.S. source rather than foreign source income to the extent the payments are attributable to income of the U.S. owned foreign corporations from U.S. sources. Initially it was unclear whether these resourcing and accumulated earnings tax rules were to prevail over inconsistent tax treaties, or whether, as the 1984 act specified with respect to the definitions of a resident alien, the treaties were to prevail. The uncertainty was cleared up in the Tax Reform Act of 1986 and related Senate Finance Committee report which retroactively expressed a congressional intent that these initially inadvertent statutory changes were to override inconsistent tax treaties. ⁵

THE TAX REFORM ACT OF 1986

Major overriding of tax treaties really began with Tax Reform Act of 1986 (the 1986 act). The 1986 act changed certain source of income rules in a new Code section 865 which provides that on a sale of noninventory personal property the source of the income is the taxpayer's place of residence, unless, in the case of a nonresident taxpayer, he maintains a fixed place of business in the United States. The House Ways and Means Committee and Senate Finance Committee reports stated that the provision expresses a congressional policy that income untaxed by a foreign country should not increase a U.S. taxpayer's foreign source income and foreign tax credit limitation and that any inconsistent treaty provision that would frustrate this policy is to be overridden. ⁶

The 1986 act also greatly expanded in Code section 904(d) the number of separate categories of foreign source income for purposes of the foreign tax credit limitation. These new foreign source income "baskets" conflicted with certain tax treaties, yet neither the 1986 act itself nor the related committee reports expressed a congressional intent as to whether the 1986 act or the treaties were to prevail. Just as with the 1984 act, a number of conflicts between tax treaties and the 1986 act were apparently not discovered until after it was enacted. Here again, a later tax statute, the Technical and Miscellaneous Revenue Act of 1988, retroactively expressed a congressional intent that the 1986 act's changes to the foreign source income "baskets" of Code section 904(d) were to prevail over inconsistent treaties. ⁷

The 1986 act also limited the alternative minimum tax foreign tax credit to 90 percent of the tentative U.S. alternative minimum tax. The Technical and Miscellaneous Revenue Act of 1988 here as well retroactively expressed Congress' intent that this provision was to prevail over inconsistent treaties. ⁸

The 1986 act enacted a new branch profits tax (Code section 884) to be imposed on a foreign corporation conducting a trade or business in the United States, but provided that the tax was not to apply if it was barred by a tax treaty, unless the foreign corporation was engaged in treaty-shopping. The 1986 act adopted a statutory anti treaty-shopping rule that denied to a foreign corporation resident in a treaty country the benefits of a tax treaty exemption from the branch profits tax if it has only minimal contacts with that country, or if one half or more of its income is used to meet liabilities to third country resident. In the anti treaty-shopping rule, codified as section 884(e), Congress expressly intended to override conflicting provisions in tax treaties.

In an article on treaty overrides in the 1986 act two commentators noted that Congress has shown itself increasingly willing to override treaty provisions which do not fit the latest tax revisions. ⁹ They suggested this may be due to the muted reaction to Congress' treaty override in FIRPTA.

THE TECHNICAL AND MISCELLANEOUS REVENUE ACT OF 1988

In the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) Congress spelled out in separate lists those provisions in the 1986 act that are to prevail over inconsistent tax treaties and those that are not to apply to the extent they are inconsistent with tax treaties. ¹⁰ The override provisions consisted of the changes to the foreign income baskets and the minimum tax foreign tax credit limitation, referred to earlier. TAMRA also enacted new Code section 6114 requiring a taxpayer to disclose on his or her return any position he or she has taken on the return that a tax treaty overrules an internal revenue law. Section 6114 applies in any case where a taxpayer relies on a treaty position that is contrary to the result the Internal Revenue Code would dictate in the absence of the treaty. ¹¹ The provision serves to caution taxpayers about taking aggressive return positions in claiming treaty benefits.

THE OMNIBUS BUDGET RECONCILIATION ACT OF 1989

In the Omnibus Budget Reconciliation Act of 1989 (OBRA) Congress enacted as Code section 163(j) an earnings stripping provision which disallowed a deduction for certain interest paid by a domestic corporation to a related tax-exempt person. The provision was aimed at U.S. subsidiaries of foreign parent corporations removing their untaxed earnings from U.S. taxing jurisdiction by paying deductible interest to the foreign parent or other foreign affiliates in whose hands the interest would not be subject to U.S. income tax.

Commentators have argued that this provision discriminates against foreign-controlled corporations in violation of the non- discrimination article in U.S. tax treaties. ¹² Two clauses of the non-discrimination article are involved. The first provides that a treaty partner shall not impose more burdensome taxes on a company controlled by residents of the other treaty country than are imposed on other domestic companies. ¹³ The other provides that interest and other payments by a domestic corporation to a corporation resident in the other treaty country shall be deductible under the same conditions as if they had been made to another domestic corporation. ¹⁴ Doernberg and van Raad argued that the deductibility clause is violated because the denial of an interest deduction applies to payments to certain foreign related enterprises but not to U.S. related enterprises.

The Conference Report to OBRA maintained that section 163(j) is not discriminatory as the national treatment clause applies only to foreign-controlled and domestically-controlled enterprises that are similarly situated, whereas a foreign-controlled corporation making interest payments to a related tax-exempt foreign corporation is not similarly situated to a domestically-owned corporation making interest payments to another domestic taxable corporation. ¹⁵ As section 163(j) applies to a domestic corporation only to the extent its interest payments to a related tax-exempt enterprise exceed 50 percent of its adjusted taxable income, and if it has a debt to equity ratio exceeding 1.5 to 1, the Conference Report further argued that the deductibility clause does not apply where related enterprises do not meet the arm's length standard as applied in a thin capitalization context. Had the interest payments been made between unrelated parties dealing at arm's length, they would have been more properly characterized as a return on equity because the debtor is thinly capitalized. ¹⁶ The Treasury Department agreed that the earnings stripping provision does not contravene U.S. tax treaties. ¹⁷

H.R. 5270 OF THE 102ND CONGRESS

In 1992 Mr. Rostenkowski, Chairman of the House Ways and Means Committee, and Mr. Gradison, then a member of the committee, introduced H.R. 5270, a bill to reform U.S. tax rules applying to international transactions. One of the bill's provisions (section 304) would have imposed on foreign-controlled corporations a minimum tax by requiring them to report taxable income of at least 75 percent of their gross receipts multiplied by an industry average profit percentage. Another provision (section 302) would have enacted a general anti treaty-shopping rule (like the one applying to the branch profits tax) denying to a company resident in a country with which the United States has a tax treaty benefits under the treaty if the company has only minimal contacts with its country of residence, or if one half or more of the company's income is used to meet liabilities to third-country residents. In testifying on H.R. 5270, the then Assistant Secretary of the Treasury for Tax Policy, objected to both provisions, asserting that the minimum tax would violate the non-discrimination article of U.S. tax treaties, while the anti treaty-shopping provision would deny treaty benefits to residents of treaty countries whose tax treaties with the United States did not already contain a similar anti treaty-shopping rule. ¹⁸ A letter to the Chairman of the House Ways and Means Committee signed by diplomatic representatives of nineteen of our trading partners protested perceived discriminatory aspects of the bill and its proposed unilateral amendment of U.S. tax treaties. ¹⁹ The letter stated that the bill, if enacted, would lead to strong pressures on their governments for the adoption of retaliatory measures.

THE CONSTITUTIONAL BASIS FOR LEGISLATIVE OVERRIDES OF TAX TREATIES

When the provisions of a treaty and an act of Congress conflict, the Supreme Court has held that under the Supremacy Clause of the Constitution the one later in time prevails. ²⁰ Courts will try to harmonize seeming conflicts between acts of Congress and treaties, but generally if an act of Congress conflicts with a prior treaty the act of Congress will override the treaty unless Congress has expressed an intent that the prior treaty remain in effect. ²¹

Under the later in time rule tax treaties typically modify the otherwise applicable preexisting rules of the Internal Revenue Code. For example, as noted earlier under tax treaties dividends paid by a domestic corporation to a shareholder resident in the other treaty country are taxed at rates as low as 5 percent, whereas under the Internal Revenue Code the applicable rate would have been 30 percent. Two Code provisions deal with the interaction of the Code and tax treaties. Section 894(a)(1) states: "the provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer." And section 7852(d)(1) states: "For purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law." Neither of these bland statutory pronouncements changes the applicability of the later in time rule and their usefulness in the Code is unclear. ²²

THE UNITED STATES' OBLIGATIONS UNDER INTERNATIONAL LAW TO PERFORM TREATIES

As a matter of constitutional interpretation the later in time rule is firmly established. But, while a later in time act of Congress may supersede a conflicting earlier treaty as a matter of domestic law, the act of Congress does not extinguish the United States' obligations under the treaty as a matter of international law. ²³ When the United States enters into an agreement with another country it is bound under rules of international law to perform the agreement in good faith. This principle is embodied in Article 26 of the Vienna Convention on the Law of Treaties, which came into effect in 1980. While the United States never ratified the Vienna Convention, the Restatement (Third) of the Foreign Relations Law of the United States accepts its provisions as reflecting customary international law. ²⁴ Thus, while a statutory override of a treaty may be valid as a matter of constitutional law, it may place the United States in the position of violating its obligations under international law. ²⁵

A breach or material breach of an international agreement by one of the parties violates its obligation to perform the agreement in good faith. The term "material breach" has been described as the violation of a provision essential to the accomplishment of an international agreement's purposes. ²⁶ If a party to a tax treaty determines that the other party has committed a material breach, under the rules of international law it may either terminate or suspend (in whole or in part) the treaty. ²⁷ Actually, U.S. tax treaties already provide that either party may terminate a treaty on six month's notice for any reason, except that under some tax treaties termination may occur only five years after entry into force. U.S. tax treaties do not grant to parties a right to suspend, as opposed to terminate, a tax treaty either in its entirety or in part. Thus, an aggrieved party's rights under customary international law and the Vienna Convention to terminate or suspend a tax treaty because of a material breach by the other party do not grant the aggrieved party any greater rights than it already has under the treaty itself, except if it wants to terminate within the five year period after entry into force and the treaty bars such early termination, or if the aggrieved party wants to suspend the treaty in whole or in part rather than terminating it.

As to a "breach," as opposed to a "material breach," of an international agreement, neither the Restatement of the Foreign Relations Law of the United States nor the Vienna Convention on the Law of Treaties defines or describes the term though the aggrieved party itself would determine whether a breach has occurred. ²⁸ If, for example, a party to a tax treaty determines that the other party committed a breach of its obligations, under the rules of international law the offending party is required to terminate the violation and to provide redress. ²⁹ As a practical matter, what this often means is that the aggrieved party may submit an official protest to the offending party and there may ensue an exchange of communications between the two.

How do the rights and obligations of parties to a treaty under international law apply to legislative overrides of tax treaties? In talking about the international law ramifications of treaty overrides it may be useful to distinguish among different kinds of overrides. The OECD's Committee on Fiscal Affairs in a 1989 Report on Tax Treaty Overrides lists several kinds of overrides which it views as not being overrides as all, or at most as overrides only in a technical sense. ³⁰ These include interpretative, inadvertent and definitional overrides. Describing a Canadian case where the legislature reversed a treaty interpretation by a Canadian court which had departed from commonly accepted interpretations of the treaty, the report found that the legislature's interpretation of the treaty was accepted by the parties and did not really constitute a treaty override. ³¹ The report also expressed the view that no treaty override occurs when a treaty partner in its domestic legislation changes the definition of a term that is also used in a tax treaty, provided the treaty does not specifically define the term, and provided also that under the treaty undefined terms are to have the same meaning as under the domestic legislation of the treaty party whose tax is being applied. ³² As noted in the Joint Committee on Taxation's explanation of H.R. 5270, changing in domestic legislation the definition of terms that are also used, but not defined, in tax treaties may raise questions under the non- discrimination article of the treaties. ³³ H.R. 5270, under certain circumstances, would have recharacterized as dividends the gains received by foreign shareholders on a liquidation or redemption.

The third kind of override which the OECD report found not to be an override, or at most an inoffensive one, was one where the legislature of one of the parties enacts legislation overruling provisions in the treaty without the legislature being aware it had done so. ³⁴ In the 1984 and 1986 acts Congress enacted such inadvertent treaty overrides, except that later legislation retroactively turned these inadvertent overrides into intentional ones.

The kind of overrides over which the OECD report expressed concern were intentional overrides where a legislature deliberately enacted laws overruling tax treaties. Many of the congressional overrides of tax treaties enacted in recent years would seem to fit into this category and may constitute either breaches or material breaches under international law. An aggrieved party would be entitled to exercise rights of redress ranging from the filing of an official protest to termination or suspension of the treaty. As a practical matter, however, it is not clear that the current rules of international law would give an aggrieved party effective relief. Termination or suspension of a treaty may be too drastic a step to be useful as the aggrieved party or its business interests may have a stake in continuing the treaty benefits that are unaffected by the override. Official protests would also be a possible option but are likely to be of limited effectiveness.

POSSIBLE APPROACHES TO RESOLVING CONFLICTS BETWEEN TAX TREATIES AND TAX LEGISLATION

As Congress' interest in tax policy relating to international investment and business transactions has grown, increasing conflicts have arisen between tax legislation and tax treaties. As Congress articulates its views on aspects of international tax policy in legislation, committee reports or other communications, these can and do serve as guidance to the Executive in negotiating tax treaties. However, Congress' tax policy views change over time whereas policy decisions once taken in a tax treaty tend to remain frozen. To renegotiate a tax treaty in order to reflect changes in tax policy generally is very time consuming and may be difficult to achieve.

A number of approaches have been proposed to reduce conflicts between treaties and tax legislation. Prospective overrides that occur only at the end of a delayed effective date for legislation -- in FIRPTA it was five years -- are designed to give the Treasury Department time to renegotiate conflicting treaty provisions. If the treaties are renegotiated before the legislation goes into effect no treaty override will occur. Some U.S. treaty partners may not care for this approach as it would require them either to negotiate against a deadline or face an eventual override. Nevertheless in appropriate situations prospective overrides may be worth considering. The OECD's Committee on Fiscal Affairs recognized that when a country makes important changes in its tax policy it is to be expected that the new policy will be incorporated in its tax treaties. ³⁵ But in order to amend tax treaties there must be a willingness on the part of treaty partners to negotiate the changes. A delayed effective date would give the Treasury Department time to renegotiate tax treaties with those treaty partners that were willing to do so, the override applying only to tax treaties where the treaty partners were unwilling to amend. The Committee on Fiscal Affairs takes the view that there is no such thing as countries unwilling to renegotiate tax treaties, ³⁶ but such a view may be somewhat unrealistic. Moreover, a willingness to renegotiate a treaty probably should mean a willingness to do so within a reasonable time frame. ³⁷

From the standpoint of a treaty partner the threatened or actual adoption of retaliatory measures may be an effective disincentive to the enactment of legislative overrides by the other treaty partner. For example, while Congress was considering the minimum tax and other proposals contained in H.R. 5270, a number of the United States' treaty partners warned that such action would cause them to retaliate by adopting similar minimum tax measures aimed at foreign subsidiaries of American companies. Such retaliatory measures would have left the tax treaties in place, though they would also have overridden the treaty non-discrimination article. The real damage from such retaliatory measures would be to the foreign operations of American companies and to good international economic relations. Retaliatory measures risk initiating an ever escalating cycle of measures and counter measures, resulting in reduced international trade and investment and reduced economic welfare throughout the world.

Starting with the 1990 tax treaty with Spain, the United States has now agreed to include override articles in several of its recently negotiated income tax treaties. In addition to the treaty with Spain, such articles appear in the treaties or protocols with Mexico, signed in September 1992, Netherlands, signed in December 1992, and Israel, signed in January 1993. In addition, such an article may be included in protocols now being negotiated to the income tax treaties with France and Canada, and in the Treasury Department's proposed Model Income Tax Treaty now undergoing revision. While the exact wording and commitments differ in each of the treaties, generally override articles provide that if one party considers that a change in the domestic laws of the other party eliminates or significantly limits a treaty benefit they shall enter into consultations with a view to restoring the balance of benefits. ³⁸ According to this article the overriding party pledges to enter into negotiations or consultations to modify the treaty if its legislative override has reduced the other party's treaty benefits. ³⁹ While such a pledge carries with it no guarantee that the consultations or negotiations will have a successful outcome, this kind of article nevertheless may represent a definite step forward in reducing international friction over treaty overrides. It is true that even without such an article a treaty partner can at any time request that the other enter into consultations or negotiations to amend the treaty. But the override article for the first time imposes on the overriding party an obligation to enter into such requested negotiations or consultations. A precursor of the new override article appears in the estate and gift tax treaty with France which provides in Article 11(3) that if changes in the domestic laws of either party reduce the tax benefits of the marital deduction or community property granted by Article 11, the competent authorities shall consult to determine whether to modify or terminate the article.

If consultations or negotiations lead to an agreement to modify a tax treaty, such a modification, like the original treaty, would have to be approved by the Senate.

And if consultations fail, the Mexican override article states the aggrieved party may terminate the treaty or take other action permitted under the general principles of international law. Since the treaty already gives the parties a right to terminate on six months notice five years after entry into force, the significance of this provision is to allow termination during the first five years after entry into force. The purpose of the reference to other action permitted under the general principles of international law is not entirely clear as governments do not forfeit their rights under international law when entering into a tax treaty.

CONCLUSION

Since about 1980 Congress has enacted tax legislation almost yearly. With increasing frequency such legislation has overridden provisions in U.S. bilateral income tax treaties with other countries.

When the provisions of a treaty and an act of Congress conflict, the Supreme Court has held that under the Supremacy Clause of the Constitution the one later in time prevails. Courts will try to harmonize seeming conflicts between acts of Congress and treaties, but generally if a later act of Congress conflicts with a prior treaty the act of Congress will override the treaty unless Congress has expressed an intent that the prior treaty remain in effect. As a matter of constitutional law the later in time rule is well established. However, even though an act of Congress may supersede a treaty for domestic law purposes, the United States government remains bound to perform the terms of the treaty in good faith under the principles of international law. Thus, when Congress overrides provisions of a treaty the United States may stand in violation of its obligations under international law.

Almost all of the major pieces of tax legislation enacted by Congress during the decade of the 1980s, starting with the Foreign Investment in Real Property Tax Act of 1980, overrode one or more tax treaty provisions. In addition, some bills, such as H.R. 5270 introduced in 1992, proposed treaty overrides. Conflicts between tax treaties and tax legislation appear to be an inescapable consequence of the fact that Congress makes tax policy and the Executive negotiates tax treaties with other countries. In recent years Congress has become more active in making and changing tax policy and corresponding changes in tax treaty policy have lagged behind.

Legislative overrides of tax treaties create international friction with other countries. A number of treaty partners have officially protested actual or proposed treaty overrides and have threatened the adoption of retaliatory measures. In recently ratified or signed tax treaties, notably the ones with Spain, Mexico, Netherlands and Israel, the United States has agreed to include a treaty override article pledging that it will enter into negotiations or consultations with a treaty partner which considers that congressional legislation has reduced its treaty benefits with a view to restoring the treaty's balance of benefits. Any proposed treaty modifications would have to go through the usual treaty ratification procedures and thus would involve a fairly long and uncertain process. Still, the existence of treaty language committing an overriding party to enter into requested consultations or negotiations to amend the treaty may help to reduce the international friction with our treaty partners caused by congressional overrides of tax treaties.

² The stock of a foreign corporation was stapled to the stock of a domestic corporation when a shareholder could not buy or sell the stock of one corporation without buying or selling the stock of the other.

³ Code section 269B(d); The Deficit Reduction Act of 1984, section 136(c)(5) (P.L. 98-369).

⁴ Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 468 (JCS-41- 84).

⁵ The Tax Reform Act of 1986, section 1810(a)(4) (P.L. 99-514, 100 STAT 2085); Senate Finance Committee, Report No. 99-313, 936, to accompany H.R. 3838, the Tax Reform Act of 1986, 99th Cong., 2nd Sess.

⁶ Ways and Means Committee, Report No. 99-426, 363, to accompany H.R. 3838, the Tax Reform Act of 1985, House of Representatives, 99th Cong., 1st Sess.; Senate Finance Committee, Report No. 99-313, 331, to accompany H.R. 3838, the Tax Reform Act of 1986, 99th Cong., 2d Sess.

⁷ Conference Report No. 100-1104, Technical and Miscellaneous Revenue Act of 1988 (H.R. 4333), sec. 1012(aa), 100th Cong., 2d Sess.

⁸ Id. at sec. 1012(aa).

⁹ John I. Forry and Michael J.A. Karlin, 1986 Act: Overrides, Conflicts, and Interactions with U.S. Income Tax Treaties, 35 Tax Notes 793 (1987).

¹⁰ Public Law 100-647, sec. 1012 (aa)(102 STAT 3342).

¹¹ Conference Report No. 100-1104, 11-12, Technical and Miscellaneous Revenue Act of 1988 (H.R. 4333), 100th Cong., 2d Sess.

¹² Richard L. Doernberg and Kees van Raad, The Legality of the Earnings Stripping Provision under U.S. Income Tax Treaties, 2 Tax Notes International 199 (1990).

¹³ For example, see Article 24(5) of the United States Income Tax Treaty with the United Kingdom.

¹⁴ Id. at Article 24(3).

¹⁵ Conference Report No. 101-386, 67-68, Revenue Reconciliation Act of 1989 (H.R. 3299), 101st Cong., 2d Sess.

¹⁶ In support of its position the Conference Report cites the OECD's study, Thin Capitalization, Para. 87 (1987).

¹⁷ Treasury Department letter, cited in 46 Tax Notes 392, (1990).

¹⁸ Hearings on H.R. 5270, the Foreign Income Tax Rationalization and Simplification Act of 1992, Statement of Fred Goldberg, Assistant Secretary of the Treasury (Tax Policy), Ways and Means Committee, House of Representatives. (July 1992.)

¹⁹ Id. at 940.

²⁰ Restatement (Third) of the Foreign Relations Law of the United States, Sec. 115(1)(a) states:

An act of Congress supersedes an earlier rule of international law or a provision of an international agreement as law of the United States if the purpose of the act to supersede the earlier rule or provision is clear OR IF THE ACT AND THE EARLIER RULE OR PROVISION CANNOT BE FAIRLY RECONCILED. (Emphasis supplied.)

See also cases cited in Reporters' Notes 1 to Section 115.

²¹ Some have also argued, relying on Cook v United States, 288 U.S. 102 (1933), that the courts will hold that an act of Congress overrides an inconsistent prior treaty only if Congress clearly expressed such an intent. According to the Restatement, section 115(1)(A), however, a clearly expressed congressional intent is not required.

²² As stated by Joseph Isenbergh in 2 International Taxation, section 42.13.1 (Little, Brown and Company, 1990):

[Section 894(a)] is, at least literally, consistent with the nullification of existing treaty provisions by every statutory change, although it does not compel this result. Assuming, as one must, that section 894(a) is something more than merely atmospheric, the difficulty of bounding the notion of "due regard" will, I suspect, earn this version of section 894(a) many fond hopes of its early retirement.

²³ Restatement (Third) of the Foreign Relations Law of the United States, sec. 115(1)(b).

²⁴ Restatement (Third) of the Foreign Relations Law of the United States, sec. 321: "Every international agreement in force is binding upon the parties to it and must be performed by them in good faith."

²⁵ For example, see Richard L. Doernberg, Selective Termination or Suspension of Income Tax Treaty Provisions, 2 Tax Notes International 1130, 1131 (1990).

²⁶ Vienna Convention, article 60.3(b).

²⁷ Restatement (Third), sec. 335; Vienna Convention, article 60.

²⁸ Restatement (Third), sec. 335, Comment b.

²⁹ Id. at sec. 901.

³⁰ Committee on Fiscal Affairs, Report on Tax Treaty Overrides, Para. 4 (OECD, 1989), reproduced at 2 Tax Notes International 25 (1990).

³¹ Id. at Para. 4.a).

³² Id. at Para. 4.b).

³³ Joint Committee on Taxation, Explanation of H.R. 5270 (Foreign Income Tax Rationalization and Simplification Act of 1992), 39-40 (JCS-11-92).

³⁴ Committee on Fiscal Affairs, Report on Tax Treaty Overrides, Para. 4.c (OECD, 1989).

³⁵ Committee on Fiscal Affairs, Report on Tax Treaty Overrides, Para.36 (OECD, 1989).

³⁶ Id. at Para. 37.

³⁷ Prospective treaty overrides giving the executive branch time to renegotiate tax treaties is an approach that was supported by the Committee on U.S. Activities of Foreign Taxpayers of the New York State Bar Association in a report on Legislative Overrides of Tax Treaties, reproduced at 37 Tax Notes 931, 937 (1987).

³⁸ In the income tax treaty with Mexico, the override article states:

When the competent authority of one of the Contracting States considers that the law of the other Contracting State is or may be applied in a manner that eliminates or significantly limits a benefit provided by the Convention, that State shall inform the other Contracting State in a timely manner and may request consultations with a view to restoring the balance of benefits of the Convention. If so requested, the other State shall begin such consultations within three months of the date of such request.

If the Contracting States are unable to agree on the way in which the Convention should be modified to restore the balance of benefits, the affected State may terminate the Convention in accordance with the procedures of paragraph 1, notwithstanding the five year period referred to in that paragraph, or take such other action regarding this Convention as may be permitted under the general principles of international law.

³⁹ Philip D. Morrison, U.S.-Mexico Income Tax Treaty Breaks new Ground-Implications for the New U.S. Model and for Latin America, 5 Tax Notes International 825, 834 (1992). Morrison notes that the treaty with Spain may contain a lesser commitment merely to consult on whether to enter into negotiations to modify the treaty.