German Ambassador Says Neal Tax Evasion Bill Conflicts With Tax Treaty

I am writing to express the German Government's concerns about several proposals that would partially deny the deductibility of re-insurance premiums paid to affiliated insurance companies. The proposals would primarily affect U.S. subsidiaries of foreign reinsurers, including those located in Germany.

The proposal by Rep. Richard Neal (H.R. 3424), for example, denies the deduction for reinsurance premiums paid to a foreign affiliate if the amount exceeds the industry average for third-party re-insurance. The Administration's budget proposal also contains a provision to limit deductions for affiliate re-insurance to 50 percent of written premiums. The proposals are intended to address concerns that foreign re-insurers are avoiding paying their fair share of U.S. tax by imposing excessive premiums on their U.S. affiliates.

It goes without saying that the German Government recognizes the U.S. Government's right to combat tax avoidance and evasion. But it is our view that the proposed legislation goes well beyond this objective and, as a result, will be in conflict with provisions of the German-U.S. tax treaty.

Firstly, due to the legislation's general scope of application, it would affect companies that re-insure themselves with their related companies headquartered in normal-taxing jurisdictions, such as Germany. Consequently, US. insurance companies related to German re-insurers would be put at a competitive disadvantage, as the proposals would not affect premiums paid to a domestic affiliate.

Secondly, Article 9 of the German-U.S. tax treaty incorporates the arm's length principle, which has long been supported by the U.S. Government within the framework of the Organization for Economic Cooperation and Development (OECD). Under the arm's length principle, related companies are taxed with respect to their commercial relations and the transactions conducted between them according to the same conditions that would apply to two unrelated parties.

The German Government believes that the arm's length principle is a fair method of determining proper allocation of income to each jurisdiction and should be respected. The application of industry averages to related party transactions, as provided for under the Neal bill, is, on the other hand, a clear departure from the arm's length principle, because it would disregard individual circumstances. The same applies to the proposal put forth by the Treasury Department, which also represents a clear departure from the arm's length principle. Industry averages have never been used to determine whether transactions between related parties were at arm's length. We seriously question the validity of this approach in the insurance industry. As with other industries, observance of the arm's length principle is subject to audits carried out by the tax authorities to ensure compliance, and Article 9 of the German-U.S. tax treaty would allow for an adjustment of taxable income of the U.S. affiliate in cases of improper application of the principle.

Both proposals would, in effect, lead to an increase in mutual agreement procedures, if not, ultimately, to double taxation.

Thirdly, the legislation would also violate the prohibition on discrimination set forth in the German-U.S. tax treaty. Specifically, paragraph 4 of Article 24 provides that a U.S. company wholly or partly owned by a German company shall not be subject to taxation in the U.S. that is more burdensome than the taxation applicable to other U.S. companies.

While the proposed legislation would not permit companies to provide evidence that their transactions are, indeed, at arm's length, it would grant the foreign insurance company the option of avoiding any disadvantage arising from the non-deductibility of re-insurance premiums by allowing the foreign re-insurer to elect to be treated as a domestic corporation for U.S. tax purposes. Yet this provision would also apply U.S. tax law in a manner which is clearly incompatible with the principles laid down in paragraph 1 of Article 7 of the German-U.S. tax treaty and has far-reaching implications. It thus would not provide an acceptable alternative.

Finally, the German Government has concerns about the legislation's compatibility with WTO principles, particularly with a view to the obligations related to the General Agreement on Trade in Services. Specifically, the German Government would like to refer to the relevant obligations concerning national treatment.

I would be grateful if you could take into account the concerns of the German Government in your deliberations as you continue to discuss these proposals.

Cc: