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The Debate on Treaty Application to Section 965, GILTI, and BEAT

Posted on May 20, 2019

Paul Tadros and Marc Schwartz are with Schwartz International in Atlanta.

In this article, the authors argue that the reduced foreign tax credits allowed in calculating the net tax liability under section 965 and the global intangible low-taxed income provision do not violate U.S. treaty obligations in granting FTCs.

Over the past few months, articles have been written debating whether the reduced foreign tax credits (“haircuts”) allowed in computing the net tax liability under section 965 (the transition tax) and the global intangible low-taxed income provision violate U.S. treaty obligations in granting FTCs or constitute a treaty override by Congress. Some have also extended the debate to the additional tax under the base erosion and antiabuse tax provision. We do not believe that there is a treaty issue and, therefore, the extensive debate on congressional override is irrelevant. More importantly, we would love to be enlightened as to the treaty connections to the tax imposed under the BEAT.

For the purposes of the transition tax and GILTI portions of this article, it is assumed that a U.S. C corporation (USP) wholly owns a foreign corporation through which business is conducted in its country of tax residency.

All section references are to the U.S. Internal Revenue Code, 1986, as amended.

Transition Tax and GILTI

The Tax Cuts and Jobs Act (P.L. 115-97) fundamentally changed the taxation of international operations conducted by USP through its controlled foreign corporation. Two of the changes were:

  • amended section 965 (commonly referred to as the transition tax because all post-1986 CFC earnings not taxed in the United States in USP’s hands became taxable in 2017 based on the premise that, allegedly, the United States was moving to a territorial system); and

  • GILTI.

Much has been written on the mechanics of the transition tax and GILTI, and we will not delve into the details thereof except to state the following to place this article in context:

  • Transition tax: 100 percent of CFC’s post-1986 earnings that would have been subject to the transition tax in 2017 in USP’s hands were, in fact, not taxed in USP’s hands. Two components of the total earnings were required to be determined — cash (specifically defined) and other assets. While the statutory rate of 35 percent (2017) was applied to each component, only 44.29 percent of the cash component was taxed and only 22.86 percent of the noncash component was taxed. The grossed-up amount under section 78 for the deemed taxes paid at the CFC level was reduced accordingly, which, of course, reduced the FTC available to USP to offset its U.S. tax liability on the section 965 amount.

  • GILTI: Solely for the purpose of this article, we assume that the tested income (specifically defined) is equal to the GILTI to be included in USP’s hands and, therefore, all deemed taxes paid at the CFC level are included in the grossed-up amount under section 78. Like the transition tax, not all GILTI (which includes the grossed-up amount under section 78) is subject to U.S. tax since a 50 percent deduction is allowed, resulting in a rate of 10.5 percent before any FTC. However, the maximum FTC allowable is 80 percent of the amount under section 78 notwithstanding that 100 percent of the section 78 amount (before the 50 percent deduction) is included. This is illustrated by the following example:

GILTI before gross-up is $1,000, and the section 78 amount is $200. Thus, the total is $1,200, with a deduction for $600, leaving a net of $600 subject to tax at 21 percent. The total U.S. tax before FTC is $126 (21 percent of $600). The maximum FTC available is $160 (80 percent of $200) resulting in no net U.S. tax.

Therefore, it is very important to bear in mind the following (percentages/amounts reflect the gross-up under section 78):

  • Transition tax: Only 44.29 percent of the cash component and 22.86 percent of the noncash component was subject to tax.

  • GILTI: Only 50 percent is taxable with a maximum FTC of 80 percent of the gross-up under section 78.

Avoidance of Double Taxation: Treaty

It does not matter which U.S. treaty is selected since the relevant article always has the following:

In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income applicable to residents and citizens.1 [Emphasis added.]

Although the U.S. treaties predate the TCJA (with many signed after the 1986 reform), Treasury’s technical explanation is consistent:

The direct and deemed-paid credits allowed by paragraph 1 are subject to the limitations of the Code as they may be amended from time to time without changing the general principle of paragraph 1. Thus, as is generally the case under U.S. income tax conventions, provisions such as Code sections 901(c), 904, 905, 907, 908, and 911 apply for purposes of computing the allowable credit under paragraph 1.

What is the common element in both the transition tax and GILTI? U.S. tax is not imposed on 100 percent of the calculated amounts — that is to say there are exempt portions that can be repatriated tax free to the United States. Therefore, why should 100 percent FTCs be granted? We have recently seen other countries deny full FTCs on the portion of exempt income. For example, Australian courts allowed only 50 percent for U.S. taxes paid on a capital gain realized by an Australian resident because only 50 percent of the gain was subject to tax in Australia. This ruling was the right result under the Australia-U.S. treaty and was not construed as a treaty override. In other words, if the government is not going to tax 100 percent of the income, how can it allow all of the foreign taxes on said income to be creditable?

In fact, when one looks at the GILTI provisions, the United States is allowing an FTC of 80 percent while only taxing 50 percent.

BEAT: Nondiscrimination

It has been posited by others that because BEAT only applies to deductible payments (interest, royalties, and services, but not inventory) from the United States to foreign related parties and not to domestic related parties, the nondiscrimination provision of a treaty may apply.

In one article, it was argued that since a BEAT-type payment made by a U.S. person to another related U.S. person is not subject to the BEAT while a payment to a related foreign person in a treaty jurisdiction is subject to the BEAT, there is a violation of the nondiscrimination provision of the treaty. Now, let us examine what a typical nondiscrimination treaty provision states (found in paragraph 1 of the treaty article):

Nationals of a Contracting State [Country X] shall not be subjected in the other Contracting State [U.S.] to any taxation or any requirement connected therewith that is more burdensome than the taxation and connected requirements to which nationals of that other State [U.S.] in the same circumstances, particularly with respect to taxation on worldwide income, are or may be subjected. [Emphasis added.]

Essentially, the nationals of Country X cannot be treated any differently than a U.S. national if identical circumstances exist. To place this specific provision into perspective, we use five different scenarios in which USCo is a U.S. C corporation and FP is a foreign corporation resident in Country X. Country X has a treaty with the United States:

  • Scenario A: USCo is wholly owned by U.S. persons and makes royalty payments to its foreign subsidiary.

  • Scenario B: USCo is wholly owned by FP and makes royalty payments to FP.

  • Scenario C: USCo is wholly owned by FP (or U.S. persons) and makes royalty payments to a related U.S. person.

  • Scenario D: FP conducts a trade or business through a fixed place in the United States; that is to say it has a permanent establishment in the United States. The PE makes royalty payments to a related U.S. person.

  • Scenario E: FP’s PE in Scenario D makes royalty payments to a foreign subsidiary wholly owned by FP.

In scenarios A and B, both USCos are nationals of the United States and both are subject to BEAT (ownership is irrelevant). Definitely not discriminatory.

In Scenario D, FP (a national of Country X) is in the same position as USCo in Scenario C whereby BEAT is inapplicable since the payments are to related U.S. persons. Definitely not discriminatory.

In Scenario E, FP (a national of Country X) is in the same position as USCo in Scenario A or B whereby BEAT is applicable to both. Definitely not discriminatory.

BEAT: FTC

In the same article dealing with the violation of the nondiscrimination provision of a treaty, it was suggested that the United States should allow an FTC to offset the BEAT. This was the most puzzling idea. Two fundamental questions:

  • Is a non-U.S.-sourced BEAT payment subject to U.S. withholding?

  • Which person is subject to the BEAT — the payer or recipient?

The BEAT is technically not on the recipient of the income but on the payer. This ensures that the provisions of a treaty (interest and royalties) are not violated (the tax is not on the beneficial owner of the income). Therefore, where is the FTC issue arising, from a U.S. tax perspective? Does the issue arise from a foreign perspective? Definitely, yes, as illustrated using the example in Scenario E. Let us assume that Country X (where FP is a tax resident) will tax FP on its earnings from the U.S. PE. One must bear in mind that FP is the person liable for the BEAT; therefore, it seems that the issue of granting the FTC lies with Country X, which must determine whether it is a creditable tax under either its domestic law or the treaty. Why is this scenario a U.S. FTC issue?

Conclusion

As far as the transition tax and the taxes on GILTI and BEAT are concerned, any treaty issue(s) being postulated are irrelevant. Having stated the preceding, it will be interesting to see how U.S. courts rule if these treaty issues are litigated.

FOOTNOTES

1 Note: The credit is on the income that is being taxed.

END FOOTNOTES

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