In response to a senator’s fall 2017 question regarding whether the Joint Committee on Taxation (JCT) included “somebody on staff that is an expert on treaties to make sure we are not violating any of the treaties”, JCT Chief of Staff Tom Barthold acknowledged the importance of tax treaty expertise to the legislation’s drafting. He then spoke about the actual concern he perceived:
I believe in particular you were talking about the proposed base erosion anti-abuse provision of the chairman’s mark. ... [I]t is structured as an alternative tax. ... I think our view is that there is not a treaty override.1
Since the enactment of the 2017 tax reform legislation and passage of a new section 59A, the base erosion and anti-avoidance tax (BEAT) provision, commentators have differed on whether the BEAT runs afoul of U.S. bilateral tax treaties, more specifically the non-discrimination articles of those treaties.2 A treaty’s non-discrimination provision treats nationals of one country that is party to a tax treaty the same as nationals of the source country that is party to a tax treaty if both sets of nationals are in the same circumstances.3 In light of the differing views, it may be helpful to consider the BEAT’s operative mechanism, non-discrimination arguments that may arise, as well as practical outcomes regarding the future of U.S. bilateral tax treaties.
The BEAT Explained
The BEAT defends against domestic base erosion by addressing applicable taxpayers’ cross-border, deductible payments to related parties.4 To do so, BEAT imposes a tax called the “base erosion minimum tax amount”. Arriving at the base erosion minimum tax amount requires two computations: ten percent of modified taxable income and regular tax liability. To the extent modified taxable income exceeds regular tax liability, the difference represents the base erosion minimum tax amount.
The first computation is to determine ten percent of modified taxable income. In broad terms, modified taxable income is taxable income taking into account neither deductions linked to base erosion payments to a foreign related party nor the base erosion percentage of any section 172 net operating loss deduction. The base erosion percentage consists of aggregate base erosion tax benefits, deductions based on payments to related foreign payees which the statute targets, divided by the sum of all deductions with some reductions.5 The second computation is section 26(b) regular tax liability decreased by most credits. The computation does not reduce regular tax liability by the section 38 research credit and applies a reduction for only a portion of other section 38 credits.
The base erosion tax amount resulting from the above steps only applies to applicable taxpayers. Applicable taxpayers include corporations (excluding regulated investment companies, real estate investment trusts, and S corporations) that have at least $500 million average annual gross receipts in the preceding three-taxable-year period and that possess a base erosion percentage of three percent or higher. Of note, the applicable taxpayer definition does not distinguish between foreign or domestic taxpayers. The base erosion payment definition hinges on a related payee being a foreign person, a distinction that underlies tax treaty non-discrimination concerns.
Nondiscrimination, Courts, and U.S. Bilateral Tax Treaties Going Forward
The text of Article 24, the non-discrimination article, in the 2016 U.S. Model Income Tax Convention and U.S. bilateral tax treaties appears sweeping relative to other treaty provisions. For instance, while a majority of provisions in U.S. treaties apply to treaty party residents and income taxes, Article 24 extends coverage to non-income taxes and offers protections to signatory country nationals in paragraph 1.6 Article 24 offers four protected areas for classes in the same circumstances as domestic nationals: signatory country nationals, permanent establishments operated by a signatory country enterprises, corporations owned or partially owned by signatory country residents, and deductions on amounts paid to a payee signatory country resident.7 For practical purposes, the “same circumstances” requirement and a narrow nationality construction take the teeth out of the four protections imposing hurdles for discrimination arguments.
In bringing a deficiency or refund action in U.S. courts for the BEAT, a taxpayer would likely base the action on either capital ownership under Article 24(3), or deductibility under Article 24(4). Several commentators raising discrimination concerns focus on the BEAT’s limitation on deductions.8 The concerns derive from the view that section 59A potentially strips Article 24(4) protections against discrimination from the allowance of deductions.9 Paragraph 4 includes a commitment to impartially allow for deductions whether the connected payment goes to a domestic or foreign payee.
[Amounts] paid by an enterprise of a [State A] to a resident of the other [State B] shall, for the purpose of determining taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned [State A].10
In particular, the words “as if they had been paid to a resident of the first-mention [State A]” gives the appearance amounts paid to related foreign payees under the BEAT would not be deducted under “the same conditions”11 as if they had been made to a U.S. payee and accordingly would violate U.S. treaties. As a counter, others argue the law’s application to companies with U.S. parents or the authority to make profit adjustments to payments between related entities under Article 9 prevails over any nondiscrimination claim.12 This second defense of BEAT refers to the power under Article 9 to allocate profits among a related enterprise’s profit centers to reach an arms-length result: the argument is that this allocation does not require a facts and circumstances analysis.13
Although Article 24(4) seems straightforward in impartially protecting deductions, commentators note that U.S. courts interpreting tax treaties often “unmoor” themselves from a plain meaning approach and adopt a pragmatic one.14 As a first step, a court generally rules under “the last in time rule” in favor of whichever authority was enacted last, the statute or the treaty. Even so, interpretive rules and past case law suggest that courts attempt to construe authorities to avoid conflict unless Congress expresses a clear intent for one to override the other.15 Furthermore, in a nondiscrimination case courts generally interpret the “same circumstances” hurdle to apply to the taxpayer. Cases suggest that courts consider carefully “on what basis should comparison be made.”16 Additionally, courts examine the facts and the challenged domestic tax provision’s text to inquire whether the result targets nationality or instead addresses a broader but defined foreign party category.
Published opinions do not address Article 24(4), but three opinions on Article 24(3) provide a potential guide to a deduction discrimination argument. In American Air Liquide, a U.S. corporate taxpayer receiving royalty income from a controlled foreign corporation (CFC) argued that it was in the same circumstances as a U.S. subsidiary receiving royalties from a foreign parent.17 The Tax Court, citing tax-relevant differences in circumstances under Subpart F and sections 951 - 964, rejected that argument. In UnionBanCal Corp., the Ninth Circuit Court of Appeals ruled that denial of a loss on a loan portfolio sale by a former U.S. member of a controlled group to a British group member did not subject the former U.S. member to a more burdensome tax than a U.S. subsidiary.18 Examining the temporary regulation’s operation, the Court found that the outcome remained the same whether the parent was an American or British corporation. Square D Co., a Seventh Circuit case, cited the taxpayer’s failure to identify a “burden . . . directed at nationality” as rationale for upholding an IRS position disallowing interest deductions in the year accrued.19 In that case, a regulation required use of the cash method of accounting for all interest payments to foreign related parties.
The arguments and the case law create uncertainty. Even if court challenges do not occur or go against the taxpayer as the prior decisions suggest, possible treaty partner responses could vary. Two key concerns held by treaty partners include reaching a deal and commitment to the deal.20 The BEAT brings the latter concern into focus. Options could include renegotiation, commitment to memoranda of understanding addressing when the treaty or the new law applies, or enforcement restraint by the IRS in certain instances.21 There is historical precedent for renegotiation: several renegotiations with treaty partners followed the 1986 Tax Reform Act.22 By contrast, renegotiations seem less likely today given the U.S. Senate’s failure to ratify any tax treaties since 2011. On the other hand, many countries continue to negotiate with the U.S. on tax treaties despite the Senate impasse. If negotiations did occur, the BEAT could potentially serve as leverage in support of other U.S. negotiating positions. In past testimony, Treasury officials explained to Congress that U.S. negotiators agreed to eliminate withholding taxes on intercompany dividends in exchange for other countries accepting limitation on benefit provisions.23 Still, some treaty partners may see the BEAT as a lack of good faith or commitment by the United States. Regardless of the exact outcome, if the past provides a guide to the present the tension between the BEAT and tax treaties will likely invite more uncertainty as treaty partners negotiate taxing rights with the U.S. ■
1 Open Executive Session to Consider an Original Bill Entitled the “Tax Cuts and Jobs Act” (Cont’n Nov. 14, 2017: Hearing on H.R. 1 Before the S. Comm. on Finance, 115th Cong. 163 (2017) (question from Sen. Ben Cardin).
2 Peter Barnes & David Rosenbloom, US plays Lone Ranger on international tax to its detriment, The Hill (Jan. 19, 2018), http://thehill.com/opinion/finance/369719-us-plays-lone-ranger-on-international-tax-to-its-detriment; Bret Wells, Get With the BEAT, Tax Notes, Feb. 19, 2018.
3 Carlo Garbarino, Judicial Interpretation of Tax Treaties 500 (2016).
4 S. Comm. on Finance, supra n. 1, at 20-21.
5 I.R.C. § 59A.
6 Boris I. Bittker, Fundamentals of International Taxation 65-72 (2014).
7 2016 U.S. Model Income Tax Convention, art. 24, Feb. 17, 2016 (hereinafter, U.S. Model).
8 David Rosenbloom, International Aspects of U.S. Tax Reform – Is This Really Where We Want to Go?, Int’l Tax Rep. (Jan. 2, 2018), https://www.internationaltaxreport.com/corporate-taxes/international-aspects-of-us-tax-reform--is-this-really-where-we-want-to-go-127955.htm.
9 Mark Martin, Sean Foley & Thomas Bettge, KPMG LLP, BEAT’s Impact on Transfer Pricing Alternative Dispute Resolution, Daily Tax Rep. (Feb. 16, 2018), www.bloomberglaw.com/product/tax/page/page_federal (follow "Daily Tax Report" hyperlink; then follow “Daily Tax Report” hyperlink on left margin; then follow “All Issues” hyperlink); Lee A. Sheppard, News Analysis: International Clawbacks and Minimum Taxes in Tax Reform, Tax Notes Int’l (Jan. 2, 2018), https://www.taxnotes.com/tax-notes-today (follow calendar hyperlink selecting Jan. 2, 2018) (quoting Danielle Rolfes KPMG LLP, former Treasury international tax counsel).
10 U.S. Model, supra note 7, at art. 24(4).
11 2006 U.S. Model Technical Explanation, art. 24, Nov. 15, 2006 (the “same conditions” and “same circumstances” have the same premise treating different treatment based on tax-related differences as not discriminatory).
12 Wells, supra note 3.
14 Rebecca M. Kysar, Interpreting Tax Treaties, 101 Iowa L. Rev. 1387, 1405 (2016).
15 Id. at 1443-44, n. 337.
16 Richard E. Andersen, Analysis of United States Income Tax Treaties § 20.02 (2017).
17 American Air Liquide, Inc. v. Comm’r, 116 T.C. 23 (2001).
18 UnionBanCal Corp., v. Comm’r, 305 F.3d 976 (9th Cir. 2002).
19 Square D Co. v. Comm’r, 438 F.3d 739 (7th Cir. 2006).
20 Diane M. Ring, When International Tax Agreements Fail at Home: A U.S. Example, 41 Brook. J. of Int’l L. 1185, 1224 (2016).
21 Natalie Olivo, New Tax Law at Odds With Treaties, International Policy, Law360 (Jan. 9, 2018), https://www.law360.com/articles/999652.
22 IR-News Rel. 1988-1434, United States and France Will Discuss Revisions to Income Tax Treaty (reprinted in Tax Notes, Feb. 15, 1988, at 681); IR-News Rel. 1988-913, Treasury Announces Treaty Negotiations with Spain (reprinted in Tax Notes, Feb. 1, 1988, at 488); Eliot Rosen, The Week in Review: An Interview with Outgoing International Tax Counsel Stephen E Shay: Part Two, 36 Tax Notes 843 (1987) (interview discussing tax treaty negotiations to accommodate tax reform).
23 Tax Treaties, Hearing Before the S. Comm. On Foreign Relations, 109th Cong. 3-15 (2006) (statement of Patricia Brown, Deputy Int’l Tax Counsel, Dep’t of the Treasury).