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.
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. 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. 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. 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. 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. 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. 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. The concerns derive from the view that section 59A potentially strips Article 24(4) protections against discrimination from the allowance of deductions. Paragraph 4 includes a commitment to impartially allow for deductions whether the connected payment goes to a domestic or foreign payee.