Limitations on Treaty Benefits: A Narrow Escape H.R. 847 – But Here We Go Again (H.R. 64)

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By Edward Tanenbaum, Esq.  

Alston & Bird LLP, New York, NY 

I can't recall how many bills providing a limitation on treaty benefits have been introduced into Congress since the last time I wrote about the topic a few years back but, from my perspective, far too many. I think we really need to consider this issue more carefully before any of these bills accidentally becomes law.

Although this is not at all a new topic, particular attention was first placed on a bill (H.R. 3160) introduced in mid-2007 by Rep. Lloyd Doggett (and his bill was subsequently attached to another bill (H.R. 2419)). Rep. Doggett's bill, which would add a new §894(d), provides that if a U.S. entity makes a deductible payment to a foreign entity that is a resident of a treaty country and the U.S. and foreign entities are part of the same foreign controlled group, then the withholding tax rate to be applied to the payment is the higher of the rate otherwise applicable on the payment to the controlled foreign entity under the tax treaty between the United States and the country in which the controlled foreign entity is a resident or the rate applicable in the case of a payment to the foreign parent corporation, taking into account any tax treaty between the United States and the country in which the foreign parent corporation is a resident.

Deductible payments include interest on loans made to the U.S. affiliate or royalties charged the U.S. affiliate for the use of intellectual property, e.g., patents, trademarks, copyrights. A U.S. corporation would be considered part of the same foreign controlled group (the common parent of which is a foreign corporation) if more than 50% of the stock is held by other corporations within the same group.

For example, if a Japanese parent company owns a U.S. subsidiary and a German subsidiary and if interest is paid by the U.S. subsidiary on a loan made to it by the German company, then, rather than a zero rate of withholding being applicable under the U.S.-Germany Income Tax Treaty, the 10% rate generally applicable under the U.S.-Japan Income Tax Treaty would apply since it's the higher of the two rates.

Needless to say, this bill evoked a major negative reaction in tax circles amongst not only practitioners but also trade associations and even government officials, all of whom were opposed to the bill in the context of broader U.S. tax treaty policy.

Fortunately (to some extent), subsequent iterations of the bill, starting with the Rangel bill (H.R. 3970) and including H.R. 4849, H.R. 847 (passed by the House on September 29, 2010, but rejected by the Senate on December 9, 2010), and now H.R. 64 (introduced in the House on January 5, 2011), take into account certain treaty conflicts and provide that the withholding tax rate applicable on a deductible party payment would be the rate under a treaty with the country of the payee corporation provided that the rate would be reduced under a treaty if the payment were made directly to the foreign parent corporation (even if that rate were higher). Stated differently, as long as there is a treaty with the foreign parent corporation that would reduce the withholding tax rate if the payment were made directly to the foreign parent corporation, then the withholding tax may be reduced under the treaty with the country of the payee corporation even if that rate were lower.

For example, in the example cited earlier, the rate of withholding tax under the U.S.-Germany treaty could be reduced to zero because a treaty rate reduction would have been applicable under the U.S.-Japan treaty had the payment been made directly to the Japanese parent (even if that rate were higher).

On the other hand, suppose the U.S. and German subsidiaries were owned by a Brazilian corporation. Here, a different result would obtain, i.e., no treaty rate reduction would be available under the U.S.-Germany treaty because there is no treaty between the United States and Brazil and, therefore, no reduction in withholding taxes would have been available if the payment of interest were made directly to the foreign parent corporation.

Well, maybe that deals with certain treaty conflicts somewhat, but it still does an end-run around U.S. tax treaty policy generally. Can anyone dispute that this is the "mother of all treaty overrides"? Of course, U.S. treaty overrides are not new but they're usually packaged in the context of a specific legislated purpose and the override is a by-product of that legislation. In other words, the overrides are usually aimed at specific provisions of our treaties. The bills, on the other hand, strike at the heart of treaties and their general applicability. Most of the bills introduced in the House have as their genesis a Congressional feeling that foreign multinationals with parent corporations located in tax haven jurisdictions are gaming the system and taking advantage of tax treaties. (This is especially the feeling with respect to "inverted" multinationals, i.e., foreign multinationals that used to be U.S. multinationals). And, what the heck: it's a great revenue raiser.

However, most treaties (although, admittedly, not all) already contain limitation on benefits (LOB) provisions which are designed to prevent unintended benefits from being secured by third-country taxpayers. To be sure, some of the LOB provisions are more robust than others, but Treasury is all over this subject and seeks to improve the LOB provisions over time as the need arises. 

It makes no sense to undercut the Treasury, which is charged with formulating tax treaty policy and negotiating treaties with other countries. If anything, the LOB provisions could (and should) be strengthened to make sure that corporations and entities in treaty jurisdictions do not improperly avail themselves of treaty benefits. A wholesale subrogation of that concept simply because a common foreign parent is located in a non-treaty country or even a so-called tax haven jurisdiction does not seem proper if the treaty country resident meets existing LOB provisions. A change should come about through a renegotiation of the LOB provisions themselves.

In addition, while U.S. tax treaty policy should not be governed by the reactions of foreign countries, our tax policy should not ignore those reactions. Treaties are taken very seriously in many other countries and represent the supreme law of the land.  While the United States, of course, treats treaties very seriously as well, our "later in time" rule does not always go over well in other jurisdictions. Nonetheless, that is the rule in the United States, but an override should be carefully considered before it is enacted, especially one that goes to the heart of treaty policy generally.

I worry about the increasing perception outside of the United States that the United States is an unfriendly jurisdiction and one that is an uncomfortable environment (from a commercial and economic perspective) in which to do business (FATCA also hasn't helped).  This can't be good for sustained job growth in the United States either.

Revenue offsets are okay provided that they are carefully considered and thought through. This revenue raiser, in my mind, does not meet those requirements. The limitation on treaty benefits provision escaped enactment in 2010 and was not included in the version of H.R. 847 that did pass. But, with the introduction of H.R. 64, it seems that it's the provision that "keeps on ticking" and, unfortunately, persistence sometimes pays off. Perhaps with a Republican-controlled House, it may not get too far.

This commentary also will appear in the February 2011 issue of BNA's Tax Management International Journal.  For more information, in BNA's Tax Management Portfolios, see Tello, 915 T.M., Payments Directed Outside the United States -- Withholding and Reporting Provisions Under Chapters 3 and 4, and Levine and Miller, 936 T.M.,, U.S. Income Tax Treaties -- The Limitation on Benefits Article and in Tax Practice Series, see ¶7160, U.S. Income Tax Treaties, and ¶7170, U.S. International Withholding and Reporting Requirements.