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A Republican plan to overhaul the U.S. corporate income tax could put the dozens of existing U.S. double-tax treaties in limbo.
U.S. companies doing business abroad may no longer be able to rely on the mechanisms in treaties for resolving cross-border tax disputes—overlapping claims on a company’s tax—or they may become one-sided. The issue is one of many technical and practical concerns practitioners are struggling to understand as the broadly outlined plan is debated.
Double-tax treaties are the backbone of the international corporate tax system, ensuring that companies can do business overseas without having their income taxed twice. They reduce or eliminate withholding taxes on payments from one country to another, and establish the way countries determine a company’s internal asset prices. But the treaties are mostly negotiated under the assumption that both countries will retain a traditional corporate income tax.
The House Republican plan would lower the U.S. corporate tax rate, exempt any profits from exports, deny deductions for imported costs and interest and allow full expensing of new investments. Many see the change as creating an entirely new tax, combining aspects of a consumption and income tax scheme. Whether this will put it outside the purview of existing tax treaties, which apply to “any identical or substantially similar taxes that are imposed,” according to the 2016 U.S. Model Tax Convention, is unclear.
“There’s a very serious question about whether these changes are not evolutionary but revolutionary, and would cause the tax to not be covered by the treaties,” said Clark Armitage, a transfer pricing and dispute resolution attorney with Caplin & Drysdale in Washington.
Furthermore, the U.S. Treasury Department may find itself tied in knots if it tries to argue the tax is still a corporate income tax, while also arguing to the World Trade Organization that it’s an indirect consumption tax, to avoid a WTO sanction. Trade laws, enforced by the WTO, don’t allow for border adjustments in a direct income tax.
It’s not even clear how this issue would be resolved. The U.S. may attempt to negotiate an understanding with its treaty partners. Or, it may only become clear when taxpayers seek double tax relief through a treaty.
“We could run into a situation where different conclusions are reached by different jurisdictions,” said David Sites, a partner in international tax services for Grant Thornton LLP in Washington.
Without double-tax treaties, taxpayers wouldn’t have the access to their bilateral dispute mechanisms, such as mutual agreement procedures through competent authorities, to resolve issues such as transfer pricing or the awarding of foreign tax credits.
If the U.S. income tax changes overnight, those procedures—even if still in place—could become largely formulaic. The U.S. would no longer deduct imported costs, so inbound transfer pricing would have no effect on the U.S. revenue. Treasury might still participate, but only as a disinterested observer.
“Under the new regime, the U.S. tax base does not depend on that transfer pricing, so there’s a real issue of whether that competent authority is going to be available,” said Steven Blough, a principal for economic and valuation services at KPMG LLP in Washington, during a Feb. 2 webcast.
Blough added he believes the competent authority would have the legal authority to enter into the process and make an adjustment, but “whether they have any incentive to do so would not be based on defending the U.S. tax base.”
“It would have to be based on a general policy decision to assist U.S. taxpayers in such matters,” he said.
Tax accountants and lawyers also wonder what role the treaties would play, if any, in the enforcement of the new tax.
Treaties include provisions to define the threshold for a “permanent establishment”—a foreign entity’s taxable presence in the jurisdiction. The U.S. has fought against efforts from other countries to lower the PE threshold to include triggers such as online activity. Overnight, the roles could be reversed. With a source-based system, the U.S. might find itself pushing other countries to adopt methods to collect revenue from online sales to foreign countries without a physical presence in the country.
“How do we deal with the offshore company that does not have an income tax filing obligation?” asked Bret Wells, a law professor at the University of Houston.
The U.S. would either have to “tear up” or “override” current treaties to expand the PE definition, said Ronald Dabrowski, a principal in the Washington National Tax Office of KPMG LLP.
“It’s not an easy course there,” he said.
Should the tax treaty network remain largely in place, other countries would consider whether the terms are still acceptable after such a massive change. By design, the Republican tax plan gives taxpayers an incentive to locate valuable assets, especially intellectual property, in the U.S.
Royalty payments to the U.S. from foreign subsidiaries would likely be considered tax-free income.
“If I’m the U.K., am I comfortable from a treaty perspective about the deal I made on the source taxation of those royalties?” asked Grant Thornton’s Sites. “This is a tectonic shift in the deal.”
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