Overriding Income Tax Treaties in Codifying a New LOB

At the time this is being written, the Ways and Means Committee has reported a bill, H.R. 3200, “America's Affordable Health Choices Act of 2009” (“AAHCA”), which contains a provision (§451 of the bill) that would override all U.S. income tax treaties. While the provision may be discarded as part of health care reform in favor of other revenue raisers, it is worth examining the provision and its various impacts, because the provision may re-surface again in the future. The provision is, after all, estimated to raise $7.5 billion in revenue over 10 years -- a modest amount in the current era of trillion-dollar deficits but not yet a rounding error. Many are also asking whether this provision will survive through final enactment, so some speculation on that point is also warranted.

The bill would amend §894 to provide that treaty benefits for “deductible related-party payments” would be available only where the “foreign parent corporation” (of the group that includes the otherwise Limitation-on-Benefits (LOB)-qualified, treaty-resident recipient of such payment) could itself obtain treaty benefits were the deductible payment made directly to such parent. So, for example, an interest payment to a U.K. affiliate with a substantial active business in the United Kingdom would not be eligible for the elimination of U.S. interest withholding tax otherwise provided by the U.S.-U.K. treaty if the U.K. affiliate were owned by a Hong Kong company.

Unlike many cases of claimed treaty override by statute, this provision would clearly override all U.S. income tax treaties, including those with comprehensive LOB articles (“LOBs”). Thus, a company's substantial active business operations in a treaty country would no longer suffice if the company were owned by a parent company not entitled to the benefits of a treaty. This is somewhat surprising, given the lack of any indication in the past 15-plus years of treaty ratification hearings that the LOBs contained in recent treaties were deficient.

As readers know, tax treaty overrides are not unconstitutional, nor even uncontemplated by the authors of the Internal Revenue Code. While most of the rest of the world gives tax treaties a higher status than purely domestic law, §7852(d) explicitly provides that neither a treaty nor a revenue law has preferential status in the United States.1 Therefore, as the legislative history confirms, the “later-in-time” rule generally applies -- whichever is enacted later controls.2 It is clear that Congress can override tax treaties -- it clearly has that power. Whether it should is another question. Typically, treaty overrides are avoided unless there is no other way for Congress to implement a critical tax policy objective. Clearly, in the case of a broad treaty override, such should be overwhelmingly justified.

One justification given for the provision in AAHCA is that it may compel a jurisdiction with which we have no tax treaty to enter into treaty negotiations. That policy objective is unlikely to be achieved, however, as it is far from certain that Treasury would want to inaugurate (or Congress encourage) negotiations looking to a comprehensive income tax treaty reducing or eliminating U.S. withholding tax with jurisdictions not likely to impose any meaningful tax on payments made from the United States to affiliates in such jurisdictions and/or that have little inward investment from the United States that Treasury would bargain to protect from local tax.

A second justification given for the provision is that it would hamper so-called “inverted” or expatriated companies from obtaining treaty benefits. (At least one bill to deal with this issue has specifically targeted expatriated companies.)3 Generally speaking, an inverted or expatriated company is a U.S. company that has become foreign. Since 2003, successfully expatriating is quite difficult, if not impossible, due to the enactment of §7874. In addition, both before and since 2003, expatriating incurs either a shareholder-level or corporate-level exit tax. Still, some in Congress have previously expressed concern with a successfully expatriated company obtaining treaty benefits through finance or intellectual property-licensing affiliates in certain jurisdictions.4 In certain jurisdictions, an affiliate might attempt to qualify for treaty benefits by attempting to prove that greater than 50% of the top public company's stock is owned by individual U.S. shareholders (and that there is no base erosion). Again, however, the H.R. 3200 provision is too broad. Newer treaties and protocols (e.g., the treaty with the Netherlands) prevent this with a strict “substantial presence” requirement, so there is no reason to override those treaties.

Thus, a major problem with the provision is that countries that have agreed to strong, modern LOBs would be just as adversely affected as countries that have not. The proposal would impact every current treaty that the United States has, even those with the most up-to-date LOBs (and even those with countries that are highly unlikely to be a host for treaty shoppers (because of their domestic tax rules)). If enacted, the United States would hear loud and clear from most of its treaty partners in the Organization for Economic Cooperation and Development about its inappropriate and unnecessary treaty override. If non-LOB treaties are the target, the provision should apply only to them.

A particularly odd impact of the provision is that, for a company that has a foreign parent company resident in a non-treaty jurisdiction, the active business alternative for treaty qualification would be rendered useless. As readers know, all modern LOBs permit treaty benefits for income derived in connection with (or incidental to) an active trade or business that is conducted in the treaty resident's country. That trade or business must be a business other than managing investments for the resident's own account, unless the resident is a bank, insurance company, or securities dealer. The active business in the resident's country must also be substantial in relation to the business in the United States which is making the treaty-benefitted payments.5 The “in connection with” requirement is typically satisfied if the payor business is in the same line, or a complementary line, of business as the payee. Affiliates under common control are aggregated to determine the qualification as, and the substantiality of, an active trade or business.

Of all the several ways to qualify under an LOB, the active business test seems the one with the greatest policy justification. The active business test actually requires bricks and mortar in the treaty resident's country. When the substantiality test is layered on, it is virtually impossible to plan into treaty qualification without meaningful assets, personnel, and income in the treaty resident's country. Other LOB tests, while all justifiable in this writer's view, have somewhat weaker policy justifications.6

Altogether, given its uneven impact and less-than-well-targeted policy implications, this treaty override doesn't seem to meet the “overwhelmingly justified” test. The provision is too broad, and it would eliminate the most sensible of the several means to qualify under an LOB. All of this seems to indicate, to this writer at least, that the provision is unlikely to survive as part of the AAHCA -- that the Administration will oppose it, the Senate will reject it as part of their bill, and the Senate will prevail in the House-Senate Conference Committee on the bill.

Although the provision raises only a modest amount of revenue in the context of a health reform effort that may require $600 billion or more of tax increases, it will provide the Ways and Means members who will eventually sit on the Conference Committee with a bargaining chip that outweighs its relative size as a revenue raiser. It is axiomatic that if treaties can be overridden unilaterally by the United States, and actually are with any regularity, other countries will be less willing to enter into them, or to make meaningful concessions under them. The Senate, in its role in giving advice and consent regarding treaties, and the Administration, in its role in negotiating and concluding treaties, have significant roles in the tax treaty process and each has historically thought that its role, and the products produced thereby, were important. The Administration and the Senate have, therefore, a greater interest in seeing that the tax treaty process is not disrupted by legislative overrides, at least not unless that override is overwhelmingly justified. The House, and the Ways and Means members, on the other hand, have far less interest, having no role in the tax treaty process at all.7 This is not simply a result of jealousy over “turf.” Indeed, as tax treaties generally trade reductions in U.S. tax for reciprocal reductions in foreign tax, over the years some Ways and Means Committee members have looked at tax treaties with a critical eye. It has been suggested that, because tax treaties generally cut U.S. tax, they might be viewed not solely as treaties but also as a type of revenue measure. Because the Constitution requires that revenue bills start in the people's House,8 the complete absence of House involvement in tax treaties might be seen as conflicting with the spirit of that requirement. This argument gives the Ways and Means members a “principled” foundation, in addition to the tax policy reasons outlined above, to support this provision, even if the principled foundation goes unstated.

The intensity with which the Senate and the Executive Branch typically resist treaty overrides may give Ways and Means Conference Committee members a bargaining chip with which to obtain important concessions from either the Administration or the Senate. In this writer's view, these political dynamics make it all the more likely that the provision will be traded away and not survive in the final version of AAHCA.

This commentary also will appear in the October 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source Income to Foreign Persons, and Levine and Miller, 936 T.M., U.S. Income Tax Treaties -- The Limitation on Benefits Article, and in Tax Practice Series, see ¶7140, U.S. Income Tax Treaties, and ¶7150, Withholding and Compliance.

1 The Constitution implies the same in Article VI: “This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land.”

2 See H.R. Rep. No. 100-795 (1988); S. Rep. No. 100-445 (1988); H.R. Conf. Rep. No. 100-1104 (1988).

3 SeeH.R. 3970.

4 See, e.g., H.R. 3970, H.R. 3160, and H.R. 2419.

5 More recent treaties and the U.S. Model restrict the substantiality requirement to payments from related persons. Some treaties provide a substantiality safe harbor measured by assets, payroll, and gross income.

6 The public trading test appears to claim that a treaty resident is truly resident and not treaty shopping simply because it is traded on a stock exchange in the country of residence (or, in most treaties, other “qualified” exchanges). Even if it once was, in the 21st century there may be some question as to whether trading in a given country is a reliable proxy for ownership by that country's nationals (assuming such ownership matters).

7 Contrast this with trade agreements, which also tend generally to cut revenue, where the House has an equal seat at the table.

8 U.S. Constitution, Article I, Section 7.