Do U.S. Income Tax Treaties Override the §4985 Anti-Inversion Tax on NRA Insiders?

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Thomas S. Bissell, CPA

By Thomas S. Bissell, CPA Celebration, Florida

A recent commentary in this section described the details of the anti-inversion excise tax under §4985 that is imposed on “insiders” of an expatriating U.S. corporation, and a follow-up commentary discussed the application of the tax to individuals who are nonresident aliens (NRAs) working mostly or entirely outside the United States. The second commentary suggested that although the tax is imposed on the entire amount of an NRA's “specified stock compensation” (SSC) in the same manner as on insiders who are U.S. citizens or resident aliens, a reasonable argument can be made that the tax is actually imposed on NRAs only to the extent that their SSC rights should be subject to regular income tax under §871(b) when the underlying income is eventually realized. This commentary discusses the additional possibility that U.S. income tax treaties may override the application of the tax to NRAs, if under the Code itself it is determined that no tax reduction or tax exemption is available to NRAs. The reader should refer to those two prior commentaries in following the discussion below.

The United States Model Income Tax Convention (U.S. Model), and almost all existing U.S. income tax treaties, provide in effect in the “dependent personal services” article (which applies to employees rather than to self-employed individuals) that compensation paid by any employer to an individual employee who is a “resident” of the treaty country (other than a U.S. citizen) for services performed for the employer outside the United States is exempt from U.S. tax. To the extent that the individual receives salary for work done within the United States, U.S. tax may be imposed on that portion of the employee's salary, but only if one of several tests is met — i.e., if the salary is either paid by a U.S. employer or “borne by” (i.e., deducted by) a U.S. permanent establishment of the employer, or if the employee is physically present in the United States for 183 days or more during the taxable year. Therefore, as previously discussed, if and when an NRA insider eventually realizes income from his/her SSC rights after the inversion occurs, U.S. income tax may be imposed on the resulting income only to the extent that the income is attributable to U.S. workdays, and if the NRA is resident in a treaty country, only if the NRA fails one of the tests in the relevant treaty.

If it is assumed that the §4985 tax is imposed on the entire value of an NRA insider's SSC rights, the question then arises whether a partial or complete exemption from the tax may be claimed where the NRA's workdays are mostly or entirely outside the United States and/or where the portion of the employee's compensation that is allocable to the NRA's workdays within the United States is exempt from U.S. income tax under the “dependent personal services” article of the relevant treaty. It is the contention of this commentary that a strong argument can indeed be made in favor of a treaty exemption.

The principal hurdle that must be overcome in arguing for the exemption is whether the §4985 tax is a tax “covered” by the treaty. Article 2.2 of the U.S. Model provides that the treaty's provisions apply to “taxes on income” and that, in the case of the United States, the treaty applies to “the Federal income taxes imposed by the Internal Revenue Code (which do not include social security and unemployment taxes) and the Federal taxes imposed on the investment income of foreign private foundations.” In parsing this language, it should be noted that the treaty does not seem to limit the term “income taxes” to taxes that are found in Subtitle A of the Code, which is entitled “Income Taxes.” Although the treaty language seems to consider social security and unemployment taxes to be “income taxes,” the only social security tax that appears in Subtitle A is the “SECA” tax on self-employed individuals (imposed by §1401 of “chapter 2” within Subtitle A). The “FICA” tax (imposed on employees under §3101 , and on employers under §3111 ) is imposed under Subtitle C, which is entitled “Employment Taxes,” as is the federal unemployment tax (FUTA), which is imposed on employers only (under §3301 ). The 4% income tax on U.S.-source investment income of a foreign private foundation is imposed under §4948 , which is found within Subtitle D, entitled “Miscellaneous Excise Taxes.” The anti-inversion excise tax in §4985 is also imposed under Subtitle D, which contains a vast number of taxes that are imposed variously on transactions, activities, sales, and income.

Staying with the language in Article 2.3(b) of the U.S. Model, therefore, one might conclude that although the §4948 tax on foreign private foundations is imposed on the foreign foundation's “income,” the fact that the Treasury mentions it specifically as a “covered tax” may mean that other “excise taxes” found in Subtitle E of the Code, such as the §4985 anti-inversion tax, should not be considered as “income taxes” for purposes of the treaty. At the same time, however, the fact that the U.S. Model has long contained an exception from the term “income taxes” for the FICA tax on employees — which is found not in Subtitle A but in Subtitle C — suggests that the term “income taxes” should have a much broader colloquial meaning which is not restricted to those “income taxes” that are found in Subtitle A. In addition, the fact that the treaty also excludes from “income taxes” the FICA tax on employers and the FUTA tax on employers — taxes which are not imposed on an employer's own income but are imposed on the employer with reference to the income of someone else (i.e., the wages paid to its employees) — suggests further that the term “federal income taxes” should not be restricted to taxes found in Subtitle A, and should also be interpreted as broadly as possible.

The only other hurdle in advancing the treaty argument is the fact that the §4985 tax is not imposed on realized income, but instead is imposed only on a “mark-to-market” basis. Thus, it could possibly be argued that the term “taxes on income” in the treaty requires a finding that the tax is imposed on income that is being realized by the taxpayer.

In considering this question, it does not appear that scrutiny of the Code should be limited to the excise tax rules in Subtitle E, because the threshold conclusion above is that the term “taxes on income” includes taxes that are imposed under any and all subtitles of the Code. There do in fact appear to be several excise taxes in Subtitle E (in addition to §4985 itself) that are imposed on a mark-to-market basis, especially in chapter 42 (dealing primarily with private foundations), and usually in the form of “penalty taxes” to discourage certain activities. Considering Subtitle A (“Income Taxes”) itself, however, there are numerous provisions that impose tax on a mark-to-market basis, including in particular the anti-expatriation rules of §877A , which are similar in intent to the anti-inversion rules of §7874 and §4985 , because they are meant to deter U.S. citizens and “long-term resident aliens” from becoming NRAs. Particularly in the deferred compensation area, whether involving cash compensation plans or equity-based plans similar to the SSC rights that underlie §4985 itself, Congress in recent years has significantly expanded the current taxation of employees who have deferred compensation rights that have not yet accrued.

Thus, for many years an employee's deferred compensation rights were taxable currently (rather than in the later year when the compensation became payable) only if the rights were “funded” and if the employee's rights were not subject to a “substantial risk of forfeiture.” In 2004, however, these rules were expanded with the enactment of §409A so as to impose current income tax on an employee (plus a 20% penalty) in certain situations with respect to unfunded deferred compensation rights if the plan did not satisfy certain statutory tests. These rules were further expanded with the enactment in 2008 of §457A , which can also tax an employee currently where there is no substantial risk of forfeiture and where the employer is a so-called “nonqualified entity” that meets certain statutory requirements (primarily foreign corporations based in low-tax countries), even though the plan otherwise does not run afoul of §409A . The only difference between these rules and the §4985 excise tax is that while the §4985 tax is imposed on the SSC rights of an insider that have become fully “vested” but not yet exercised, the §4985 tax is also imposed on an insider's SSC rights that have not yet become fully vested and may also still be subject to a substantial risk of forfeiture. That difference does not seem to be material, however, especially in view of the fact that the anti-expatriation rules of §877A (enacted in 2008) also require that deferred compensation items be taxable immediately to an expatriating individual even though they may be subject to a substantial risk of forfeiture.

Because the §4985 tax is reported by the “insider” on a “self-assessed” basis — i.e., the insider is required to report it on his/her Form 1040 or Form 1040NR and to pay the tax, without withholding at source on the part of the employer, or even (apparently) reporting by the employer of the SSC right to the IRS on Form W-2 or Form 1099 — the question arises whether an NRA who claims a treaty exemption from the excise tax must disclose this in some manner to the IRS. Although §6114 requires certain treaty-based return positions to be disclosed to the IRS on Form 8833 (or risk the imposition of a $1,000 penalty under §6712 ), Reg. §301.6114-1(c)(1)(iv) provides for an exemption from reporting in the case of a treaty reduction in the “taxation of income derived from dependent personal services… .” That language could provide for a reporting exemption, although all of the provisions in the §6114 regulations should be carefully considered by the NRA and by the NRA's U.S. tax advisor.

If a particular NRA insider who is resident in a tax treaty country takes the position that he/she is exempt from the §4985 excise tax under the terms of the treaty, an additional question must still be faced — whether Congress in enacting §4985 in 2004 intended to nullify any or all existing income tax treaties to the extent that their provisions do in fact provide for an exemption from the tax — thus permitting the Code to impose the tax without regard to the treaty. Such a nullification could possibly have happened by applying §7852(d)(1) (enacted in 1988), which provides very cryptically that “for purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.” If such a nullification did occur, then an NRA insider who is resident in a country with a “nullified” treaty would have to fall back on the Code itself to claim an exemption from the tax. Because the question of the potential nullification of tax treaties is extremely important not only for §4985 but also for some of the “anti-expatriation” legislation that was enacted in 2008, this issue will be discussed in a follow-up commentary.

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