U.S. Model Income Tax Treaty.
On July 17, 1992, the U. S. Department of the Treasury announced a project to review the U.S. Model Income Tax Treaty. At the same time, the Treasury Department announced the withdrawal of both the proposed Model Treaty of June 6, 1981, and the Model Treaty of May 17, 1977. In response to the Treasury Department's request for comments, representatives of Tax Executives met with Treasury Department representatives on November 20, 1992 to discuss the Institute's preliminary comments. TEI's more detailed comments and recommendations are set forth below.(1)
Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the proposed revision of the U.S. Model Income Tax Treaty.
TEI commends the Treasury Department for undertaking to revise the U.S. Model Treaty. Given the dramatic increase in international commerce since the publication of the 1981 Draft, TEI believes it is critical for the United States to safeguard multinational businesses more effectively against the threat of double taxation. The Institute has long been concerned that arbitrary tax rules restrict the ability of U.S. multinationals to compete effectively abroad. In a perfect world, tax rules would not affect business decisions. The world is far from perfect, however, and tax rules can -- and do -- affect the decisions of multinational corporations.
TEI believes that the overriding goal in treaty negotiations should be to create as level a "playing field" as possible. Tax barriers should not impede the flow of goods across borders.(2) To this end, we recommend stronger coordination of treaty partners' rules, especially with respect to sourcing and tax-free reorganizations. Treaties should also seek to provide relief from the double taxation that may occur when both source and residence countries tax the same income. We thus recommend that binding arbitration procedures be included in the Competent Authority provisions. We also recommend that the limitation-on-benefits provision not be applied mechanically to deny treaty benefits in respect of income derived for a valid business purpose in or through a treaty country.
Finally, we submit that safeguards against treaty overrides are central to preserving the integrity of U.S. tax treaty network and to the ongoing process of treaty negotiations. TEI urges the Treasury Department to take steps ensuring that legislation does not abrogate extant agreements between sovereign states.
TEI's specific comments, set forth below, are directed toward not only eliminating tax barriers such as withholding taxes, but also reducing the potential for inconsistent tax treatment by treaty partners.
Relief from Double Taxation
The 1981 Draft adopts the credit mechanism for avoiding double taxation of income. Article 23 provides that the United States shall allow a resident or citizen of the United States as a credit against the U.S. tax on income --
* The income tax paid to the Contracting
State by or on behalf of
such citizen or resident; and
* In the case of a U.S. company
owning at least 10 percent of
the voting stock of a company
resident in the Contracting
State and from which the U.S.
company receives dividends,
the income tax paid to the Contracting
State by or on behalf of
the distributing company with
respect to the profits out of
which the dividends are paid.
Paragraph 3 of article 23 generally provides that source rules for income follow the allocation of taxing jurisdiction. The 1981 Draft fails, however, to source items of expense.
The function of the source rules in the 1981 Draft is to ensure that allocation of primary taxing jurisdiction to the source country is respected by the residence country in giving double tax relief. ALI Proposals at 233. Double taxation may result, however, when domestic rules for calculating and allocating expenses are not consistent between treaty partners. Although it may not be feasible to require that a country of residence always defer to the source country's tax rules, we strongly recommend that the United States attempt to reduce double taxation by coordinating the rules for the sourcing of income and expenses. Accordingly, the U.S. Model Treaty should provide that, for purposes of providing relief from double taxation, the residence country should treat income items as sourced within the other Contracting State to the extent that the source country is afforded primary taxing jurisdiction over such items under the treaty.
In addition, TEI recommends that the residence country be required to calculate items of income -- and expenses allocable to such items -- in accordance with the rules of the country with primary taxing authority over such items. The residence country should be permitted, however, to apply its own rules to apportion expenses not directly allocable to any item of income (i.e., in accordance with section 861 of the Internal Revenue Code).
With respect to items of net income that are re-sourced under the U.S. Model Treaty, TEI recommends that no separate foreign tax credit limitation apply. Such a limitation adds still another layer of administrative complexity to the labyrinthine U.S. foreign tax credit regime and does nothing to further any legitimate goal of U.S. international policy.
Finally, we recommend that the U.S. Model Treaty eliminate the separate foreign tax credit limitation for foreign taxes creditable solely by reason of the treaty. In most cases where a particular tax is designated as creditable under a treaty, uncertainty exists whether that tax would also qualify as creditable under section 901 of the Code. The separate limitation invites controversy without serving any apparent purpose. In the event that treaty partners agree to allow creditability for a specific tax that is clearly not creditable under section 901, a separate limitation provision could be included solely with respect to that tax.
Creditability of Minimum Taxes
Beginning with the Mexican Implementation Act of 1988, many countries have initiated taxing scheme that are computed on an asset base Following Mexico's lead, similar asset or capital taxes in have been enacted in Canada (the Large Corporation Tax), Argentina, and Venezuela. The most recent Brazilian Tax Reform proposals also include an asset tax.
Asset taxes are designed to provide a stable revenue base for governments in a manner that eliminates the susceptibility of a pure income tax to the economic cycle. Simply put, these taxes are minimum taxes that may be computed in a manner that, while varying from the U.S. alternative minimum tax, achieves the same objective. In Mexico, for example, the level of tax is predicated on an expected level of economic return on assets. Such taxes should generally be creditable under U.S. tax policy.
TEI recommends that the U.S. Model Treaty expressly specify that asset taxes that are essentially a form of minimum tax, should be creditable.
Article 25 of the 1981 Draft provides that, where a person considers that the actions of one or both of the Contracting States result or will result in taxation not in accordance with the provisions of the Convention, that person may, irrespective of the remedies provided by the domestic law of those States, present the case to the Competent Authority of the Contracting State of which the person is a resident or national. This "mutual agreement" procedure is designed to achieve relief from double taxation in cases not otherwise resolved by treaty. ALI Proposals at 95.
1. Arbitration. In its July 28, 1992, comments on the proposed section 482 regulations, TEI recommended that the United States in its bilateral tax negotiations seek a provision requiring that the Competent Authorities submit to binding arbitration in the event they are unable to agree. We expressed concern that the number of transfer-pricing cases going to Competent Authority will materially increase and asserted that, to avoid the undue burden of double taxation in such situations, taxpayers needed the certainty of resolution provided by an appropriate arbitration clause.
TEI continues to believe that the arbitration provisions included in the U.S.-Germany Tax Convention (and the related letter of understanding) and the U.S.-Mexico Treaty represent a positive development. We recommend, however, that the U.S. Model Treaty go beyond the provisions contained in these two treaties by providing for mandatory arbitration where the Competent Authorities are unable to agree within a specified time period (say, two years). An appropriate model for the arbitration mechanism is the European Economic Community (EEC) Model. See Convention on the Elimination of Double Taxation in Connection with the Adjustments of Profits of Associated Enterprises 90/463/EC (as agreed upon by the EEC members on July 23, 1990).(3)
Some government officials have suggested that the United States should defer negotiating any additional arbitration clauses until it has obtained substantial experience under the U.S.-Germany arbitration procedure. We submit, however, that any such "deferral" would essentially scuttle the arbitration proposal, especially since implementing changes to existing tax treaties can usually be measured in decades, rather than years. Consequently, we recommend that an arbitration clause based on the EEC Convention be included in the U.S. Model Treaty now.
2. Interest on Adjustments. Taxpayers may be subject to double taxation because of the inconsistent treatment by Contracting States of interest on tax deficiencies and overpayments. For example, corporations may deduct the interest paid on deficiencies in the United States, but not in Canada.
TEI recommends that the U.S. Model Treaty expressly direct the Competent Authorities to address and coordinate the tax treatment of interest on deficiencies and overpayments. Such a provision should expressly permit the waiver of all or a portion of statutory interest.
3. Treaty Overrides. Article 29 of the 1981 Draft provides that the Convention shall remain in force until terminated by a Contracting State. Either Contracting State may terminate the Convention within five years, if at least six months' notice is provided.
In recent years, numerous laws have been enacted or proposed in the United States that were perceived by treaty partners as unilateral overrides of treaty provisions. See, e.g., Public Law No. 99-14, 99th Cong., 2d Sess. [sections] 1241 (1986) (providing for a branch profits tax).(4) TEI believes that treaty overrides violate international law and invite retaliation. The threat of future overrides impairs tax treaty negotiations and creates an uncertain environment for multinational business.
TEI recommends that the U.S. Model Treaty include an article to minimize the possibility of unilateral overrides. We suggest that the Competent Authorities be required to consult within a specified time period in the event of an override, as provided in the protocol to the U.S.-Mexico treaty. In the absence of an agreement by the overriding Contracting State to restore the balance of treaty benefits following an override, the other Contracting State should be permitted to terminate the treaty or to take such other action as permitted under international law. Such a provision would help to prevent retaliation and should enhance the likelihood that treaty overrides occur only for extraordinary reasons. It would, as noted, also be consistent with the protocol to the recently signed U.S.-Mexico treaty.
Limitation on Benefits
Article 16 of the 1981 Draft provides that a person (other than an individual) that is a resident of a Contracting State shall not be entitled to relief from taxation in the other Contracting State unless --
* more than 75 percent of the
beneficial interest in such person
is owned, directly or indirectly,
by one or more individual
residents of the first-mentioned
Contracting State; and
* the income of such person is
not used in substantial part, directly
or indirectly, to meet liabilities
to persons who are resident
of a State other than the
Contracting State and who are
not citizens of the United
This paragraph shall not apply, however, if the acquisition or maintenance of such person and the conduct of its operations "did not have as its principal purpose obtaining benefits under this Convention."
In December 1981, the Treasury Department issued an alternative discussion draft that provided that a corporation resident of a Contracting State shall not be entitled to relief from taxation in the other Contracting State with respect to an item of income, gains, or profits unless the corporation establishes that:
* its stock of any class is listed
on an approved stock exchange
in the Contracting State, or is
wholly owned, directly or
through one or more corporations
each of which is a resident
of a Contracting State, by
a corporation the stock of which
is so listed;
* it is not controlled by persons
who are not residents of a Contracting
State, other than citizens
of the United States; or
* it was not a principal purpose
of the corporation or of the conduct
of its business or of the
acquisition or maintenance by
it of the shareholding or other
property from which the income
in question is derived to obtain
any of such benefits.
Comprehensive "limitation on benefits" provisions have become a common feature of U.S. tax treaties; such provisions have been the subject of discussions in recent negotiations with both Canada and the Netherlands. U.S. treaty policy has been to limit benefits to those residents of other countries who are deemed properly "entitled" to receive them. These provisions are generally designed to prevent residents of a third country from establishing an entity in the other Contracting State as a vehicle for receiving unjustified U.S. treaty benefits. See Statement of Assistant Treasury Secretary for Tax Policy Ronald A. Pearlman before the Senate Committee on Foreign Relations (July 30, 1985).
TEI acknowledges that the need for limitations on treaty benefits in certain circumstances both to protect U.S. revenue and to encourage non-treaty partners to engage in treaty negotiations with the United States. We remain concerned, however, that a strict application of the ownership and base erosion tests in the U.S. Model Treaty will deny treaty benefits to viable commercial entities that have bona fide business reasons for operating in a particular country. Thus, while payments of interest, royalties, and service fees to related parties may be a legitimate concern in limited circumstances, a viable commercial entity should not be penalized for sourcing capital, financing, or intangible licenses from unrelated parties throughout the world.
Accordingly, we recommend that the U.S. Model Treaty provide an exception from the ownership and base erosion tests. In addition to the subjective "principal purpose" test contained in the 1981 Draft (which should be retained), we urge that the U.S. Model Treaty include objective exceptions to provide certainty (i) to taxpayers in structuring their multinational operations and (ii) to minimize the need to resolve limitation-on-benefits issues through Competent Authority. Specifically, an exception should be provided where an entity either is engaged in an active trade or business in the source country, or is able to demonstrate that there is no significant reduction in overall tax liability (say, not more than 10 percent) as a result of the application of treaty benefits.
Finally, we recommend that, in negotiating new treaties or protocols with existing treaty partners, entities and operations that are in existence as of the date of signing a treaty with a new treaty partner should be "grandfathered" for purposes of the ownership and base erosion tests.
Income tax treaties should strive to mitigate taxation that, while not duplicative, is so burdensome that it constitutes a barrier to international trade. The most common impediment to international commerce is withholding tax on dividends, interest, and royalties. ALI Proposals at 9. For this reason, the European Economic Community has sought to eliminate such taxes. See June 11, 1990, Directive on Dividends from a Subsidiary and Memorandum of April 18, 1990, on EC Company Taxation (recommending the elimination of withholding taxes on dividends, interest, and royalties paid within an EEC corporate group). This principle has also been recognized by various countries. For example, in February 1992 Canada offered to reduce by five percentage points (from ten to five percent) the withholding tax on dividends to holders of 10 percent or more of a company's shares, and Brazil reduced the withholding tax rate on dividends from 25 percent to 15 percent as of January 1, 1993. We urge the United States to join this trend by working toward the reduction and ultimate elimination of such withholding taxes.
1. Dividends. Article 10 of the 1981 Draft provides that the dividends paid by a corporation in a Contracting State to a resident of the other Contracting State may be taxed in that other State. Such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident. If the beneficial owner of the dividends is a resident of the other Contracting State, however, the tax so charged may not exceed --
* Five percent of the gross
amount of the dividends if the
beneficial owner is a company
owning at least 10 percent of
the voting stock of the company
paying the dividends; and
* Fifteen percent of the gross
amount of the dividends in all
In the absence of a treaty provision, dividends are taxed under section 881 of the Internal Revenue Code at a flat 30-percent rate to the extent the income is not effectively connected with a U.S. trade or business.
TEI submits that the United States should consider reducing the five-percent withholding rate for 10-percent owned companies to zero. Zero withholding enhances the free flow of capital across borders -- a principle recognized in 1991 by the EEC when it eliminated withholding taxes on direct investments because such taxes distort cross-border investments. Moreover, a 1991 study by the OECD Committee on Fiscal Affairs concluded that withholding taxes tend to result in less favorable treatment of foreign direct investment in comparison to domestic direct investment. The OECD study stated, "A general removal or reduction of these taxes could help move countries toward greater capital export neutrality, to the extent it can be done without opening up new avenues for tax evasion and avoidance." Committee on Fiscal Affairs, Organisation for Economic Cooperation and Development, Taxing Profits in a Global Economy 16 (1991).(5)
In addition to eliminating the withholding taxes on dividends, the U.S. Model Treaty should provide a look-through provision for purposes of the 10-percent ownership requirement, permitting dividends paid to a partnership to be subject to zero withholding (or the applicable treaty rate) based on the indirect interests of partners.
2. Interest. Article 11 of the 1981 Draft provides that interest derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State. Again, in the absence of a treaty provision, interest paid to a nonresident not engaged in business in the United States is generally subject to flat withholding rate of 30 percent. I.R.C. [sections] 881(a).
TEI believes that the rationale for lowering the withholding rate on dividends applies with equal force to interest."(6) Eliminating withholding rates on interest, as well as dividends, will reduce the influence of tax considerations on decisions regarding capital structures of multinational operations and controversies in respect of the debt-vs.-equity characterization of hybrid instruments. We therefore recommend that the withholding rate for interest be zero.(7)
3. Royalties. Article 12 of the 1981 Draft provides that royalties derived and beneficially owned by a resident of the Contracting State shall be taxable only in that State. The 1981 Draft exempts royalties from withholding. In its announcement, the Treasury Department specifically requested comments regarding the appropriate treatment of software royalties.
TEI believes that withholding on any royalty for the use of intangible property, including copyrighted software, is ill advised. Royalty payments for the use of intangible property typically represent business profit, with which significant development costs are associated. The activities and costs involved in the creation of the intangible property generally occur in the jurisdiction of the licensor, not in the source jurisdiction. Consequently, it is appropriate not to tax the royalty in the source jurisdiction.
Imposing withholding tax on software royalties would also draw an improper distinction between the sale and licensing of intangible property and is contrary to the principle that each Contracting State is entitled to taxing jurisdiction over business profit attributable to activities conducted within its borders. The OECD Model Convention adopts a zero withholding rate on royalties, and TEI believes that the U.S. Model Treaty should similarly retain the zero rate."(8) See Committee on Fiscal Affairs, Organisation for Economic Cooperation and Development, Model Tax Convention on Income and on Capital, Commentary on Article 12, [paragraph] 3 (Sept. 1, 1992) (hereinafter cited as the "OECD Model Convention").
4. Capital Gains. Article 13 of the 1981 Draft provides that the gains derived by a resident of a Contracting State from the alienation of real property and situated in the other Contracting State may be taxed in that other State. Gain from the alienation of shares of the stock of a company (whether or not a resident of a Contracting State), the property of which consists principally of real property situated in a Contracting State, may be taxed in that State.
Recent legislative proposals in the United States would impose a tax on capital gains realized by a non-U.S. resident upon the disposition of shares of a U.S. corporation. In 1989, the OECD Committee on Fiscal Affairs concluded that such legislation "could" justify termination of the treaty. See Committee on Fiscal Affairs, Organisation for Economic Cooperation and Development, Tax Treaty Override [paragraphs] 28-30 (Oct. 2, 1989). The enactment of such legislation could thus jeopardize the status of U.S. tax treaties.
TEI believes that the U.S. Model Treaty should expressly provide that capital gain arising upon disposition of shares of a corporation resident in one country is taxable only in the country in which the shareholder resides. To impose a tax upon disposition of shares by a nonresident (as permitted, for example, under the U.S.-Spain Treaty) seriously impedes the ability of multinational corporations to effect corporate restructurings that do not remove corporate assets from a taxing jurisdiction. It is critical that multinational corporations be able to adjust their corporate structures to respond to operating and financial needs.
Some countries (including the United States) have special concerns regarding preservation of taxing jurisdiction over dispositions of real property held in corporate form. To the extent these concerns foreclose an outright exemption for capital gains, we recommend that the U.S. Model Treaty endorse and preserve the primary taxing authority of a shareholder's country of residence by providing that the nonresidence country may tax capital gain on dispositions of shares only where the assets of a corporation consist primarily of real property. Even in such cases, however, no tax should generally be imposed where a disposition of shares is made pursuant to a transaction treated as nontaxable (including a tax-free reorganization) in the shareholder's country of residence.
a. Investment Activity. Article 5 of the 1981 Draft provides that the term "permanent establishment" means a fixed place of business through which the business of an enterprise is wholly or partly carried on. The term includes a place of management, branch, office, factory, workshop, and mine, oil or gas well, quarry, or any other place of extraction of natural resources.
TEI recommends that the definition of a permanent establishment be revised to specifically exclude activity of a purely investment nature.
b. Building Site. Article 5 of the 1981 Draft also defines a building site or construction project as constituting a permanent establishment "only if it lasts more than twelve months."
TEI believes that a separate permanent establishment determination should be made with respect to each building site, unless the sites are contractually or economically integrated. In addition, the U.S. Model Treaty should explicitly provide that a subcontractor's permanent establishment be based on a 12-month period, regardless of the overall duration of the project. This clarification would prevent subcontractors who may work on a site for only a few weeks from establishing a permanent presence in the country. These provisions would be consistent with the OECD Model Convention. See OECD Model Convention, Commentary on Article 5, [paragraphs] 18-19.
c. Investment Income. Owners of pools of capital that want to have a direct control over investment decisions may not have a presence in the United States to manage the capital without running afoul of the permanent establishment test; these companies generally manage their assets in traditional banking centers such as Switzerland, thereby depriving the U.S. banking centers of the opportunity to attract this type of capital.
TEI recommends that the U.S. Model Treaty expressly provide that investment income may be taxed only by the country of residence, unless it is effectively connected with a source country trade or business. This would be consistent with the rationale for eliminating withholding taxes only passive income and would permit nonresident investors to have a direct influence on business decisions without having a permanent establishment.
Tax Executives Institute appreciates this opportunity to present our views on the proposed revision of the U.S. Model Income Tax Treaty. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at (201) 573-3200 or Mary L. Fahey of the Institute's professional staff at (202) 638-560. (1) For simplicity's sake, references to the "1981 Draft" shall be to the 1981 draft Model Treaty that, although never finalized, has been used as the "actual" U.S. Model Treaty in recent negotiations. (2) "The principal function of income tax treaties is to facilitate international trade and investment by removing -- or preventing the erection of -- tax barriers to the free international exchange of goods and services and the free international movement of capital and persons." American Law Institute, Federal Income Tax Project: International Aspects of United States Income Taxation II (Proposals on United States Income Tax Treaties) 1 (1992) (hereinafter cited as the "ALI Proposals"). (3) Inclusion of such an arbitration provision in the Model Treaty would be consistent with arbitration provisions of the U.S.-Canada Free Trade Agreement and the North American Free Trade Agreement. (4) This was not always the case. The Internal Revenue Code of 1954 provided explicit protection for the provisions of extant treaties (which was curtailed in 1986) and the Foreign Investors Act of 1966 similarly gave precedence to tax treaties. See I.R.C. [sections] 7852(d); Public Law No. 89-809, [sections] 110. (5) The OECD report also recommended the elimination of withholding taxes on interest. (6) That withholding on interest can impede international investment is graphically illustrated by the German experience. In 1989, the Federal Republic of Germany initiated a 10-percent withholding tax on interest paid to foreigners on the bonds of German issuers. The adverse effect on German issuers forced the repeal of the provision six months later. See ALI Proposals at 194 n.515. (7) We believe that elimination of withholding on interest is particularly important with respect to interest paid to a related party. (8) Because the United States is a net exporter of software, a bilateral exemption of software royalties from withholding should increase U.S. tax receipts.
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|Date:||Jan 1, 1993|
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