On June 25, four tax treaties were passed out of the Senate Foreign Relations Committee. There is an expectation that the treaties will soon be considered by the full senate. The four treaties include updates to existing tax treaties with Spain, Switzerland, Japan, and Luxembourg.
The four treaties that passed on June 25 are not the only ones pending in the Senate, however. There are also tax treaties with Poland, Chile, and Hungary. Additionally, there is the Protocol Amending the Convention on Mutual Administrative Assistance in Tax Matters.
Unlike the bilateral tax treaties, the Protocol is a multilateral agreement open to all countries and is part of a set of multilateral agreements designed to facilitate automatic sharing of information among tax authorities—even with countries where we do not have tax treaties.
All seven treaties and the Protocol were previously passed by the Senate Foreign Relations Committee in 2015 during the 114th Congress. However, just the treaties with Spain, Switzerland, Japan, and Luxembourg are currently moving ahead in the Senate. Affirmative votes from two-thirds of the Senators present are required for a treaty resolution to be approved.
Tax treaties align many tax laws between two countries, particularly with regard to withholding taxes, and attempt to reduce double taxation. Countries with a greater number of partners in their tax treaty network have more attractive tax regimes for foreign investment and are more internationally competitive. The U.S. currently has 58 income tax treaties with countries around the world. According to the U.S. Chamber of Commerce, companies from the seven bilateral treaty countries have invested more than $1.2 trillion in the United States and those investments are connected to hundreds of thousands of U.S. jobs.
This post will highlight five key issues relating to tax treaties generally and provide some context for the treaties pending in the Senate.
1. Why are tax treaties important?
Companies that operate in several countries often face various tax issues that arise in jurisdictions with differing laws. For example, a Japanese company that owns and operates a factory in the United States will need to know how profits from that U.S. subsidiary will be taxed. Additionally, the company will need to know what taxes will apply to dividends from that U.S. subsidiary to the Japanese headquarters or other shareholders.
To simplify things and clarify which countries can tax what income and when, countries often enter into bilateral and sometimes multilateral tax treaties. These treaties commit countries to playing by the same set of rules when taxing multinational businesses.
The treaties facilitate cross-border trade and investment by creating certainty for investors when they are making decisions about setting up new offices and factories in another country or deciding to build a manufacturing base in the United States.
2. What does taxation look like in the absence of a tax treaty?
In the absence of tax treaties, most countries apply withholding taxes to dividends paid by a subsidiary to its headquarters or other shareholders in another country. The U.S. applies a 30 percent withholding tax to payments to foreign shareholders in situations where there is not a tax treaty. If the foreign country also taxes those dividends, the result would be double taxation.
The foreign shareholder (whether it is an individual or a foreign company) could file a tax return with the U.S. to try to reconcile its domestic tax liability with its U.S. liability. However, without a tax treaty in place, the U.S. could simply choose not to refund part or all of the withholding tax collected.
Domestic and foreign withholding taxes act like sand in the gears of the global economy, making it more challenging for foreign businesses to invest in the U.S. and for U.S. companies to invest abroad. In effect, they raise the required rate of return necessary for investors to choose to invest in another country. If a Spanish company would like for a new office in the U.S. to generate a certain level of profits for it to be worthwhile, the U.S. withholding tax on dividends (absent a treaty) could in some cases keep that investment from happening.
3. When were these treaties negotiated?
The treaties pending in the Senate were all negotiated and signed several years ago: In 2009 with Switzerland and Luxembourg; in 2010 with Hungary and with Chile and the Protocol; in 2013 with Poland and Japan; and in 2014 with Spain.
Over the years, not only has the U.S. significantly changed its tax rules, but our treaty partners have made reforms as well. Businesses interested in growing their footprint either in the U.S. or in a partner country through reforms have effectively had those benefits delayed while waiting for the Senate to approve the treaty resolutions for ratification.
As mentioned, the seven treaties and the Protocol were passed out of the Senate Foreign Relations Committee in 2015, but the ratification resolutions were never considered or approved by the whole Senate.
4. What has changed for exchange of information?
One of the reasons that ratification has been delayed is that Sen. Rand Paul (R-KY) has concerns that the treaties would fail to protect the privacy rights of U.S. taxpayers.
Under a tax treaty, tax authorities (like the IRS) can request information connected to disputes with the partner country in order to evaluate facts that are relevant to the case or to carry out other treaty provisions. The requested information is protected by secrecy requirements embedded in the tax treaties.
The bilateral treaties each have articles that address this exchange of information between the tax authorities of our partner countries and the IRS. The language in these articles reflects the U.S. model treaty that allows tax authorities to request information that is “foreseeably relevant” to settling a tax dispute. This is a shift from previous treaty language that required requesters to make the case that information was “necessary” to addressing a tax dispute.
The U.S. already uses the “foreseeably relevant” language in exchange of information agreements with the British crown dependencies and some other taxing jurisdictions. Other tax treaties allow exchange of information that “may be relevant” to carrying out the provisions of the treaties. This language is in our tax treaties with nine other countries including Canada, France, New Zealand, and India.
Some recent international court decisions have provided some basis to understand when governments requests for information meet the “foreseeably relevant” standard.
In general, the process of requesting the information by one tax authority to another is what sets apart the bilateral treaties from the multilateral Protocol. It is very different from a privacy standpoint to have an automatic exchange of information with other governments under the Protocol rather than standard bilateral requests for information.
5. Why are just four of the treaties moving ahead?
Among the bilateral treaties, the three with Hungary, Chile, and Poland are not currently moving ahead and were not passed out of the Senate Foreign Relations Committee on June 25. This developed in regard to treaty implications of the Base Erosion Anti-abuse Tax (BEAT).
According to a letter sent by Sen. Bob Menendez (D-NJ, ranking member of the Senate Foreign Relations Committee), the Treasury Department included reservation language concerning the BEAT in the resolutions of advice and consent for the treaties. Sen. Menendez points out in his letter that such reservations could trigger renegotiation of the treaties.
Treasury has decided that the reservation language is not necessary for the other four bilateral treaties and the Committee was comfortable moving ahead with those treaties. It is unclear how much of a delay the reservations regarding BEAT will cause for the tax treaties with Hungary, Chile, and Poland.
The variety of approaches that countries take in tax policy can create some serious challenges to cross-border business and trade. Tax treaties are designed to limit these challenges and avoid double taxation of income. The bilateral treaties pending before the Senate present an opportunity to make the U.S. a more attractive place for companies from our treaty partner countries to invest and hire.