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Biden Administration Overriding Tax Treaties. Does This Mean Existing Treaties Are Worthless?



Biden Administration Overriding Tax Treaties

(The above tweet was a response to a recent article in the Financial Post.)

Introduction

This post is a comment on yesterday’s Tax Connections post “Ranking Members Warn Against Bypassing Treaty Process“. As is well known the United States has been hugely supportive of the International Tax Reforms known as “Pillar 1” (granting source country taxing rights to certain profits earned by certain multinationals) and “Pillar 2” (establishing a global minimum tax on the profits of certain multinationals). Apparently 136 of 140 countries have agreed to the two Pillars of international tax reform. The agreement signified a country’s commitment to make the necessary domestic changes to meet its international obligations.

Yesterday’s post focussed on the response of the Ranking Members to the US implementation of Pillar 1 only. How is the US to implement Pillar 1? Is a treaty necessary to implement Pillar 1? If so, can a treaty be done without involving Congress? For that matter, is a treaty even necessary? Could Congress implement Pillar 1 through a “tax treat override”? To be clear: I don’t know the answer to this question. But, thinking about how to answer the question is an interesting “thought experiment”.

Context: What exactly is the issue that Pillar 1 is attempting to fix?

Much of international taxation is based on the tension between the desires of source and residency countries to tax profits earned in the source country. (I have come to see that most issues in international tax are about the tension between source and residence taxation). Let’s begin with a couple of examples.

20th Century Example

Q, Should a Canadian mining company be able to go to the African country (leaving aside employment issues) of Eritrea, carry on business in Eritrea, arguably earn profits in Eritrea and expect that Eritrea should not be able to tax those profits? Should the taxing rights to the profits belong to Canada, Eritrea or both?

A. One could imagine an argument to the effect that the Canadian company supplied the capital and was extracting product to be sold elsewhere. The actual sale of the product did not take place in Eritrea. The Canadian company provided jobs in Eritrea and the Eritrean workers were paid (maybe) for their labour. Because no product was actually sold in Eritrea there should be no basis for Eritrea taxing the profits of the Canadian company. Maybe …

21st Century Example

Q. Should Google (a US company) be able to carry on business in India, make profits from the vast population of India (who pay money for its services) and expect that India should have little or no taxing rights to the profits earned by accessing the huge India consumer market?

A. This seems a little bit different from the first example of the Canadian mining company. The 21st century is the digital age. Google is not exporting any capital to India. Google is simply profiting from India’s vast consumer market. The argument for India NOT having taxing rights over the profits earned by Google in India doesn’t seem all that compelling to me.

What country should have the right of taxation? The source country (India or the African nation) or the country of residency of the corporation (USA or Canada)?

Interesting questions …

Although mining companies (extractive industries) exist in the 21st century, digital companies did not exist in the 20th century (or at least the early part of the 20th century when the existing tax treaties were designed. In fact as Professor Steven Dean points out:

To find the answer, let’s begin by going back 100 years

In June of 2021 I wrote a post suggesting that “United States Tax Treaties Should Reflect The 21st Century And Not The World Of 100 Years Ago“.

Domestic Legislation:

Obviously every country has the right to tax profits/activity that is carried on in the country. Therefore, it’s obvious that (in my two examples) both India and Eritrea would have the right to tax the

Based on current OECD and Us tax treaties it appears that the source country can tax those profits only to the extent that the company has a “permanent establishment” in the source country.

First: The “Permanent Establishment” clause found in US and OECD tax treaties

In History of tax treaties and permanent establishment concept, Michael Kobetsky reminds us that:

The current international tax treaty system still reflects the principles and structures developed in the 1920s by the League of Nations, despite the effects of globalization. These principles were developed in a world economy in which international trade was in tangible items and international communication was slow. During the inter-war period, the double taxation of cross-border income resulting from the overlap of source jurisdiction and residence jurisdiction led to calls for measures to prevent double taxation. The International Chamber of Commerce (ICC), on behalf of enterprises, articulated a pressing need for measures to prevent double taxation. In 1928, the League of Nations developed its first model tax treaty to prevent double taxation, and this was the foundation of the 2010 OECD Model, the UN Model and of modern tax treaties. The League of Nations could not foresee the longevity of the principles and structure of its 1928 model tax convention, nor that the bilateral tax treaty system would become an extensive network. Its preference was for a multilateral tax treaty system with multiple bilateral tax treaties being a compromise intermediate measure.

The international tax system, as expressed in tax treaties, is based on a world where there was no digital commerce. It was based on a world where the treaties generally recognized the distinction between exporters of capital (more wealthy countries) and importers of capital (less wealthy countries). This was reflected in a “permanent establishment” clause, that allowed Country B to impose taxation on the profits of companies of Country A, only to the extent the Company from Country A had a “permanent establishment” in Country B. The “permanent establishment” clause continues to exist today. For example the 2016 US Model Tax Treaty (in addition to the OECD treaty) includes the standard “permanent establishment” clause:

The “permanent establishment” clause is generally interpreted to prevent a treaty partner country from imposing taxation on the profits of US tech companies that do NOT have a permanent establishment in that treaty partner country. In other words, because of the “permanent establishment” clause, the treaty partner country would not be able to tax the profits of the US company, allowing the United States to tax all of the available profits. (Interestingly the UN Model Treaty allows for greater taxing rights for the country where the profit is sourced.)

Does the “permanent establishment” clause makes sense in a digital world?

Is it reasonable for companies in Country A to sell their products on the retail level to consumers in Country B and expect that Country B should have no taxing rights over those profits? Is it reasonable that the “permanent establishment” clause should be used as a shield to protect the company in Country A from taxation of its business profits by the Government of Country B? Why should the United States be able to tax all of the profits earned by a US business which are sourced outside the United States?

Many countries do NOT agree that a “permanent establishment” clause should protect digital services companies from taxation on profits earned by selling to the consumers in their country. Tech companies do NOT export capital to other countries. They simply sell their products to consumers in other countries. Welcome to the digital world. What possible justification would justify the use of a “permanent establishment” clause to shield tech companies from local taxation? Is it time for principles of taxation rooted in the first part of the 20th century to be changed to reflect the economy of the 21st century?

Have a question? Contact John Richardson, Citizenship Solutions.

The Reality of U.S. Citizenship Abroad

My name is John Richardson. I am a Toronto based lawyer – member of the Bar of Ontario. This means that, any counselling session you have with me will be governed by the rules of “lawyer client” privilege. This means that:

“What’s said in my office, stays in my office.”

The U.S. imposes complex rules and life restrictions on its citizens wherever they live. These restrictions are becoming more and more difficult for those U.S. citizens who choose to live outside the United States.

FATCA is the mechanism to enforce those “complex rules and life restrictions” on Americans abroad. As a result, many U.S. citizens abroad are renouncing their U.S. citizenship. Although this is very sad. It is also the reality.

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