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United States Tax Treaties Should Reflect The 21st Century And Not The World Of 100 Years Ago



JOHN RICHARDSON

Prologue

The rules of taxation should follow changes in society. The ordering of society should NOT be hampered by the rules of taxation!

As the world has become more digital, companies can carry on business from any location. Individuals have become more mobile. Multiple citizenships, factual residences and legal tax residencies are not unusual. It has become clear that the rules of international tax as reflected in tax treaties (as they apply to both corporations and individuals) are in need of reform.

The purpose of this post is to identify two specific areas where US tax treaties are rooted in the world as it was one hundred years ago and NOT as it is today.

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

Second: US Citizenship-based taxation which the US exports to other countries through the “saving clause” found in almost all US tax treaties

Each of these will be considered.

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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 parter country. In other words, because of the “permanent establishment” clause, the treaty parter 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?

Two responses to the problem of the “permanent establishment” clause

A. A Multilateral Response – OECD Pillar 1

This is an attempt to change the rules of international tax on a multilateral level. The multilateral response is expressed as OECD Pillar 1. In general terms, the purpose of Pillar 1 is to agree on a mechanism where profits attributable to economic activity in a country should be taxed by that country.

This principle is well summarized by the Valentiam group:

OECD Pillar 1: According to the OECD, Pillar 1 should “adhere to the concept of net taxation of income, avoid double taxation, and be as simple and administrable as possible.” In layman’s terms, the OECD has determined that companies aren’t paying enough tax in jurisdictions where they have market-facing activities.

Consider Facebook, for example. While Facebook has users in every country, it doesn’t have physical operations in every country. A country like Egypt might have millions of Facebook users; advertisers are targeting those users, and Facebook is earning revenue and profit from those advertisers. However, since Facebook has no physical presence in Egypt, the company pays no tax there.

The OECD’s contention is that significant value is being created by Facebook’s operations in Egypt, so it should pay some amount of tax there. Pillar 1 would give Egypt a share of Facebook’s profits for its revenue-generating activities in the country.

While Pillar 1 is primarily focused on digital companies, it would also potentially apply to consumer-facing businesses in which a company that does not have a physical presence in the jurisdiction sells products directly to consumers. This could include companies such as Amazon and others that sell and/or deliver their products directly to consumers.

Unsurprisingly it has been and continues to be difficult to determine what rules should achieve these objectives. In June of 2021, the G7 agreed in principle to some form of shared taxing rights to profits earned by certain companies.

B. Unilateral Responses: Countries taxing revenues generated in a country instead of taxing profits earned in a country

A number of European countries have proposed imposing digital service taxes (“DST”) on large (primarily US) tech companies. Predictably the United States has (at least during the Trump administration) taken the position that the those European countries are not entitled to impose taxation on the revenue generated through sales to European residents. (The Trump administration threatened to retaliate by imposing tariffs on certain good of countries with DSTs.)

Summary: How the permanent establishment clause allocates taxing rights under tax treaties

Clearly the effect of the permanent establishment clause is that the treaty partner country, which is where the profits are earned is unable to tax those business profits earned in that country. This leaves the United States free to impose taxation on the those profits earned in the partner country.

Second: US Citizenship-based taxation which the US exports to other countries through the “saving clause” found in almost all US tax treaties

Citizenship as a sufficient condition for “tax residency” in the United States

As confirmed by the US Supreme Court in the 1924 (yes 100 years ago) decision of Cook v. Tait, the United States imposes worldwide taxation on US citizens, regardless of where they live in the world. I have previously argued that Cook v. Tait is of minor relevance and relies on assumptions that are completely disconnected with the modern world in terms of the meaning of taxation and the meaning of citizenship.

The exporting of US citizenship-based taxation to other countries via the tax treaty saving clause

The standard US tax treaty includes a provision similar to what is found in the 2016 US Model Tax Treaty:

The “saving clause” exports US citizenship-based taxation to individuals who are tax residents of other countries.

Summary: How the saving clause allocates taxing rights under the tax treaty

Clearly the effect of the saving clause is that the treaty partner country, permits the United States to impose taxation on income earned in that country by tax residents of that country. This is so even if that income has no connection to the United States.

Considering the permanent establishment clause and the saving clause together

On the one hand: The United States (because of the permanent establishment clause) has taken the position that European countries cannot impose tax on the profits of US companies generated in Europe by selling to European residents. (Only the United States can tax that income sourced in Europe.)

On the other hand: The United States uses its citizenship-based taxation rules (reinforced by the “saving clause” in tax treaties) to impose US taxation on European profits earned by dual US/European citizens resident in Europe.

In other words the United States takes the position with respect to business profits earned in European countries that:

1. Absent a permanent establishment, European countries cannot tax the profits of US companies earned in those countries; but that

2. Because of the saving clause the United States can tax the income earned in Europe by European residents.

Obviously this arrangement is for the benefit of the United States and to the detriment of European countries (hence the reason for Europe’s DST). Interestingly each of these arrangements follows from rules that were adopted approximately 100 years ago – a different time and different place.

When it comes to tax treaties, one might reasonably ask the question:

Q. Should the terms of a tax treaty follow from the economic and social realities of the 21st century or should they be based on the principles of economics, social realities and political assumptions of 100 years ago?

A. The permanent establishment clause and the saving clause are not compatible with a 21st century world. It’s time for the permanent establishment clause and the saving clause to be removed from modern tax treaties!

To be continued …

John Richardson, Citizenship Solutions, Toronto, Canada

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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