If the border-adjustable tax is adopted in the U.S., it is unclear whether it will be considered a covered tax under the network of U.S. tax treaties, and further, whether the U.S. will even have a say in making that determination, according to practitioners.
Given the radical departure from the U.S.’s current income tax regime, it is unclear whether the border-adjustable tax would fall under the category of covered taxes generally listed in article 2 of U.S. treaties, or alternatively, if it could qualify as a substantially similar tax so it would fall under the treaty, according to Gretchen Sierra of Deloitte. Speaking May 12 at the U.S. Activities of Foreigners and Tax Treaties session of the American Bar Association Section of Taxation meeting in Washington, Sierra said there is little guidance in either the U.S. treaties or the technical explanations.
When evaluating whether the border-adjustable tax is a covered tax, assuming the U.S. is the state that determines whether it is covered by the treaty, IRC section 901 is a good place to start, Sierra said. “The term income tax is not defined in [treaties in force], [other] treaties, or the models of the U.S. or OECD, which raises the question of where we would look for a definition,” Sierra said. “Whenever a treaty does not define a term in the text, article 3, which has general definitions in it, says that where a term is not defined in the text it will have the meaning that it has at that time under the law of that contracting state for the purposes of the taxes to which the convention applies.”
The placement of the border-adjustable tax in the tax code itself could play an important role in determining whether it is a covered tax, said Jesse Eggert, a principal with KPMG. He noted that article 2 specifies that the IRC is included in covered taxes, so if the border-adjustable tax were adopted outside the tax code as opposed to restructuring the IRC, it may fall outside the scope of treaty article 2 as an initial matter.
The process for determining which country decides whether a tax is covered by a treaty has been controversial in the past, but may offer the U.S. some insight into how it could craft tax reform to reach the outcome it desires, Sierra said. She cited as an example the U.K.’s diverted profits tax (DPT). In that case, the state enacting the law decided whether the tax was covered under its treaties.
The U.K. enacted the DPT outside of its normal income tax law and took the position very clearly that it was not a covered tax, Sierra said. She also noted that Queen’s counsel issued an opinion stating that it was not a covered tax in order to make the U.K.’s position clear. “It was a very strategic move to have Queen’s counsel come out and say it was not a covered tax,” Sierra said. "I think most of us would have said it was a covered tax if they had not done that. It raised tough [section] 901 issues because of the realization concept, and it was kind of someone else’s income, but in terms of whether it was an income tax, I don’t think that was as difficult. And yet they were very clear from the outset that they didn’t want it covered and didn’t want to have to cede it their treaty partners."
Robert Stack, former Treasury deputy assistant secretary (international tax affairs), said the U.K. chose to take the position that the DPT was not a covered tax so it could impose the tax on a foreign company that did not have a permanent establishment in the U.K. Stack added that the U.K. was very concerned that the tax be creditable in the U.S. “What the DPT points out is taxes that are income taxes from the U.S. perspective can be creditable outside the treaty,” he said. “So you can have a non-covered tax but still get a credit in the U.S. because of our definition of an income tax. We are not obligated to credit a non-covered tax, but we did with the DPT, and it was very clever on the part of the U.K.”
According to Eggert, the determination of which country chooses whether the tax is covered may depend on how the question is phrased. “If you ask whether the U.S. has taxed in accordance with the convention, then it likely defers to the U.S. to make the determination,” he said. “But if you ask the question whether this is a covered tax, and does article 23 apply under any circumstances, it makes you wonder whether the residence country makes the determination, and I’m not sure. It could be a situation that has to go to [mutual agreement procedure] to get hashed out.”
Eggert also raised the issue that the U.S. would have significantly less leverage to contest transfer pricing disputes in MAP. For instance, he said, in a case in which a U.S. corporation exports to Italy and claims the value of the export is $100, but Italy claims the proper transfer price should have been $40, the adjustment does not affect U.S. taxable income because the income from the export is eliminated from the U.S. tax base by the border-adjustable tax.
“What incentive would Italy have to do anything at all to help if they know that anything they do does not cause double taxation?” Eggert asked. “If we end up with countries proceeding along with their treaties with this tax excluded from covered taxes and us completely changing our tax base, do treaties even function, or will all our treaties need to be drastically changed in order to function?”
Eggert also said there are questions regarding whether the border-adjustable tax could be considered a special tax regime under the 2016 U.S. model treaty. “The [special tax regime (STR)] rule applies to a regime that results in a preferential rate for interest, royalties, guarantee fees, or similar income relative to income from sales of goods or services, or a reduction in the tax base for a type of income relative to sales of goods or services,” Eggert said. “Here, it’s hard to argue that that’s our situation because the same rule applies to exports and imports of goods and services that applies to exports and imports of intellectual property. It does seem like we don’t have an STR. It does seem, however, to implicate the later provisions in the U.S. model that mandate renegotiation.”