On July 14, the House Democratic leadership released the text of the American’s Affordable Health Choices Act of 2009 (H.R. 3200), which promotes health care reform. Among the revenue provisions of the act is one to restrict, in certain cases, the use of tax-treaty benefits by foreign firms with operations in the United States. The proposal would amend Section 894 of the Internal Revenue Code (“Code”) relating to income affected by a treaty.  

Background  

A foreign person that earns non-business U.S. source income in the nature of interest, dividends, rents, royalties and certain similar types of income is subject to a flat 30-percent U.S. withholding tax. However, in addition to certain statutory exemptions, the withholding tax can be reduced or eliminated under the provisions of a tax treaty between the United States and the country of residence of the foreign person. The United States has entered into over 60 bilateral income tax treaties, almost all of which significantly reduce the statutory 30-percent withholding rate otherwise imposed by the Code. The typical tax treaty reduces the withholding tax on interest and royalties to zero. However, a foreign corporation, for example, may not benefit from a provision of a U.S. tax treaty with a foreign country that eliminates or reduces U.S. withholding tax unless the foreign corporation is both a resident of such foreign country and qualifies under a limitation-on-benefits provision contained in the U.S. tax treaty with such foreign country.  

Since the late 1970s, the United States has attempted to curb so called “treaty shopping,” which is an arrangement whereby a foreign firm from a non-treaty jurisdiction attempts to benefit from a treaty by routing its U.S. source income through an intermediate subsidiary in a third country that is a signatory to a tax-reducing treaty with the United States. Most U.S. treaties have significant anti-treaty-shopping provisions to curb this abuse. However, over the past few years, Congress has considered several proposals to curb treaty-shopping abuses even more significantly. In all of these proposals, withholding taxes would be imposed on deductible payments (e.g., interest and royalties) made to a treaty country person if the common parent of its group was either not entitled to any treaty relief or was entitled only to a higher rate of tax, if the payments had been to the common parent directly from the United States.  

At the time these earlier proposals were introduced, taxpayers that were potentially affected by these bills weighed in, arguing that the previous bills ran counter to U.S. treaty policy, effectively negating various provisions of U.S. tax treaties, and that the limitation-on-benefits provisions contained in most U.S. tax treaties are already designed to curb treaty-shopping. In addition, taxpayers argued that the previous bills ignored the commercial and business reasons for why corporations establish separate subsidiaries in different jurisdictions. Taxpayers also argued that the previous bills would further render the United States an uncompetitive environment in which to do business. Finally, fear of retaliation by treaty partners was cited as a concern.  

Current Proposal

H.R. 3200 proposes to limit tax treaty benefits with respect to U.S. withholding tax imposed on deductible related-party (e.g., payee and payor share a related parent) payments in a manner similar to one of the earlier Congressional bills. Under the proposal, if a U.S. subsidiary makes a deductible payment to a foreign corporation that has a common foreign parent, any withholding tax with respect to such payment would not be reduced under any treaty of the United States unless the withholding tax would be reduced under a U.S. treaty if such payment were made directly to the foreign parent corporation.  

The provision would only apply to payments deductible under the U.S. corporate income tax (e.g., interest and royalties). A payment is a deductible related-party payment if it is made directly or indirectly by any entity to any other entity, it is allowable as a deduction for U.S. tax purposes and both entities are members of the same “foreign controlled group of entities.” The degree of common ownership is based on a modified definition of “foreign controlled group of entities” requiring “more than 50 percent” common ownership. Thus, the provision would apply to payments to a foreign corporation where the U.S. corporation and the payee corporation were linked to a common foreign parent by chains of more than 50 percent ownership.  

The bill provides that the IRS may prescribe regulations providing for the treatment of two or more persons as members of a foreign controlled group of entities if such persons would be the common parent of such group if treated as one corporation, and regulations providing for the treatment of any member of a foreign controlled group of entities as the common parent of that group if such treatment is appropriately taking into account the economic relationships among the group entities.  

Supporters of the anti-treaty-shopping proposal cite tax revenue as their central concern; foreign firms that reduce their U.S. withholding taxes with treaty shopping reduce the tax revenue the U.S. collects on U.S.-source income. The treaty-shopping restrictions proposed in H.R. 3200 would increase revenue by an estimated $3.3 billion and $7.5 billion over five and ten years, respectively. Opponents of the measure have argued that the provision would increase the cost to U.S. firms of doing business in the U.S., and would thus harm U.S. employment and wages.

The Senate has opposed this and similar provisions twice in the past two years and, since then, Congress has not held any hearings to examine the issue or to determine whether the proposal is the appropriate remedy to address any perceived concerns. Although some taxpayers view H.R. 3200 as having positive changes since it was originally introduced in 2007, they remain opposed to it because they believe that it still discriminates against U.S. subsidiaries of companies headquartered abroad and violates many of our international agreements. Some opponents have suggested that renegotiation of existing income tax treaties is a more appropriate way to address the concerns underlying this bill.