Brief commentary on recent cases, rulings, notices, and related federal tax guidance.
International tax policy has been in focus for the past several years. The Organization for Economic Cooperation Development (OECD) proposals for a more harmonized cross-border tax system have dominated the stage, but U.S. foreign relations continue to advance by the negotiation (and termination) of treaties for the avoidance of double taxation and prevention of tax evasion. This article provides a brief update on treaty considerations thus far in 2022.
The U.S. Senate Foreign Relations Committee approved the proposed tax treaty between the U.S. and Chile in early 2022. The treaty has been in process for over a decade, having been initially signed in 2010. It was considered by the Foreign Relations Committee in 2014 and 2015, but never made it out of committee and to the Senate floor.
The treaty still needs to be approved by two-thirds of the Senate before becoming effective. Additionally, the Foreign Relations Committee approval comes with some reservations that would need to be agreed upon by Chile’s government before the treaty could take effect.
The U.S. and Croatia announced a desire for increased coordination between the nations, including with respect to trade and investment. After undertaking substantive negotiations in early 2022, the nations have agreed in principle on a new tax treaty draft. The proposed treaty follows the 2016 U.S. model, and is currently under review by the State Department. To become effective, this treaty will need the approval of the Senate Foreign Relations Committee and approval of two-thirds of the Senate.
The U.S. Treasury Department recently indicated that it will terminate the tax treaty between the U.S. and Hungary, a treaty that has been in place since 1979. Treasury’s move would bring an end to a thirty-year span of cooperation between the nations. The termination will become effective on January 8, 2023, but the terms of the treaty will continue to apply to tax withholding and tax periods ending before January 1, 2024.
Ramifications of Terminating Treaties
Treasury’s position is that the existing tax treaty with Hungary is not reciprocal. Hungary maintains a corporate income tax rate at 9 percent, in comparison with the U.S.’s 21 percent corporate income tax. Treasury asserts that Hungary’s favorable tax regime benefits Hungarian taxpayers, but that Hungarian taxes are so low that U.S. businesses and investments into Hungary don’t need to rely on the provisions of the treaty.
Although the purpose of this article is not to question Treasury’s policy decisions, this approach feels short-sighted. U.S. taxpayers undoubtedly benefit from Hungary’s favorable tax policies when conducting business in Hungary, and the existence of the tax treaty allows Hungarian taxpayers to conduct business in the U.S. on more favorable terms. There is a great deal of economic literature suggesting that encouraging foreign investment into the U.S. economy is a good thing. Further, terminating the treaty removes some level of certainty for multinational organizations conducting business in those countries, and subjects U.S. businesses to the risk of unfavorable changes to Hungarian tax laws. This uncertainty could reduce or delay trade or investments between the nations.
Not unimportantly, adopting or revising a treaty can take years. The U.S. and Hungary actually negotiated an update to the existing tax treaty in 2010 — but that version of the treaty hasn’t been ratified twelve years later! That proposed version sought to resolve some longstanding issues by preventing entities unaffiliated with the treaty countries from exploiting favorable treaty conditions. While there may be legitimate reasons for terminating the existing treaty, perhaps some caution is in order as it will be hard to put this relationship back together once it’s been taken apart.
There is also reason to believe that the treaty termination is retaliation for Hungary’s opposition to the 15 percent global minimum tax proposal advanced by the OECD. Hungary has vetoed the adoption of the global minimum tax within the EU, citing the proposal’s affront to Hungary’s national sovereignty and economic competitiveness. There is still a fair debate within the U.S. and abroad as to whether the global minimum tax is a good idea. Ultimately, Hungary’s stance probably calls for more discussion and negotiation, rather than less.
Coordination with Base Erosion Anti-Abuse Tax (BEAT) Regime
The U.S. Senate Foreign Relations Committee noted several reservations with respect to the negotiated tax treaty with Chile. The committee noted that provisions of the U.S. model tax treaty could, in some instances, conflict with the base erosion anti-abuse tax adopted by the U.S. in 2017 (BEAT).
In particular, the U.S. model tax treaty provides that the taxable profits of a business should be determined under the same conditions for residents and non-residents. The BEAT rules may conflict with this provision in some cases, insofar as BEAT imposes an additional tax for certain U.S. resident entities that is not reciprocated for all U.S. resident and non-resident entities.
There is an additional concern that the U.S. model tax treaty provisions granting relief from double taxation may be violated by the BEAT. The model tax treaty requires that the U.S. permit taxpayers to take tax credits for taxes paid to treaty-nations; however, the BEAT denies certain foreign tax credits in ways that appear inconsistent with this principle.
Because neither U.S. law nor treaty is afforded special status, the general rule is that the one adopted later will be the one in force. This means that, to the extent the BEAT is inconsistent with any particular treaty entered into post-2017, taxpayers may have an argument that those conflicting provisions of the BEAT regime do not apply to them. In the end, it will likely be the case that these issues will be resolved in renegotiation of proposed treaty provisions. As noted above, this process can be lengthy, and there is no guarantee of resolution in the near future.