Tax Treaties

and Other

International

Agreements

By Ernest R. Larkins

In Brief

The Law of the Land

There are different types of tax related agreements between countries. They include income tax treaties; estate and gift tax treaties; totalization agreements; exchange of information agreements; international transportation agreements; and friendship, commerce, and navigation treaties.

These agreements are legally binding and created in the same manner with the one major exception that treaties require the approval of the Senate.

Such agreements are treated as the supreme law of the land, equal in status to that of the U.S. Code. The Supreme Court has determined that if there are any conflicts between the IRC and an agreement, the most recently enacted provision controls. To prevent unanticipated and unintended overrides, it has also clarified that the words of the statute or treaty must be examined to determine an intent to override.

Accompanying the article is an extensive exhibit of places to research for the details of all the various types of agreements.

An international agreement (or convention) is a negotiated contract, usually between two countries, that establishes the legal rights and obligations of the signatory governments and their residents in relationships with each other.

Types of Agreements and
Their Objectives

Generally, an international agreement can be classified either as a treaty or as an executive agreement. Both types of international agreements constitute binding international law. As discussed in more detail later, the primary difference lies in the manner in which each is created. Treaties require the Senate's approval while executive agreements do not.

Income Tax Treaties. The U.S. has 45 income tax treaties in force. Each income tax treaty has two primary objectives. First, an income tax treaty is intended to mitigate the burden of double taxation and, as a result, encourage international trade. This objective is accomplished in a number of ways. Income tax treaties use tie-breaker rules to determine the country of residence when an individual or entity is considered to reside in both treaty countries (under the respective domestic laws). In deference to the country of residence, treaties often place limits on the taxing power of the source or host country to avoid double taxation. Thus, treaties often prohibit the host country from taxing certain types of business income. The U.S.-Portugal treaty, for example, precludes Portugal from taxing a U.S. party's profits from conducting business in Portugal if no permanent establishment in Portugal is used to carry on the activity. Similarly, the treaty does not allow Portugal to tax the profits of a U.S. company providing international transportation services, even when some of the profits are earned in Portugal. Also, treaties generally require that investment income be taxed at rates below those specified in the country's domestic law. Though IRC section 871 (a)(1)(A) generally imposes a 30% withholding tax on dividends, the U.S.-Russia income tax treaty imposes a 10% withholding tax (five percent if the Russian recipient owns at least 10% of the payor) on dividends that U.S. corporations pay to Russian parties.

The second primary objective of income tax treaties is to establish cooperation between taxing authorities, namely the IRS and its counterpart in the signatory country. Cooperation is established through articles dealing with exchange of information, administrative assistance, and mutual agreement. The purpose of the exchange of information article is to prevent tax evasion. The IRS receives about a half million documents annually through requests pursuant to the exchange of information articles found in tax treaties. The administrative assistance article in U.S. treaties facilitates the collection of taxes. The mutual agreement article helps taxpayers to settle disputes through a mechanism known as "competent authority."

To illustrate, consider a taxpayer with income that two countries are asserting jurisdiction to tax. If a tax treaty exists between the two countries, the taxpayer can ask the competent authorities (i.e., the IRS and its foreign counterpart) to decide whether only one country should be entitled to impose its tax. U.S. taxpayers sometime assume paying taxes on the same income to both the U.S. and treaty country is acceptable since they can claim a foreign tax credit for the tax paid to the treaty country. However, failure to invoke the competent authority procedure in some situations risks the loss of foreign tax credit benefits. Rev. Proc. 96-13 (1996-3 IRB 31) states the rules for requesting competent authority. The CPA Journal presented an extensive discussion of the new procedure in its March 1997 issue.

Sometimes the U.S. enters income tax treaties with objectives in addition to those mentioned above. For example, treaties with developing countries often have a secondary objective of promoting economic progress or opening new markets. China and the newly-independent states of the former Soviet Union are cases in point. Most U.S. treaties also seek to promote cultural and educational exchanges with temporary tax exemptions for students, teachers, and trainees.

Estate and Gift Tax Treaties. The U.S. has 16 estate tax treaties in force, half of which cover gift taxes also. The primary objective of these treaties is to mitigate the effect of double transfer taxation. Double estate (or gift tax) can occur when a decedent (or gift transferor) is domiciled in more than one country (according to the respective domestic laws of each country). U.S. estate and gift tax treaties establish tie-breaker rules to determine which country can impose its transfer taxes whenever a person is domiciled in both treaty countries. Double transfer taxation can also occur when an individual is domiciled in one country but has property located in another. Estate and gift tax treaties allow the country of domicile to tax the worldwide transfers of such individuals; however, a tax credit is generally allowed for transfer taxes paid to other countries based on the location of property. Finally, estate and gift tax treaties generally allow the country of the transferor's domicile to tax transfers when a treaty country seeks to impose an inheritance tax on the transferee of property.

Like income tax treaties, a secondary objective of treaties dealing with transfer taxes is to establish cooperation between the IRS and its foreign counterpart. Articles dealing with mutual agreement and exchange of information evidence this second objective.

Totalization Agreements. The U.S. has entered into 17 totalization agreements, which affect tax payments and benefits under social security systems. One objective of totalization agreements is to minimize the burden of double social security taxation. The agreements provide relief from social security taxes for old age, survivors, and disability insurance, and hospital or Medicare insurance. A second objective is to provide for a totalized social security benefit whenever an individual's working career has been spent in more than one country. The totalized benefit is determined by combining the periods of coverage in the two signatory countries.

In many cases, totalization agreements allow individuals to continue paying social security taxes in their home countries and exempt them from social security taxation in the country where they are temporarily working. Generally, an American employer must send a U.S. employee to a signatory country on a temporary assignment lasting no more than five years to qualify for this special arrangement. Without this temporary assignment provision, many U.S. employees could be subject to social security taxation in both the U.S. and the foreign host country during their time abroad. Coverage under both social security systems might further complicate the individual's receipt of benefits under the systems.

Exchange of Information Agreements. The U.S. has 14 exchange of tax information agreements in force, which are similar to the exchange of information and administrative assistance article found in U.S. income tax treaties. These agreements require the contracting countries to assist each other in the accurate assessment and collection of tax, the prevention of tax evasion, and the development of improved sources for tax information (e.g., through joint studies of noncompliance). In addition, agreements with some non-Caribbean countries provide means to prosecute tax fraud cases involving illegal drug trade. Though much of the information exchanged relates to Federal income tax, these agreements can extend to Federal estate, gift, excise, and employment taxes as well. State, local, and possession tax information is not generally covered.

Typically, exchange of information agreements are with Caribbean nations or countries in South or Central America. Several of these agreements are with signatory countries that impose little or no taxes. Though these agreements facilitate enforcement of U.S. tax law, signatory countries imposing no tax derive little or no corresponding direct benefit. The inducement for these countries to sign such an agreement is often found elsewhere. For example, IRC section 274(h)(6) allows U.S. individuals attending a convention or similar meeting in a qualified Caribbean country that has an exchange of information agreement with the U.S. to deduct their travel expenses. Similarly, IRC section 922(e)(3) permits foreign sales corporations to be established only in countries that have an exchange of information agreement in force with the U.S. As another example, IRC section 936(d)(4) permits a possession corporation to claim a tax credit when it invests its business income in a financial institution that, in turn, invests the funds in business assets or development projects in a Caribbean Basin country with which the U.S. has an exchange of information agreement. Thus, entering into an exchange of information agreement with the U.S. can attract U.S. business and capital to a country.

International Transportation Agreements. The U.S. is a party to 30 international shipping and/or aviation agreements, which generally exempt transportation income from taxation in the source or host country. These agreements are often based on IRC sections 872(b) and 883(a), which provide that the income of a nonresident alien or foreign corporation from the international operation of ships or aircraft is exempt from U.S. income tax if the foreign country where the nonresident alien resides or the foreign corporation is organized grants an equivalent exemption to U.S. residents and corporations.

Friendship, Commerce, and Navigation Treaties. Since the American Revolution, the U.S. has concluded many commercial treaties that collectively have become known as friendship, commerce, and navigation treaties (FCNs). The primary objective of FCNs is to promote international trade through the protection of private capital and the pledge of fair dealing.

Among other things, these treaties provide some assurance that U.S. investors will not be subject to discriminatory tax practices. Some FCNs provide for fair national treatment, meaning that the tax burden in the signatory country will be no more burdensome on U.S. parties than it is on residents in the signatory country. Most U.S. income tax treaties also provide for fair national treatment, but the U.S. has a FCN with some countries with which it does not have an income tax treaty. Other FCNs grant most-favored-nation status to U.S. investors. This status is sometimes called fair international treatment and means that tax incentives and benefits granted to third country investors must be allowed to U.S. parties also. Thus, FCNs can provide a measure of protection against discriminatory taxation beyond the safeguard that may be found in income tax treaties.

Though there are many FCNs still in force, the last one was signed with Thailand in 1966. Today, FCNs are considered obsolete for purposes of protecting U.S. investors from the regulatory practices and government meddling common in the global market. Since the early 1980s, the U.S. has relied on bilateral investment treaties (BITs) to protect foreign investment and insure that compensation for expropriation losses are prompt, adequate, and effective. Unlike FCNs, however, BITs generally do not preclude discriminatory tax practices.

Creation of International
Agreements

All international agreements are legally binding. However, treaties differ from other international agreements in the manner they are created. Treaties require approval of the Senate whereas executive agreements do not. In terms of volume, executive agreements in the U.S. far outnumber treaties.

Taxpayers and their advisors must understand how international agreements become laws for at least two reasons. First, understanding the process enables them to judge the likelihood that a proposed agreement will become law and when the agreement's provisions become effective. Second, the documentation this process generates assists in reaching the correct interpretation of the agreement's provisions.

Creating Tax Treaties. The treaty-making process in the U.S. generally involves three distinct stages. First, the text of the treaty must be negotiated. Second, the Senate must give its advice and consent. Third, the U.S. President must ratify the treaty.

The U.S. begins the treaty-making process examining the other country's tax law and identifying situations that potentially can result in double taxation. As a starting point and a statement of its preferred position, the U.S. begins with the U.S. Model Tax Treaty. Similarly, member countries of the Organization for Economic Cooperation and Development (O.E.C.D.) have a model income tax treaty they prefer to follow. Developing countries often begin with the United Nations (U.N.) Model Tax Treaty.

Once the parties from each country agree on a completed draft, the negotiators initial it, which serves to identify the text. Next, the Secretary of State (or the U.S. Ambassador to that country) and the Secretary's foreign counterpart sign the treaty. This initial signing of the
treaty marks the end of the negotiation and conveys a moral duty to pursue
ratification.

At this point, the negotiators seek
ratification of the treaty from the governments in their respective countries. Since the procedure varies from one country to the next, only the ratification process in the U.S. is described here. The State Department sends the treaty text to the U.S. President with a submittal letter that provides background information and explains the treaty provisions. If the President approves of the treaty, he sends it, accompanied by a letter of transmittal, to the Senate. The Senate refers the treaty to its Foreign Relations Committee.

The President has the power to conclude a treaty only with the "advice and consent" of the Senate. Both the Treasury Department and the Joint Committee on Taxation prepare explanations of the treaty text for the Senate's use. The Senate Foreign Relations Committee considers the treaty first and customarily holds public hearings. Assuming a positive recommendation, the Foreign Relations Committee issues its own report on the treaty and a resolution to the full Senate recommending that the treaty be ratified.

A two-thirds vote is required for approval in the Senate. Following Senate passage, the U.S. President signs instruments of ratification. The treaty enters into force (i.e., becomes binding under international law) on the date instruments of ratification are exchanged and becomes effective according to the terms of the treaty.

Concluding Executive Agreements. The process of negotiating and concluding executive agreements is similar to that of negotiating and concluding treaties. The primary difference is that the U.S. Senate does not directly provide advice and consent to the former. Totalization, exchange of tax information, and international transportation agreements are executive agreements that Congress has specifically authorized in prior legislation (Congressional-executive agreements). For example, Sec. 233 of the Social Security Act allows the U.S. President to enter totalization agreements.

Authoritative Weight of International Agreements

Article VI, Clause 2 of the U.S. Constitution states that "[t]his Constitution, and the laws of the U.S. which shall be made in pursuance thereof; and all treaties made, or which shall be made, under the authority of the U.S., shall be the supreme law of the land." Though this supremacy clause does not specifically mention non-treaty agreements, the U.S. Supreme Court considers Congressional-executive agreements to be equal in authoritative weight to treaties.

Thus, the U.S. Code, treaties, and Congressional-executive agreements are treated as the supreme law of the U.S. IRC section 7852(d) echoes the Constitution's equipotent rule in stating that "neither the treaty nor the law shall have preferential status by reason of its being a treaty or law." As the supreme law of the land, an international tax agreement prevails any time a true conflict exists between it and a Treasury regulation, revenue ruling, or other administrative pronouncement. The U.S. Constitution is silent, however, about how to resolve conflicts between the IRC and an international tax agreement.

Resolving Conflicts with the IRC. The later-in-time rule has often been used to determine how conflicting IRC and international agreement provisions should be applied. Under the U.S. Supreme Court's traditional application of this rule, the most recently enacted provision controls. Thus, a treaty that enters into force in 1977 overrides any conflicting IRC provision enacted in 1975. To prevent unanticipated and unintended overrides, the U.S. Supreme Court later clarified that the words of the statute or treaty must be examined to determine an intent to override.

In requiring that due regard be given to U.S. tax treaties, IRC section 894(a)(1) codifies the judicially-developed later-in-time rule. The due regard standard requires the most recently adopted provision (whether in the IRC or treaty) be examined to determine whether there was any intent to override the earlier provision. The intent may be explicitly stated or inferred from the legislative history. Absent any evidence of such intent, the earlier provision prevails.

The legislative history may explicitly state whether an IRC provision is intended to supersede conflicting treaty articles. For example, the Omnibus Reconciliation Act of 1980 asserts that IRC section 897 overrides existing treaties in determining whether gains from the disposition of U.S. real property interests are taxable. The Conference Report to the Tax Reform Act of 1984 indicates that its new statutory definition of a resident alien generally prevails over contrary definitions in U.S. income tax treaties. The Technical and Miscellaneous Revenue Act of 1988 identifies specific conflicts between 1986 amendments to the IRC and provisions found in earlier treaties and clarifies in each instance whether the IRC or treaty prevails.

Other coordination rules appear in the IRC. For example, IRC section 245(a)(10) allows the taxpayer to treat a dividend from a 10% owned foreign corporation as though it is from U.S. sources even though a treaty might consider it from foreign sources. IRC section 269B(d) states that conflicting treaty provisions are ignored in applying the stapled entities provisions of that section. If elected, IRC section 865(h)(2)(A)(ii) allows gains from the sale of certain stock in a foreign corporation and certain intangibles to be sourced according to the IRC rather than according to a conflicting treaty article. IRC section 884(e),(f)(3) explains the conditions under which a treaty can exempt the taxpayer from the IRC's branch profits tax. IRC section 904(g)(10) explains how to reconcile conflicting source rules for amounts derived from a U.S.-owned foreign corporation. IRC section 927(e)(4) denies income tax treaty benefits to foreign sales corporations; in effect, the IRC overrides conflicting treaty provisions. IRC section 2102(c)(3)(A) modifies the unified credit allowed to the estate of a deceased nonresident alien whenever a treaty so provides.

Force of Attraction Rule in Treaties. IRC section 894(b) provides one instance in which the IRC explicitly overrides some of the older U.S. income tax treaties. To appreciate the importance of this provision and its application, some understanding of the pre-1966 IRC is necessary. Before 1966, the IRC taxed the nonbusiness investment income of a nonresident alien or foreign corporation at regular U.S. rates whenever the foreign party had a permanent establishment in the U.S. In effect, the rule treated the investment income as though it was magnetically attracted or drawn to the taxpayer's U.S. business operations and, thus, taxed the investment income the same as business income.

Like the pre-1966 IRC, pre-1966 treaties include a "force of attraction" rule. Thus, pre-1966 treaties deny application of the reduced withholding provisions to investment income whenever the recipient has a permanent establishment in the U.S. The treaty denial of reduced withholding rates, when read in conjunction with the pre-1966 IRC, meant that investment income was taxed at regular U.S. rates if the foreign recipient had a U.S. permanent establishment.

However, current IRC section 894(b) provides that a foreign party is deemed not to have a U.S. permanent establishment in applying the force of attraction rule in these older treaties. Reg. section 1.894-(b)(1) clarifies that this statutory provision overrides all U.S. income tax treaties. In effect, this IRC provision nullifies the force of attraction rule in pre-1966 treaties.

For example, assume Knud, a nonresident alien and Danish citizen, is engaged in a U.S. business through a sales branch in Philadelphia. Unrelated to his U.S. business, Alexander receives dividend income of $40,000 from U.S. sources. Pursuant to Article VI(2) of the U.S.-Denmark Income Tax Convention, the reduced withholding rate of 15% is not allowed because Knud has a permanent establishment in the U.S. However, IRC section 894(b) requires this treaty provision be read as if Knud did not have a U.S. permanent establishment. Thus, the 15% withholding rate is allowed.

Treaty Disclosure and Penalties. IRC section 6114(a) requires a taxpayer to disclose any position in which a treaty is treated as overriding a conflicting IRC provision. Form 8833, Treaty-Based Return Position Disclosure, is used for this purpose. Treasury waives the disclosure requirement in some cases. For example, Reg. section 301.6114-l(c) permits treaty positions for reduced withholding on investment income or dependent service income to be taken without
disclosure.

Except when Treasury waives the disclosure requirement, IRC section 6712(a) imposes a $1,000 per failure penalty on taxpayers other than regular corporations for each failure to disclose a treaty-based return position. C corporations are subject to a penalty of $10,000 per failure to disclose. Note that these penalties are based on the number of transactions for which the taxpayer failed to disclose a treaty-based position. The dollar amount of the transaction is not considered. Thus, large penalties can apply to small dollar transactions. Further, the penalty applies to each separate payment or income item, even if multiple payments are received from the same party. According to IRC section 6712(c), the penalty is imposed in addition to any other penalty the law might impose. However, IRC section 6712(b) allows Treasury to waive the penalty if the taxpayer acted in good faith and the failure to disclose was for reasonable cause.

Resources for International
Agreements

International agreements and related materials are found in a variety of places, including official government publications, indices, loose-leaf services, serials, and electronic databases. The Exhibit lists and briefly describes sources of information about international
agreements. *

Ernest R. Larkins, PhD, is a professor of accounting at Georgia State
University.

EXHIBIT

RESOURCES FOR INFORMATION ABOUT INTERNATIONAL AGREEMENTS