Publications

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The United States House of Representatives, under budgetary pressures, has included a measure sponsored by Representative Lloyd Doggett (D-Texas) in legislation authorizing farm programs. If enacted, this legislation would significantly raise taxes for many foreign-based multinationals with operations in the US.

The measure, which aims to raise $7.5 billion over the next ten years, is just one of many proposals affecting international business that Congress will consider in the coming months.

Measure Attacks Certain Payments to Affiliates

The measure is designed to attack payments of interest, royalties, and other deductible payments made to an affiliate when the withholding tax rate on the payment to the affiliate is less than the rate that would apply if the payment is made directly to the foreign parent company.

For example, under current law, if a US subsidiary of a French-based multinational pays royalties to a Swiss sister subsidiary, provided the Swiss subsidiary is eligible for treaty benefits, there would be no withholding tax under the US/Swiss income tax treaty. If the royalties were instead paid directly to the French parent, a 5 percent withholding tax would apply under the US/French treaty.

The proposed legislation attacks this perceived abuse by requiring that the applicable withholding rate on the payment to the Swiss affiliate be the rate that would apply if the payment by the US subsidiary was made directly to the French parent company. As a result, notwithstanding the provisions of the US/Swiss treaty, a 5 percent withholding tax would apply.

Similarly, if a US subsidiary of a Japanese multinational pays interest to a Dutch-based group finance subsidiary, a 10 percent withholding tax would apply to the payment even though interest is not subject to a withholding tax under the US/Dutch income tax treaty.

The proposed legislation would apply even though the recipient affiliate is the beneficial owner of the income and qualifies for relief under the provisions of the relevant income tax treaty and the existing provisions of the Internal Revenue Code designed to prevent tax treaty abuse.

Tax Treaty Abuse

Congress and Treasury have taken significant steps over the last 20+ years to prevent the abuse of tax treaties. These steps have included the development of a comprehensive Limitation of Benefits (LOB) article which is now included in every new or renegotiated US income tax treaty as well as the new US Model Income Tax Treaty. The LOB provisions in a tax treaty are supported by similar provisions in Internal Revenue Code Section 7701(l) which were enacted in 1993 as a backstop to prevent treaty abuse.

As a result of these steps, taxpayers have significant hurdles to meet when seeking to obtain treaty benefits. These hurdles generally ensure that recipients of treaty-protected income are not merely shell companies but are active companies with material substance and structure in their countries. The proposed legislation puts aside these steps in favor of a mechanical comparison between the treaty withholding rates at the subsidiary and parent company levels.

Structures That Will Be Impacted

The proposed legislation will be particularly problematic for foreign-based multinationals using group finance and licensing company structures. The charts below illustrate the issue.

Group Finance Company Structure

 

In this example, the US group (as well as the other subsidiaries around the world) borrows from and pays interest to the Japanese multinational’s UK group treasury center. From both an operational and an income tax perspective, the treasury center will have substantial operations in the UK. It will employ significant personnel, manage currency risk, and administer credit for the group’s worldwide operations. The treasury center would need to have qualified for benefits under the UK treaty and IRC Section 7701(l).

Interest paid by the US group to the UK treasury center would ordinarily be exempt from withholding tax under the US/UK income tax treaty. The proposed legislation would impose a 10 percent withholding tax on the interest payments, using the withholding rate under the US/Japan treaty as the applicable rate even though the payments are not being made to the Japanese parent.

Group Licensing Company Structure

A group licensing company raises similar issues. Multinationals routinely consolidate intellectual property ownership and licensing in an IP holding or licensing company. This is often implemented for operational efficiencies as well as for the multinational’s global tax planning.

Here, royalties by the US group to a Dutch licensing center of a Spanish group would ordinarily be exempt from withholding tax under the US/Dutch income tax treaty. The proposed legislation would impose an 8 percent withholding tax on the royalty payments, using the withholding rate under the US/Spain treaty as the applicable rate even though the payments are not being made to the Spanish parent.

Countries Impacted

The legislation will impact multinationals headquartered in any country where there is either no US income tax treaty or where the treaty reduces but does eliminate withholding taxes on interest and royalties. Some of the major countries affected include:

Europe	Asia	Americas	Middle East
Belgium	Australia	All countries	All countries
France	Hong Kong
Italy	Indonesia
Portugal	Korea
Spain	Japan
	New Zealand
	Thailand
	Singapore

The legislation will also directly impact the group treasury and licensing affiliates located in countries where these structures are usually implemented, for example the Netherlands, Switzerland, Luxembourg, and the UK. The issue in these countries is whether the increased withholding tax on the receipt of interest and royalties will be creditable against the local income tax imposed on the treasury or licensing company. It is doubtful that a local country tax authority would continue to allow a credit for taxes imposed unilaterally by the US and contrary to existing treaty obligations. Moreover, even if a credit were allowed, most finance and licensing companies operate on thin margins so that any increase in withholding tax would become a true cost to the group.

Prospects for the Proposal

Under the “pay-go” rules adopted by the new Democratic Congress in January to control the federal deficit, any new tax cuts or spending increases must be fully offset by tax increases or spending cuts, and, as a result, Congress is on an ongoing search for new revenues. The Doggett measure was adopted as a way to offset an increase in spending in a federal program that provides food subsidies to indigent families in legislation authorizing agriculture programs.

Republican opponents of the measure, including the Bush Administration, have objected on three grounds: first, that the measure is a tax increase which will have a negative impact on the international competitiveness of the US economy; second, that it would violate aspects of international law as well as the hard won treaty rights of many of America’s trading partners; and third, that the provision was added to the farm bill without any public consideration or debate in the Ways and Means Committee, where tax and trade proposals are first vetted.

Representative Lloyd Doggett defended his proposal as a necessary measure to close a loophole that permits multinational companies to “abuse” their tax treaty rights by shopping around for low tax jurisdictions. The chairman of the Ways and Means Committee, Charles Rangel (D-New York) while sympathetic to Republican complaints that the measure had not been publicly vetted, nonetheless noted that it was necessary as a way of paying for the cost of subsidizing food for 26 million Americans in poverty.

In the near term, it appears likely, given the way in which the proposal was advanced, that the Senate will reject it when it considers the farm bill and will look for an alternative way to meet the pay-go rules. But that outcome is not certain.

Moreover, even if the Senate rejects the Doggett proposal, it is likely that it will be considered once again under procedural circumstances that are less subject to criticism. The House Ways and Means and the Senate Finance Committees are likely to hold hearings on the issue of alleged tax avoidance through the use of tax treaties.

As drafted, the provision is extremely broad. In effect, the outbound payment from the US subsidiary is taxed at its parent’s higher rate whether or not the corporate structure was designed with a tax avoidance purpose. There is already discussion among some tax writers in Congress about whether the provision would be more palatable to its critics if it were so limited.

Over the next several months, Congress is expected to consider several tax proposals that in the aggregate could cut taxes for middle-class families for a cost in excess of $200 billion, all of which must be offset. Addressing concerns about the Doggett measure, Chairman Rangel on the House floor said:

We weren’t going to raise individual taxes and we knew we couldn’t raise corporate taxes, so I thought the common sense way was to find out who wasn’t paying taxes and get money from them.

The international area will continue to be at the center of the tax debate in Congress.