International Tax Planning

Tax Cooperation, Past, Present & Future


By Professor Allison Christians, H Heward Stikeman Chair in Tax Law, McGill University Faculty of Law, Montreal, Quebec, Canada (01/03/2014)

In 2014, the extra-territorial portions of a controversial law enacted by the United States in 2010 are scheduled to come into effect. The law, known as the Foreign Account Tax Compliance Act (FATCA), will impose an extensive third-party monitoring and disclosure regime on financial institutions around the world in an effort to ‘smoke out’ US tax cheats and expose their undeclared foreign assets to the IRS. Because this flow of information from non-US financial institutions directly to the IRS would violate privacy and confidentiality regimes in other countries (as such a move by foreign governments would under US law), laws around the world must be changed to accommodate US demands.

 

In order to produce that effect, the US is entering into so-called inter-governmental agreements (IGAs) with other countries, under which the ‘partner’ jurisdictions undertake various promises to ensure that FATCA can be implemented as a matter of domestic law with respect to their financial institutions. FATCA and the IGAs meant to implement it feature a number of troubling legal aspects[1], including the fact that they constitute a clear breach of the terms found in US tax treaties with other countries. The status of these IGAs is murky under US law and the Treasury has suggested that such agreements merely interpret existing treaty terms. For this reason, the IGAs will not be presented to US lawmakers as treaties, but are being implemented under agency discretion in the United States. IGA partners have taken various views, with some treating them as interpretive documents and others treating them as alterations to the existing agreement that must be agreed to under internal ratification procedures. 

 

Treaty breach violates principles of international law, and should be rejected by other countries because it compromises the integrity of the entire international tax system. Breach in the form of treaty override is unfortunately not a new behaviour by the United States, but it is an aggressive move that puts the international tax law system, and its implicit need for “commitment projection” through international agreement, at grave risk[2]. It demonstrates that promises undertaken by the United States in its tax treaties are fundamentally weak as they are vulnerable to unilateral nullification by internal political whims. That should make everyone in the international community wary about making any deals with the US on tax, whether FATCA-related or not, since the government is demonstrating that it is willing and able to unilaterally change agreed upon terms in its own favour, at any time. There is no redress in law for a unilateral US treaty override. But that fact alone makes it imperative that the international community acknowledge that an override is currently occurring, and that such a breach will have important consequences for tax cooperation among countries going forward.

 

Treaties as Contracts

 

To understand why FATCA and the IGAs are treaty overrides, we must begin with the nature of tax treaties themselves. Treaties in general are more or less contracts between sovereigns. Every country establishes its jurisdiction to impose income taxation under sovereign claim of right, and when these sovereign claims overlap in the context of cross-border activity, governments consider entering into treaties to allocate the available tax revenues between themselves. Under tax treaties, the signatories agree to the taxation each will impose on activities that span their respective jurisdictions. Of course, to the extent that sovereignty in the classical sense “means simply the power of law-making unconstrained by any legal limit,”[3] a treaty between two sovereigns operates in the space between laws, with attendant difficulties in the case of breach[4].

 

Such a breach could occur many ways, but perhaps the most obvious is a failure to implement the treaty terms as agreed. When a country behaves in such a manner, the question of enforceability arises, and a specter of doubt concerning the whole project appears: if there is no supranational body to lay down the law, what is the basis for entering into such agreements in the first place? This is a well-studied problem and many scholars of international law have produced a volume of work on the subject of treaty enforceability and its related issues, including dispute resolution and the assertion and collection of remedies[5].

 

In the case of treaty override, the failure to implement the treaty terms occurs because a domestic law compels it. That is to say, agreed treaty terms are not met because Congress has enacted legislation that imposes conflicting terms. This is the case with FATCA, and the IGAs merely compound the violation. The scenario is perhaps best understood by means of a case study. A ready case is found in the tax relationship between the US and its major trading partner, Canada.

 

Studying this case seems to be at least as appropriate as studying any other US tax relationship for two reasons. First, Canada and the United States already have an automatic information-exchange regime in place (this makes FATCA a clearly unilateral imposition since there is nothing new in terms of tax cooperation to be gained by Canada in signing an IGA). Second, Canada has perhaps the world’s largest population of people who would be immediately and negatively affected by FATCA (with the possible exception of Mexico, though statistics are not currently available to confirm whether this is the case).

 

It is important to observe that the vast majority of people in Canada who will be negatively affected by FATCA are likely to be so not because they are tax cheats, but instead because they are caught up in the US tax net, often without knowledge or understanding of this fact and its corresponding obligations. This happens because of the exceptionally extra-territorial nature of the US income tax system, virtually alone in the world, which treats people as if they were US residents based solely on their legal status as US citizens or green-card holders. Thus, the United States not only claims the right to tax all of the people actually resident in its jurisdiction—as all other countries with income tax systems do—but it also claims the right to tax all the people in the world that have legal ties to it, which virtually no other country in the world does (with the exception of Eritrea, a dictatorship that has been sanctioned by the UN for attempting to impose a two per cent tax on its diaspora in order to raise money for ongoing war efforts).

 

The US practice of status-based taxation demonstrates why treaty override should be considered particularly pernicious in this case, since its effect is to enable the US to expand its jurisdictional reach beyond that exercised by any other country, in a manner and to an extent that is unprecedented in the history of the income tax. While status-based taxation has long been the law on the books in the United States, it was minimally enforced by the IRS. There is no evidence that FATCA was enacted for the purpose of perfecting this extra-territorial jurisdictional claim[6]. US tax treaties are written in such a way that they acknowledge the legal claim of status-based taxation, but the addition of FATCA to the treaty directly enlists the aid of treaty partners in exercising unprecedented jurisdictional claims of another sovereign over their own residents. That is a fundamental change in the undertakings of treaty partners, which should not be ignored by reframing the change as a mere interpretation of an existing agreement. The US-Canada tax treaty relationship should prove instructive in this regard.

 

The US-Canada Tax Relationship

Canada and the United States have a tax treaty in force under which each government cooperates with the other to allocate taxing rights between them and to engage in cooperative compliance efforts. As to the allocation of taxing rights, each government agrees to impose specified tax rates on domestic-income received by investors in the other country. For example, a Canadian person (individual or entity) that invests in the stock of a US corporation and receives dividends on that stock would be subject to a maximum rate of 15 per cent US withholding tax on that dividend under the treaty;[7] for royalties, the maximum rate would be 10 per cent[8], and for interest and most capital gains, no tax would be withheld by the United States[9].  

 

In most cases, a tax treaty overrides domestic statutory law that would otherwise impose a higher source-based tax rate on payments made to foreign persons. Accordingly, the statutory US rate on a Canadian resident receiving passive income from US sources in the absence of the treaty would be 30 per cent (with several exceptions)[10]. The agreement undertaken in tax treaties is that the US will not impose that statutory rate on payments to Canadian residents, but will restrict its tax to the treaty rate; Canada provides a reciprocal promise. In brief, the effect of this reciprocal promise is to allow each country to claim some taxes when it is the country where the income arises (source-based taxation) and some when it is the country where the recipient of the income is resident (residence-based taxation).

Every tax treaty also includes information exchange provisions under which each country agrees to “exchange such information as may be relevant for carrying out the provisions of this Convention or of the domestic laws of the Contracting States concerning taxes to which this Convention applies insofar as the taxation thereunder is not contrary to this Convention.” In the Canada-US treaty the information exchange provisions are located within article 27. The provisions of the treaty are not conditional; that is, the treaty entitles Canadian residents to the specified tax rates independent of their government’s compliance with undertakings on information exchange and assistance in collection.

FATCA’s effect is to impose a new condition on the treaty-based withholding tax rate. Under FATCA, the only way for resident Canadian institutions to continue to get the treaty rate (of zero per cent, 10 per cent, or 15 per cent, depending on the type of income in question) is to fulfill FATCA information gathering and reporting requirements. If they do not fulfill these requirements, they will not be eligible for the treaty rates and will instead be subject to a 30 per cnet withholding rate on all “withholdable payments”—an expansive concept of US-source income items[11].

The Override: A New Conditionality

 

FATCA is thus a new condition on the treaty rate for Canadian residents (it is obviously not a reciprocally imposed condition so would have no impact on US persons’ eligibility for reduced Canadian withholding under the treaty). This is a unilateral, post-agreement term that is not included or in any way contemplated by the text of the treaty as currently agreed-upon. Of course, FATCA could hardly be contemplated by any treaty that came into force prior to 2010, as it did not exist as law before that time. This is not to say that the US cannot place conditions on access to treaty rates by Canadian residents; there are many existing conditions for treaty benefits—including the limitation on benefits clause—which are quite expansive and form a major part of any treaty negotiation with the US[12].  Rather, it is to say that FATCA’s particular condition is not in the treaty.

As a result, FATCA overrides the existing treaty by unilaterally denying the treaty rate to Canadian resident financial institutions that would otherwise qualify for those rates under the existing, duly negotiated, treaty provisions currently in force, unless certain conditions are met both by the taxpayer and the government of Canada.

 

It might confuse some readers to say that the United States Congress could enact a law that overrides the treaty. As a matter of law, that appears to be an impossibility in many countries. Accordingly, a brief review of the status of tax law versus tax treaties in the United States is in order.

 

Treaty Override under US Law

The status of a treaty in a country depends on its internal recognition thereof in law. In the United States, treaties have the same effect as acts of Congress, and are equivalent to any other US law[13]. As such, they are subject to and may be overridden by subsequent revisions in domestic law under a statutory ‘last in time’ rule[14]. This is counter to the practice of many countries, where treaties are considered superior to domestic law and cannot be changed unilaterally. As in contract law, there is an argument to be made that breach can be appropriate; for example, when “what is gained from the party that breaches exceeds what is lost by the party against whom the breach occurred”[15]. According to this argument, a breach might be appropriate as long as the United States compensates the aggrieved party.

 

The US practice of override is of course long-standing and therefore not an unknown; indeed, it has prompted major rewrites of the US-Canada tax treaty among others. As such, the possibility of unilateral override is a known risk of negotiating with the United States. It should therefore come as no surprise that the US-Canada tax treaty currently in force contains a mechanism for dealing with this eventuality. To the extent this provision is absent in other treaties, FATCA serves as a cautionary tale for treaty negotiators to consider including similar language in any future agreements with the United States, although its inclusion may appear futile in the instant case.

 

Dealing with Override

 

Article 29(7) of the US-Canada treaty lays out a regime for the countries to deal with potential tax treaty overrides that arise when one country enacts a domestic law that conflicts with the treaty in effect:

 

Where domestic legislation enacted by a Contracting State unilaterally removes or significantly limits any material benefit otherwise provided by the Convention, the appropriate authorities shall promptly consult for the purpose of considering an appropriate change to the Convention. [emphasis added]

 

This is an assertion, expressly within the text of the treaty, that officially identifies the enactment of conflicting legislation as a treaty override. When one country enacts a law that would restrict or remove a material benefit—for example, a specified tax rate on a payment of income to an investor entitled to the treaty—immediate negotiations for a change to the convention are to be initiated.

A change to an existing convention is undertaken either in a protocol, or, if the change is fundamental, in a new convention. A protocol is in legal terms nothing less than a new treaty that overrides specific provisions of the existing treaty to reflect the parties’ later agreement. That is, to change a treaty, each government must agree to the change via a new treaty, which each government must ratify under its internal treaty-making processes.

 

The existence of remedial treaty measures to deal with override in the Canada-US treaty demonstrates in the case of Canada (and implies by extension to other treaty partners), that the inter-governmental agreements proposed by the US are not a valid means to implement FATCA internationally. In a bizarre kind of double override, any IGA with Canada that was not implemented as a protocol by both countries would double down on the statutory override FATCA imposes with respect to the tax rate provisions of the treaty by also bypassing the treaty undertaking with respect to such override.

 

Consequences of Treaty Override

 

Treaty overrides have a deleterious effect on tax treaty-making because such occurrences  demonstrate the weakness of the commitments purportedly undertaken in treaties involving the United States. Since there is no world tax authority to police compliance with tax conventions, it falls to the parties to assure each other that their promises will be kept. Once it is clear that promises will not be kept, but instead will be broken with little regard for cost or consequence, trust in the system as a whole is indelibly shaken.

 

As a treaty override that comes with great cost and consequence to governments, financial institutions, and most of all human beings, FATCA stands as an ongoing violation of long-standing cooperative efforts on taxation by the international community of states. It is in danger of undermining that cooperation by forcibly engaging the whole world in the project of compelling global compliance with just one tax jurisdiction, and the planet’s most expansive one at that. No compensation has been offered for the breach, and no remuneration is being offered for the cost of complying with the new, unilaterally imposed conditions. Moreover, scant attention appears to have been paid to the fact that accepting the treaty override in this particular case means assisting the US in expanding its extraterritorial enforcement with respect to taxpayers who by overwhelming international consensus do not belong in the US tax net at all. This puts treaty partners in the odd position of accepting a violation of foundational international tax norms based in the residence principle, against residents of their own jurisdictions, and at their own cost.

 

Some believe that in the long run even a flawed unilateral move toward information exchange could lead to a more universal information exchange compact that would benefit other countries as well. But to the extent that the incorporation of FATCA into tax treaties via IGAs demonstrates that the United States is willing to break past commitments in order to secure its own goals, little would seem to stand in the way of future promise-breaking for securing other US domestic goals. There is little reason to believe that US contributions to multinational information sharing efforts would continue with conviction once its own goals have been secured.

 

The international community of states has for a century demonstrated that it relies on tax treaties to create any kind of workable income tax system in an economically integrated world. Accordingly, it seems imperative to recognise a breach where it has occurred, and to call the nation that has caused the rift to task for undermining a system in which all have tremendous resources at stake.

 



[1]               For example, their status as legal instruments in the United States is ambiguous at best. See Allison Christians, The Dubious Legal Pedigree of IGAs (and Why It Matters), 69:6 Tax Notes Int’l 565 (2013).

[2]               Arthur J Cockfield, The Limits of the International Tax Regime as a Commitment Projector, 33 Virginia Tax Rev 59 (2013).

[3]               AV Dicey, Introduction to the Study of Law of the Constitution 27 (Liberty Classics, 1982) (1915).

[4]               For a discussion, see Allison Christians, Hard Law, Soft Law, and International Taxation, 25:2 Wisconsin Int’l LJ 325 (2007).

[5]               For a discussion, see Allison Christians, How Nations Share 87 Indiana LJ 1407 (2012) (2013).

[6]               In enacting FATCA, Congress was not focused on rounding up its diaspora. Instead the target was resident Americans who were hiding their assets in Switzerland with the help of UBS and other Swiss banks.

[7]               Tax Convention, U.S. - Canada, art 10 (1985).

[8]               Id at art 11.

[9]               Id at art 13(4).

[10]             IRC §  871.

[11]             IRC § 1471.

[12]             Tax Convention, US - Canada, art. 29A.

[13]             US Const art VI, cl 2; see American Trust Co v JG Smyth, 247 F2d 149 (1957); J Samann v Commissioner, 313 F2d 461 (1963); Dames & More v Regan, 453 US 654, 686-88 (1981).

[14]             IRC § 7852(d).

[15]             See Richard L Doernberg, Overriding Tax Treaties: The US Perspective, 9 Emory Int’l L Rev 71 (1995).