By Anthony Diosdi
Congress in 1993 added Section 7701(l) to the Internal REvenue Code. Section 7701(l) authorizes the Department of Treasury and the Internal Revenue Service (“IRS”) to promulgate regulations which allow for the “recharacterization” of multi-party financing transactions as a transaction directly among two or more of the parties to it if such characterization “is appropriate to prevent avoidance of any tax ***.” The IRS has implemented this authority by issuing “anti-conduit” regulations. The result of the anti-conduit regulations is that intermediate entities (“conduits”) are disregarded in the determination of U.S. taxes on international financing arrangements, which may include loans, leases, and licenses. The key factors that will result in the recharacterization of a conduit entity are:
1) The participation of the intermediate entity or entities which reduces the tax imposed by Section 881 of the Internal Revenue Code Section 881(a) imposes a 30-percent tax on “interest, dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income”)..
2) Such participation is “pursuant to a tax avoidance plan,” and either
3) The intermediate entity is related to the financing or financed entity or would not have participated in the financing arrangement but for the fact that the financing entity engaged in the transaction with the intermediate entity. See Treas. Reg. Section 1.881-3(a)(4).
The anti-conduit regulations identify factors that will determine whether there is a tax-avoidance purpose:
1) Is there a “significant reduction” in the tax otherwise imposed under Section 881?
2) Did the conduit have the ability to make the advance without advances from the related financing entity?
3) Did the financing transactions occur in the ordinary course of business of the related entities? See Treas. Reg. Section 1.881-3(b)(2).
The regulations establish a rebuttable presumption in favor of the taxpayer if the conduit entity “performs significant financing activities with respect to the financing transactions forming part of the financing arrangement.” Such activities might include the earnings of rents and royalties from the active conduct of a trade or business or active risk management by the intermediate entity. See Treas. Reg. Section 1.881-3(b)(3).
The effect of invoking the anti-conduit regulations is that the payments will be deemed to be paid directly by and to the entities other than the conduit. The role of the conduit will be disregarded. If these provisions were invoked in the case of a finance subsidiary, for example, the interest payment by a U.S. corporation that borrowed money from a foreign lender through the use of a financing subsidiary in a tax treaty country would be treated as if the interest were paid directly to the foreign lender. The treaty would not apply, and the 30-percent withholding tax would be imposed unless the true lender were a resident of another treaty country where the withholding rates on interest were reduced or eliminated.
Relationship Between Treaties and the Internal Revenue Code
Often terms of a U.S.bilateral income tax treaty modify the tax results that would otherwise apply under the Internal Revenue Code. Section 7852(d)(1) of the internal Revenue Code provides that “[f]or purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preference status by reason of its being a treaty or law.” The application of this principle occurs when a new tax treaty is finalized which reduces the U.S. tax burdens for a foreign person. Since the treaty is later in time, the courts in the U.S. will typically apply the treaty and the U.S. tax liability of the foreign person who is a resident of a tax treaty partner will be reduced. The converse is also true. If a U.S. statute is enacted that is inconsistent with an existing tax treaty provision, the statute, being later in time, will prevail and the benefits of the treaty will no longer be available. U.S. courts will typically apply these principles even if the result would violate the applicable tax treaty and international law.
Congress has enacted legislation in conflict with treaty obligations on several occasions. This is known as a “treaty override.” One example of a treaty override is the passage of Internal Revenue Code Section 897 as part of the Foreign Investment in Real Property Tax Act of 1980 otherwise known as (“FIRPTA”). Another example of a treaty override occurred in 1996 with the amendments to the expatriation rules found in Section 877 of the Internal Revenue Code. Section 7701(l) of the Internal Revenue Code does not directly express a Congressional intent to authorize a “treaty override.” Neither Section 7701(l) nor its legislative history explicitly overrides any treaty commitments.
Delegation to Override Tax Treaties
Assuming that Section 7701(l) does not represent another treaty override, can Congress authorize regulations under Section 7701(l) that override bilateral tax treaties to the IRS or the Treasury? Delegation of treaty override authority may take place in two ways. Congress may delegate authority to the Treasury or IRS to override a tax treaty. Congress could remain silent on the override issue and instead delegate authority to the Treasury or IRS to override a tax treaty.
Inevitably, administrative agencies (such as the Department of Treasury) are recipients of some greater or lesser amount of legislative power. Some lesser amount is ordained by limitations of language and the fact that Congress is not omniscient; some greater amount is deliberate, as Congress determines that parts of public policy are best done by agencies. And just so, “the power of an administrative agency to administer a Congressionally created … program necessarily requires the formulation of policy and making of rules.” See Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843, 104 S.Ct. 2778, 2781 81 L.Ed.2d 694 (1984). With regard to Internal Revenue Code Section 7701(l), since the legislative history of the statute did not specifically indicate Congressional intent to override treaties, it is not clear that Congress would not have wanted regulations to override tax treaties.
The Treasury Department has statutory authority under Section 7805 of the Internal Revenue Code to interpret and administer the Internal Revenue Code. The Internal Revenue Code authorizes the IRS to provide operational rules for specific Internal Revenue Code provisions known as regulations. There are three types of regulations promulgated by the IRS- legislative, interpretive, and procedural. A legislative regulation carries the same weight of authority as the law itself. Interpretive regulations help explain the IRS’s position on various Internal Revenue Code provisions. Procedural regulations address procedural rather than interpretative matters, such as how to go about filing tax returns and making elections on tax returns.
Because legislative regulations have the effect of law, the question may arise as to what powers Congress may delegate to a federal agency such as the IRS to aid in carrying out the necessary functions of the government. The Constitution provides that “[a]ll legislative powers herein granted shall be vested in Congress of the United States.” See U.S. Const. Art. l Section 1. This means that the Congress cannot simply delegate its legislative authority to the President (or an agency under the executive branch such as the Treasury and the IRS) unless there are clear standards to be followed. See Field v. Clark, 143 U.S. 649, 692 (1892).
In Panama Refining Co. v. Ryan, 293 U.S. 388, 430 (1935), the Supreme Court held that a congressional delegation authorizing the President to interdict interstate transportation of petroleum produced in excess of amounts permitted by state authority was invalid because “Congress has declared no policy, has established no standard, has laid down no rule” to guide the President’s discretion. The Supreme Court found that, because the statute was devoid of criterion governing the President in his actions and contained no limits to the President’s actions, Congress had given the President unlimited authority to declare a policy of his own. The Supreme Court was unable to find any criterion that would restrict the President and thus determine that the President was acting more like a “legislative rather than … an executive or administrative officer executing a declared legislative policy.” Thus, in order to find a permissible delegation of power, the delegation must provide a policy and standards by which the policy must be implemented.
In other words, so long as a Congressional delegation of power is accompanied by adequate standards to guide a federal agency such as the IRS to follow, the delegation is not unconstitutional. This means that Congress can simply delegate to the IRS the power to override a tax treaty without issuing a clear statement and provide adequate standards for the IRS to follow. Congress has not provided a clear statement to the IRS in Section 7701(l). It should be understood that the IRS or the Treasury Department cannot initiate its own treaty override procedures. For example, in Tate & Lyle, Inc. v. Commissioner, 103 T.C. No. 37 (1994), the United States Tax Court face with a regulations that indirectly limited the benefits of the U.S.-United Kingdom bilateral income tax treaty. The United States Tax Court held that the regulations went beyond the authority granted by statute. A similar conclusion can be reached in regards to the regulations promulgated under Section 7701(l) of the Internal Revenue Code.
Applying the Late In Time Concept to the Section 7701(l) Regulations
As discussed above, it is unlikely that the regulations promulgated under Section 7701(l) can be characterized as a treaty override United States treaty commitments. This means that the later in time rule should apply in case of a conflict between the Section 7701(l) regulations and a treaty. For example, Section 7701(l) was enacted on August 10, 1993 and the United States enacted a tax treaty with country X on October 31, 1995. In this example Section 7701(l) and its accompanying regulations should not override the U.S.-Country X tax treaty for later in time purposes. On the other hand, if the United States enacted a tax treaty with country Z on August 1, 1993, Section 7701(l) and its regulations would override the U.S.-Country Z tax treaty for later in time purposes.
Can the Anti-Conduit Regulations be Classified as Treaty Supplements?
In the preamble to the proposed anti-conduit regulations, the U.S. Treasury Department explained their view of the relationship of the anti-conduit regulations to current U.S. treaties as follows:
These regulations are intended to provide anti-abuse rules that supplement, but do not conflict with, the limitation on benefits articles in U.S. tax treaties….It has been recognized that contracting states may supplement these rules by transactionally-based domestic anti-abuse rules, including rules under a particular transaction may be recast, in accordance with the substance of the transaction. These regulations, which reflect common law substance over form principles as applied to conduit financing arrangements, complement the limitation on benefits provisions of income tax treaties and are not precluded by the inclusion of such provisions. See 59 Fed. Reg. 521110, 52112-13.
This statement indicates that the Treasury and the IRS do not view the anti-conduit regulations as a treaty override but rather as being a supplement to tax treaties. Whether or not this claim is debatable. Even if the anti-conduit regulations were not intended to override treaties, in practice, the anti-conduit regulations override treaty provisions. For example, the U.S.-Netherlands bilateral tax treaty has a limitation on benefit provision or (“LOB”) under which a Dutch corporation (B) that satisfies an ownership test is entitled to treaty benefits only if it also satisfies a base reduction test. B meets the base erosion test if less than 50 percent of its income is used to make deductible payments in the current taxable year to persons other than qualified persons (i.e., individuals that are not residents of the Netherlands). Suppose that A, a treaty nonresident, makes an interest free demand loan to B, a Dutch corporation wholly owned by individual residents of the Netherlands, and B makes an interest-bearing loan to C, a U.S. borrower. Since none of B’s income (interest from C) is used to make deductible payments to nonresidents, B satisfies the ownership and base reduction tests, and the treaty limitation on benefits does not deny B the benefits of the interest article, which give the Netherlands the exclusive authority to tax the transaction. Under the anti-conduit regulations, C’s interest payment to B will probably not qualify for treaty benefits if the purpose for B’s participation was to obtain a withholding exemption under the U.S.-Netherlands tax treaty. See Treas. Reg. Section 1.881-3(e) Ex. 11. Even if the anti-conduit regulations may not have been intended to be treaty overrides, in many cases, the anti-conduit regulations can be regarded as treaty overrides.
Conclusion
In order for a treaty override to take place, Congress must explicitly act. The regulations promulgated under Section 7701(l) cannot represent another treaty override because the statute does not on its face or in its legislative history explicitly provide for an intent to override tax treaties. Even if the anti-conduit regulations were not drafted with the intent to override tax treaties, in application, the anti-conduit regulations deny treaty benefits that would otherwise be available. It appears that whether or not the IRS has been delegated the authority to override tax treaties, the Treasury (and the IRS) are utilizing the anti-conduit regulations to override tax treaties that were enacted after Section 7701(l) became law.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.