Caterpillar v Comm'r and the Rule of Law in International Tax

James P. Fuller has an interesting summary of the recently-filed Caterpillar case in his latest U.S. Tax Review [gated], in which he laments the competent authority breakdown and argues that the case would have been better off going to treaty-based arbitration, rather than to domestic judicial decision-making channels. I disagree with this conclusion because, given the structure of tax treaty arbitration today, it would--at best--provide a remedy for only one taxpayer at great cost, while the judicial route potentially creates rule of law upon which all can rely. If competent authority arbitration were instead to create a publicly viewable resolution, I could agree with Fuller because what is needed is (1) a multilateral solution to a multilateral problem and (2) a solution with precedent-making force.

Per Fuller:

Caterpillar Inc. has petitioned the Tax Court for a redetermination of income tax deficiencies that resulted from the IRS's allocation of royalty income to it from its Belgium and French subsidiaries. 

While the case was only recently docketed and has not yet been decided, I thought it worth discussing the case as it results from a breakdown in the competent authority process. It is, of course, the very process that is designed to prevent the consequences faced by Caterpillar. There should be no need for the taxpayer to litigate in one country or the other when treaty relief is an available remedy and the countries involved can settle the issue between themselves. 

Following a 1990 reorganization that pushed management power, responsibility, and accountability to subsidiaries such as Caterpillar Belgium and Caterpillar France, the taxpayer entered into amended license agreements with those subsidiaries limiting the maximum royalty in any given year to each subsidiary's net income from the sale of Caterpillar products. Also, if the subsidiary suffered a post-effective-date net operating loss, it would pay no royalty for that year and could carry the loss forward as a negative adjustment to future years' income for purposes of the royalty calculation. 

... The IRS ... concluded that the relief-from-royalty provision in the Belgian and French license agreements did not comport with the arm's-length standard under section 482.

 Fuller points out that there are "several Tax Court cases that permitted related-party license agreement provisions" like Caterpillar's, and as to which the IRS subsequently acquiesced. He goes on to discuss Caterpillar's attempt to obtain competent authority relief, which failed because the French and Belgian tax authorities disagreed with the US position, and US Appeals simply went along with the IRS decision despite these other rulings that would suggest reconsidering the issue, for litigation hazard purposes at minimum:

The Belgian and French tax authorities, having a thorough knowledge of the local operations of the Caterpillar subsidiaries in their respective countries, looked at the same facts that were addressed by the IRS exam team and found that Caterpillar's royalty limitation provision required no adjustment. Caterpillar subsequently had the adjustment reviewed in an IRS Appeals office proceeding. The IRS Appeals officer simply accepted the IRS exam team's economist's report. 

...it appears from Caterpillar's Tax Court petition that the IRS exam team's economist simply used that agreement as grounds for asserting that such a relief-from-royalties' provision is inappropriate, and not at arm's length.

Fuller notes the dual-bureaucracy created by two simultaneous review procedures, i.e., competent authority and internal appeals, and concludes that binding arbitration of the competent authority procedure, rather than resort to the US judiciary, would have been the better approach:

If the two countries' competent authority negotiators cannot reach an agreement, then there should be some form of compelled arbitration to bring about an agreement. Otherwise, the taxpayer is stuck in the middle. A taxpayer should not have to litigate its case in one country or the other (or both) simply because the U.S. competent authority negotiators could not reach an agreement with the foreign country's competent authority negotiators. This is especially true in a situation such as that faced by Caterpillar: The Tax Court has already held that such provisions are appropriate in related-party license agreements.

I appreciate Fuller's argument about the taxpayer's bind, but as I have noted before, if the case went the way of binding arbitration, in the long run the issue could potentially never be settled, since the decision in arbitration would be completely confidential and therefore not accessible or applicable to other taxpayers. That makes international tax dispute resolution much more expensive than it has to be, all because the powers that be have prioritized absolute taxpayer confidentiality over the rule of law. I think that is a miserable trade-off as well as being an unnecessary one: as this case shows, the taxpayer is willing to sacrifice some measure of its own confidentiality in order to get resolution in domestic law, so it is not clear why international law should be so different. (The arguments for difference are weak--see my analysis in the link above.)

The competent authority route, which (by being duplicative as in this case) already increases costs for producing the rule of law, would only be exacerbated by arbitration, because Caterpillar's problem would be perfectly preserved for another day, another taxpayer, and another expensive litigation involving multiple parties and governments.

Therein lies the conundrum for international tax law in the current status quo: either we can get taxpayer-specific outcomes but no rule of law (arbitration) or we can get unilateral rule of law but no international resolution (domestic appeals). I am not sure which to prefer, since both are bad for international tax law.

Accordingly, I am glad to see the Caterpillar case go forward in a forum which is open to public view and that, if not settled in the interim, then becomes a part of the body of law, creating more certainty for taxpayers going forward. However, I am unhappy that the forum is unilateral and potentially preserves an unsolvable problem for the taxpayer if the Court agrees with the US position, since France and Belgium will not be consulted in the process and can be expected to continue to disagree with the IRS view of things.

As a result, I can only agree with Fuller that the better route would be bilateral/multilateral decision-making via arbitration if that decision-making is, like internal judicial decision-making, open and accessible to public view.

IRS brushes aside the constitution to make way for FATCA

In a Tax Notes International article [gated] today, Lee Sheppard discusses remarks about FATCA by Jesse Eggert, Treasury associate international tax counsel, at a March 1 IFA meeting. The most troubling aspect for me comes in the last part, when Sheppard describes a Q&A over the intergovernmental agreements and the IRS rep casually dismisses any constraints on the Treasury's attempt to bind the US with these documents as a matter of international law. There are two main questions here and both answers strike me as deeply problematic. First, there is this:

Can there be an IGA with a country that has no treaty or tax information exchange agreement? Yes, Eggert responded. It would have to be a Model II or nonreciprocal Model I . Amendments would have to be made to add information protections and assistance provisions.

With respect, this does not accord with what we have been given to understand so far about these IGAs. One need only read the preambles to the IGA models and signed agreements and consider the treaty power briefly to see that there is a very large legal difficulty here. As I have said before (and have a feeling I will be saying repeatedly), the Executive Branch cannot simply bind the US to any agreement it wants to without doing violence to a constitutional process that has been expressly laid out and subject to decades of analysis and debate by the country's most preeminent legal minds.

This is why the IRS has been very quietly implying that the IGAs interpret existing treaties. I don't agree on the merits that this could possibly be true, but the IRS needs it to be true because if it is not true, the only alternative is that the IGAs are sole executive agreements entered into by the executive branch with no congressional oversight whatsoever. That puts them on the most precarious legal ground in terms of foreign policy power in the US, and by this statement Eggert pushes them closer in that direction.

Second, there is this:

Does Treasury have authority to make IGAs? Eggert argued that IGAs are within Treasury's statutory authority to make FATCA regulations (section 1471(b)). Treasury and IGA signatories are discussing how to make domestic implementing laws consistent.

Again with all due respect, this just simply is not true as a matter of US law. The executive branch does not have the power to authorize itself to enter into treaties without congressional oversight. It is the constitution that provides the treaty power, and Congress is expressly involved. Congress could have granted the executive specific authority in this case, as it has done in other cases, but it clearly did not do so here. It is not clear what Eggert means by "making domestic implementing laws consistent." Maybe that refers to the domestic laws of treaty partner countries, which will have to change their data privacy laws to accomodate the information sought by the IRS. If so, that has nothing to do with the US. From what we have seen so far, it seems clear that the IRS is treating the IGAs as operational once the other country so indicates it is operational from their perspective (cf Mexico).

Arguing that the authority is implied within Congress' mandate to Treasury to issue regulations under 1471 is blowing a hole through the treaty power. It argues that Congress empowers the Executive Branch with treaty making authority with each and every directive to enact regulations. It makes a farce of the congressional executive agreement process that has been begrudgingly accepted as authentic by most constitutional scholars today. And never mind the old standard, the Article II treaty power. By this logic if the President wants an international agreement--any international agreement of any kind--he never needs to consult the Senate again, he can simply find some reference by the Congress directing his regulators to regulate. If Eggert is right in this assessment, it is not a stretch to see this as the beginning of the end of the Article II treaty ratification process in the United States. In other words if this works, then it's anything goes when it comes to the Executive Branch overriding domestic law with an international agreement.

Finally, I note that one other Q&A Sheppard mentions is also intriguing, though on the surface it seemed uncontroversial:

Existing IGAs will be interpreted to say that countries may choose the definition of an item in the final regulations which came later in time. Treasury will not amend IGAs wholesale when regulations change, Eggert explained.

This may seem benign--it provides flexibility despite the apparently rigid parameters of the documents (which are treaties, after all, and not so easy to just unilaterally alter at whim). But this is in fact very interesting as a legal matter because it quietly moves the world a little closer to yet another US tradition that many people in other countries find odd if not outright incompatible with international law, namely, the treatment of treaties as equal in legal status to other laws, including statutes and case law, so that treaties can be overridden at any time by a new statute or judicial decision. But it goes a further step to include regulations within that overriding scope--where they might not so clearly belong even under US law.

In other words, the IRS is saying that not only does the "last in time" rule apply to IGAs (as they would to any US international agreement), but we'll apply the last in time rule to other countries too (even if under their own laws the treaty would override later-enacted domestic laws); moreover the last-in-time rule is now extended to treasury regulations (a unilateral law that will be used to "interpret" a bilateral agreement, yet another controversial treaty interpretation position), and finally we are going to make it the treaty partner's choice to pick among the regimes to get the best result (which treats treaty partners not as negotiators in a bilateral agreement but rather in the same way as taxpayers subject to an elective regime).

It is getting progressively more difficult to keep up with the sheer volume of violations of laws and norms being undertaken by the IRS in order to get FATCA to work. It is rather disheartening (in the sense of being a scholar who studies legal process as though it matters) to realize that to many or most people involved in this project, all of these violations are just technicalities and semantics getting in the way of a result everyone wants.

Note on Enforcing the Long Arm of the Tax Law

I came across this paper when I was doing some treaty research. It may be of interest: “But the Americans Made Me Do It!”: How United States v. UBS Makes The Case For Executive Exhaustion. No abstract, but here are some excerpts:

In 2008, the U.S. government launched an investigation into UBS AG (“UBS”) following the indictment and conviction of one of UBS’s senior bankers on charges of assisting a wealthy American with tax evasion. ...The United States filed a summons in federal court seeking information from UBS concerning the identities of ... unknown taxpayers. Swiss bank secrecy laws, however, explicitly forbade such disclosure. 

UBS was caught in a classic conflict-of-laws dilemma. On the one hand, UBS and its employees would face potential criminal sanctions if they violated Swiss bank secrecy laws to comply with a U.S. court order. On the other hand, UBS could decline to comply with a potential U.S. court order and face contempt of court....

...U.S. courts thus have a dilemma when the United States, through its executive agencies, wants parties to disclose foreign accounts for tax or other investigatory purposes but bank secrecy laws stand in the way of these investigations. While many courts have used balancing tests to solve this problem, they have found that U.S. law-enforcement interests trump the interests of foreign nations. This places a defendant financial institution in the position of either providing client data in violation of its home state’s laws to meet the demands of the United States or disregarding U.S. discovery orders to meet its home state’s legal requirements.  

... One of the factors for a court to weigh in the balancing formula is “the availability of alternative means of securing the [requested] information.” 

This Comment uses the recent tax investigation into UBS and its account holders as a case study to argue that the alternative means factor from the Third Restatement should be a mandatory step for Executive Branch agencies to exhaust before they can petition a court to compel disclosure of foreign discovery that would require the defending party to violate foreign law. 

This mandatory step, which this Comment terms executive exhaustion, is derived from the concept of administrative exhaustion, in which courts decline to hear cases until the moving party has exhausted all available administrative remedies. The application of executive exhaustion will prevent courts from having to engage in the Third Restatement’s balancing test. By avoiding the Third Restatement’s balancing test, a court can avoid placing parties in a catch- 22—following one state’s laws at the expense of violating those of another state.

And from the conclusion:

[F]ederal courts are aware of the various international interests at stake in certain high-profile litigation. .... Even after the United States, the Swiss government, and UBS came to an agreement regarding the transfer of data, the independent Swiss judiciary held that the UBS client data could not be transferred pursuant to the Treaty Request Agreement because the agreement was not actually a treaty—and thus not officially Swiss law.  If the Swiss government was unable to transfer data pursuant to an agreement it drafted and signed, how did the IRS and the DOJ realistically believe that UBS would be able to comply with a possible order compelling disclosure? An order compelling disclosure would have resulted in a full-blown diplomatic disaster, with the Swiss seizing UBS client data and the IRS and DOJ moving to have contempt-of-court sanctions imposed against UBS.   

In light of the powerful international interests at stake when it comes to an order compelling disclosure of information in violation of foreign law, it is imperative that Executive Branch agencies seek all alternative means before petitioning a court for disclosure. Federal courts should be the last resort for compelling disclosure when an Executive Branch agency seeks information from abroad that would require the violation of foreign law.

 You can read the full paper at the link.

Why FATCA is a Tax Treaty Override

I've been asked to explain comments I made in a recent talk about FATCA, when I said that this regime constitutes a tax treaty override, and that I don't think that IGAs are a valid fix as a matter of law. Here is my reasoning. I will use the US-Canada tax treaty as an example, but the override applies to all US tax treaties currently in force.

This is a lengthy post so let me preface with the executive summary, after which I will provide more detail:

• US and Canada have an existing tax treaty that imposes specific rates for investment income earned by Canadian residents from US sources.
• FATCA places a new condition on receiving those rates.
• This restricts the benefits of the treaty, which is treated as a treaty override by the terms of the treaty itself.
• The treaty provides that the remedy for such an override is a change to the terms of the treaty.
• the IGAs do not change the terms of the treaty but purport to interpret it to allow a different new condition (which condition is itself an override of the domestic FATCA statute) to take effect immediately. 

And now for the detail.

Canada and the US have a tax treaty in force in which 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% US withholding tax on that dividend under the treaty (see Art. 10); for royalties, the maximum rate would be 10%, and for interest and most capital gains, no tax would be withheld by the US (see Art. 11 and 13(4)).  In most cases, a tax treaty overrides domestic statutory law that would 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 would be 30% (with several exceptions, see s. 871). 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 15% (dividends), 10% (royalties), or even 0 (most interest and capital gains).

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 that is Article 27.

Although this is not critical to the override argument, it is worth noting that the various provisions of the treaty are not conditional on each other; that is, Canadian residents are entitled to the specified tax rate even if, for example, the countries get into a tangle over their information exchange efforts.

FATCA's effect is to impose a new condition on the treaty-based withholding tax rate. That is, under FATCA, the only way for resident Canadian institutions to continue to get the treaty rate (of 0, 10, or 15%, 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 rate, but rather they will be subject to a 30% withholding rate on all "withholdable payments"--an expansive concept of US-source income items which you can read in the statute.

FATCA is thus a new condition on the treaty rate, a condition that is not by any stretch included or even contemplated in the treaty.  Indeed, how could FATCA be contemplated by any treaty that came into force prior to 2010, as FATCA did not exist as law before then.  This is not to say that no conditions can be placed on the access of Canadian residents to treaty rates. There are many existing conditions for treaty benefits--see particularly the limitation on benefits clause (Art 29A), which are quite expansive and form a major part of any treaty negotiation with the US.  But it is to say that FATCA's particular condition is not in the treaty.

Therefore FATCA overrides the existing treaty by unilaterally denying the treaty rate to Canadian residents who would otherwise qualify therefore under the existing, duly negotiated, treaty provisions currently in force.

Now let us look at Art 29(7), which tells us how the countries are supposed 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."

Thus the remedy to a law that would restrict or remove a material benefit--namely, a specified tax rate on a payment of US-source income to a Canadian investor--is a change to the convention.

A change to an existing convention is undertaken in a protocol. 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.

This therefore suggests that the proposed intergovernmental agreements (IGAs) are not a valid means to get FATCA to work as a matter of law. This is because the US is not treating IGAs as treaties at all; it is treating them as interpretations of the existing treaty, specifically, the information exchange provision.  You can read this setup in the preamble to these agreements. This position seems plainly incorrect, but the subject of the legal status of the IGAs is its own complicated analysis, and I will post more on that subject very soon.

I will note, however, that the IGAs further muddy the interpretive waters since what they do is in fact override the terms of the FATCA statute, by switching the reporting relationship from Canadian resident institutions to a government-to-government relationship. Some have argued that they do not override but merely use Treasury's mandate to define exemptions to FATCA. Perhaps, but Treasury was not given any mandate by Congress to encase those exemptions in international agreements. Moreover, it seems a real stretch to assert that the IGAs simply interpret existing information exchange provisions, especially when it is clear that many or most countries will have to enact domestic legislation to fulfill the new reporting requirements. The valid way forward for Treasury would have been to create straightforward conditional exemptions: exempt countries from FATCA provided those countries enacted laws according to Treasury specifications. That would still be an extra-territorial reach, perhaps, but there are precedents for the mechanism (such as what was done to shut down bearer bonds--thank you to Michael Schler for reminding me of that example, and I know that there are others as well). But, importantly, this established way forward would not solve the tax treaty override problem. Therein may lie a main reason for going the IGA route, even though it is not a clearly valid resolution.

What is clear at this stage is that FATCA overrides the existing tax treaty by significantly limiting a material benefit thereunder, and the only valid way to fix that override is to change the treaty itself, by entering into a new protocol. We can see that the US and Canada have a lot of experience with protocols: protocols to the current tax treaty were signed on June 14, 1983, March 28, 1984, March 17, 1995, July 29, 1997 and September 21, 2007. One of those was to fix another infamous US tax treaty override: the branch profits tax. In short, it doesn't seem to have been that big deal in the past to agree to changes to the treaty terms by the normal treaty-making process, even when the issue was unilateral override, which is typically seen as a bit of bad faith in international relations. That raises the question why this particular change is not being marshaled through the same process.  I will leave it to the reader to speculate for now, and will have more on this later as well.

US-Mexico IGA on FATCA: in force as of Jan 1 2013

Mexico is following the US lead in treating the IGA as a competent authority agreement that merely interprets and clarifies the existing tax treaty between the two countries and therefore does not need to be subjected to internal ratification or implementation processes. From a Baker & McKenzie client alert posted at Tax Analysts today:

Upon a number of consultations with the relevant tax authorities, we have concluded that no need exists for the United States and Mexico FATCA Intergovernmental Agreement to be published in the Mexican Federal Official Gazette in order for it to be effective. The Intergovernmental Agreement has become effective as of January 1st, 2013 as stated therein.  

The Intergovernmental Agreement merely constitutes an accord between the two countries as to the actual implementation of the exchange of information in connection with taxes already covered in other Conventions – i.e., the Convention on Mutual Administrative Assistance in Tax Matters the US-Mexico Double Tax Treaty, and the US-Mexico Tax Information Exchange Agreement, all of which are in effect and authorize the exchange of information for tax purposes on an automatic basis. This Intergovernmental Agreement sets the framework for the coordination of the Competent Authority of each country in their efforts to improve international tax compliance.

I confess, I still don't see it. How can an agreement to implement a law passed in the US in 2010 "interpret" an existing treaty that predates it, especially when the law in question would override the treaty? A possible explanation is that Mexico's internal financial reporting rules already require financial institutions with the specific information being asked by the US, and that this is just a matter of turning over an existing data stream on an automatic basis. But how can that be--is it likely that Mexican financial institutions already as all of their clients for indicia of US person status? And that it imposes withholding taxes on US-source payments in excess of treaty rates in cases of noncomplianee? Not likely, and obviously not, respectively.

I note that Mexico does seem to have much more info flow between its financial institutions and its tax authority--so much so that it wants to provide the US with monthly average balances of accounts held by US persons, because its banks have monthly info requirements to the Mexican tax authority, you can read about that here.

Current status of US tax treaties, with FATCA IGA update

Latest US tax treaty update is available here, with a new section covering the developments on FATCA IGAs. I'm still not convinced they should be included in such a list, since from the US perspective these appear to be nothing more than competent authority agreements, presumably entered into under the CA's authority "to clarify or interpret" existing treaty & TIEA provisions.  Certainly, it seems that no internal legislative procedure will be undertaken to get these in force in the US--they await only the internal ratification by FATCA partners.

I have seen absolutely nothing offered by the IRS or Treasury that explains the character of these agreements, so I am deducing that they are being considered CA agreements from what I've seen so far.  But I'll admit the evidence is conflicting and confusing: for example, the IGA with the UK was apparently signed by a non-Treasury embassy official, and not the CA, so how could it be a CA agreement?

Fortunately, at some point the mystery will be solvable: I'll be able to confirm the legal status of the IGAs as soon as the first one enters into force, by checking to see if it lands in the pages of the US treaties and international agreements series. If it does not (as I suspect), then the IGAs really belong only in a list of competent authority agreements, where they will be treated not as treaties or international agreements per se but merely as interpretations of existing treaties. That will be interesting because it really stretches the boundaries of how I think we've understood up until now the competent authority's ability to stray beyond the text of the treaty. Of course, even if they do not end up in the TIAS I can certainly understand why Connery et al included them in their regular tax treaty update, because they sure look like treaties, don't they.

If I am wrong, though, and the IGAs do land in the treaties and international agreements series, then things get even more interesting.  We will be witnessing an unprecedented first in the history of US treaty making: the introduction of sole executive agreements on tax, not pre-authorized by congress, not expressly authorized by any existing treaty, and serving to override existing statutory tax law without any congressional oversight at all. Intriguing to say the least.

Of course, none of this has any bearing on the legal force of the IGAs from an international perspective. In the eyes of the world, these are just like any other international agreement. But in terms of those who think about the treaty making power in the US, I would think this would be a very interesting and controversial development.