The pending U.S.-Italy Income Tax Treaty ("Italy Treaty") that was negotiated in 1999 may finally come into force in 2003. Although this event, if it occurs, is generally good news, one aspect of the Italy Treaty deserves particular comment because it highlights an emerging and questionable position being taken by the United States with respect to the payment of royalties. The specific point at issue under the Italy Treaty is (1) whether royalties paid by a U.S. person to an Italian recipient with respect to the use of intangibles in both the United States and third countries are fully subject to U.S. withholding tax at the treaty rate, or (2) whether the recipient can claim exemption from tax for that portion of the royalties attributable to non-U.S. use.
Article 12(2) of the Italy Treaty contains what has become relatively standard U.S. language in those treaties that allow the taxation of royalties by both the residence state and the source state. Article 12(2) provides that royalties "may also be taxed in the Contracting State in which they arise and according to the laws of that State," at a rate not to exceed the treaty rate.
Article 12(6) of the Italy Treaty sets forth a three-part test for determining where a royalty may be "deemed to arise." In general, a royalty is deemed to arise in a Contracting State if the payer resides in that State, or if the payer has a permanent establishment ("PE") in a Contracting State in connection with which the obligation to pay royalties was incurred and the royalty payments are borne by the PE. Trumping those two rules is the so-called "place of use" rule, under which (irrespective of place of residence of the payer or the existence of a PE) royalties paid for the use of, or the right to use, intangibles within one of the Contracting States are deemed to arise in that State.
In contrast to the three-part test contained in the Italy Treaty (and in a number of other treaties as well), the "place of use" rule is the only source rule contained in the Internal Revenue Code. Section 861(a)(4) provides that royalties paid for the use of intangibles in the United States are considered U.S. source income, while §862(a)(4) provides that royalties paid for the use of intangibles outside the United States are considered foreign source income. Under §§871 and 881, only U.S. source income is subject to the U.S. 30% statutory withholding tax.
Suppose an Italian enterprise licenses a U.S. corporation to use certain intangibles both in the United States and in a third country. Under the Code, the royalties attributable to U.S. use would be subject to the 30% withholding tax, while the royalties attributable to third-country use would be exempt from U.S. tax even though paid by a U.S. resident. However, the Italy Treaty, along with many others like it, overrides the statutory source rule by providing that royalties for intangibles used outside a contracting state are deemed to arise in the country where the payer resides. This obviously presents a conflict between the Code source rule and the Treaty source rule.
Article 3(1) of the Italy Treaty Protocol, also signed in 1999, contains what has generally become standard treaty language making it clear that the Treaty "shall not restrict in any manner any exclusion, exemption, deduction, credit, or other allowance now or hereafter accorded" by the laws of either Contracting State. On the face of it, therefore, one might reasonably conclude that, notwithstanding the broader Treaty source rule for royalties, the exemption available under the Code with respect to foreign source royalties would be available to the Italian recipient in our example. Only the royalties attributable to U.S. use would seem to be subject to withholding, and at the reduced treaty rate. That position is arguably reinforced by the treaty language to the effect that royalties may be taxed by the source state "according to the laws of that State."
The United States apparently does not agree. The Treasury Technical Explanation accompanying the Italy Treaty ("Italy TE") provides that "under a basic principle of tax treaty interpretation," the recipient may not "cherry pick" between Code and Treaty by claiming the benefit of the Code's source rules and the Treaty's withholding tax rates. The recipient must either subject all royalty payments to the Treaty rate or, if it wishes to claim an exemption for the foreign source royalties, it must subject the U.S. source royalties to the 30% statutory rate. The basis for this position is said to be Rev. Rul. 84-17, 1984-1 C.B. 308, which involved the Business Profits Article of the U.S.-Poland Treaty.
Before analyzing Rev. Rul. 84-17 and its potential application to the example being considered, it is important to note that a totally different view regarding royalty payments was expressed in conjunction with the 1988 Protocol to the U.S.-France Treaty. That Protocol added the residence-of-the-payer test to the royalty source rules contained in the then-existing France Treaty. The Senate Foreign Relations Committee Report acknowledged that including the residence of the payer in determining the source of royalty payments "slightly expands the category of U.S. source royalties" to include royalties paid by a U.S. resident for the use of intangible property outside the United States. The Report notes that the United States thus could "potentially extend its taxing jurisdiction over royalties paid to French residents." But, the Report concludes, because the Code does not permit a U.S. gross basis tax on such royalties, "no practical effect on U.S. tax liabilities of such persons results from this change." Report of Senate Foreign Relations Committee on 1988 Protocol to U.S.-France Income Tax Convention, Exec. Rept. 100-25, 100th Cong., 2d Sess., p. 14. The Treasury Technical Explanation of the 1988 French Protocol does not specifically address the potential impact of the source rule change on the U.S. taxation of royalty payments. It states that the consequence of broadening the rule "in practical effect is quite narrow and relates only to French tax."
Seven years later, the U.S. position on royalties appears to have changed to the view now reflected under the Italy Treaty. A 1995 Protocol with Canada made certain nongermane modifications to the three-part royalty source rule already contained in the U.S.-Canada Treaty. The Treasury Technical Explanation of the Canada Protocol declared that under a "basic principle of tax treaty interpretation recognized by both Contracting States," a Canadian resident receiving royalty payments from a U.S. resident relating to the use of intangibles partly in the United States and partly in a third country would be precluded from "cherry picking" by seeking to claim the low treaty withholding rate on the royalties relating to U.S. use and the Code exemption for the royalties relating to third-country use. Rev. Rul. 84-17 was cited in support of this proposition. See generally the discussion in Bennett and Cope, "Selected Highlights of the New U.S.-Canada Protocol and the New U.S.-France Treaty," May 1996 Bulletin of the International Bureau of Fiscal Documentation, p. 190. (Oddly, in the case of five other treaties the United States has negotiated between 1996 and 1999 containing a residence-of-the-payer source rule for royalties, the Technical Explanations of three (Turkey (1996), Latvia (1998), and Lithuania (1998)) contain a discussion of the application of Rev. Rul. 84-17 to royalty payments, while those for the other two (Thailand (1996) and Slovenia (1999)) are silent on the point).
Is the Treasury's anti-cherry picking position regarding the taxation of royalty payments sound? As a threshold question, is the principle enunciated in Rev. Rul. 84-17 sound?
Rev. Rul. 84-17 involved a Polish company that carried on business in the United States in different ways. With respect to product A, the Polish company maintained a permanent establishment here from which it sold product A in the United States and elsewhere. With respect to products B and C, the company sold both products in the United States without the use of a PE. Products A and B were profitable, but product C was not. The question presented was whether the Polish company could (1) elect to report only the profits of product A and not those of product B (relying on the Business Profits Article of the U.S.-Poland Treaty to limit the U.S. taxation of business profits only to those attributable to a PE in the United States), and at the same time (2) claim the losses it incurred from the sale of product C in the United States.
Rev. Rul. 84-17 rules that the Polish company can choose either the Treaty route or the Code route, but not both. Under the Treaty route, the profits of product A are taxable, but the activity relating to both products B and C is ignored because of the absence of a PE for either product line. Under the Code route, the profits of products A and B would be taxed and the losses from product C could be claimed. This result was reached notwithstanding Article 5(2)(a) of the Poland Treaty, which states that nothing in the Convention shall deny a resident of either country the benefit of any exclusion, exemption, deduction or other allowance available under domestic law.
According to Rev. Rul. 84-17, the intent of the Business Profits Article of the Treaty is to subject Polish companies to U.S. tax only on their business profits attributable to a PE in the United States. The ruling claims that such intent would be "thwarted" if losses not attributable to a PE could be offset against profits attributable to a PE. In addition, the ruling noted that if the losses were allowed, there would be inconsistent treatment during a taxable year for the profits not attributable to a PE (product B) and the losses not attributable to a PE (product C).
Under §882, a foreign corporation carrying on business in the United States by selling three separate products here is subject to U.S. tax on its business activity. It must therefore file a U.S. tax return reporting all such activity. Absent the application of a treaty, it would report its gross income from all three product lines, deduct all of its appropriate expenses, and report either taxable income or a loss for the year. With the overlay of a treaty, however, the foreign corporation is able to invoke the Business Profits Article and limit its profits subject to U.S. tax to those profits attributable to PEs it may have in the United States. That would of course fully justify reporting the income and expenses relating to the sale of product A and omitting the income and expenses relating to the sale of product B. But what about the income and expenses relating to the sale of product C, which resulted in a loss? May those items be included in the U.S. return?
As Rev. Rul. 84-17 declares, the intent of the Business Profits Article of a treaty is to limit the taxation of a foreign enterprise's business profits to those profits attributable to a PE in the United States. For this purpose, the term "business profits" might arguably be said to embrace all business activity or none, rather than product-by-product activity. In other words, if the Business Profits Article is invoked, the only business activity reportable by the foreign enterprise on its U.S. return is activity attributable to any PEs it has in the United States. Had the Polish taxpayer engaged in the sale of product C through a PE, the loss resulting from that operation could have been claimed by the taxpayer as an offset against the profits attributable to the PE selling product A. The results of both PEs would properly have been reported on the taxpayer's return because the language limiting U.S. tax to "business profits" properly attributable to a PE must be read as contemplating that losses attributable to a PE may also be taken into account. That being the case, there is perhaps some basis for concluding, as Rev. Rul. 84-17 does, that it would be inappropriate to allow the product C loss to be claimed whether or not it was attributable to a PE.
The counterargument, of course, is that the Treaty expressly preserves for the taxpayer all deductions allowed under domestic law. If that provision is applied literally, the taxpayer should be able to include on its return the expenses relating to the sale of product C even though they are not attributable to a PE because such expenses (offset by the related income) would be allowable as deductions under domestic law.
The last word on the validity of Rev. Rul. 84-17 in the "business profits" context probably has not yet been heard. But where does it all lead in the context of royalty payments, where the issue is actually quite different?
In the business profits context, we are considering deductions or losses that relate to income the Code would tax under §882, but which the Treaty would allow to go untaxed because of the absence of a PE. In the royalty context, we are considering income the Code expressly allows to go untaxed under §§862, 871 and 881, but which the Treaty seeks to tax under its broader source rule. Can the Treaty properly impose a tax on income the Code excludes from tax? Can the Treasury's "basic principle of tax treaty interpretation"—described as a prohibition against "cherry-picking"—properly be applied to produce a tax on income that is excluded from tax under the Code?
The business profits case and the royalty payment case are two fundamentally different situations. Arguably, it may be appropriate to apply the anti-cherry picking rule of Rev. Rul. 84-17 in the business profits context by requiring all business income and expenses to be reported under either the Treaty or the Code in order to preserve the intended scope of the beneficial PE limitation on domestic taxing power. But there is no basis for applying the anti-cherry picking rule in the royalty context to justify an expansion of domestic taxing power beyond that authorized by the Code. Whatever the proper result in the business profits context, a treaty should not be interpreted so that it imposes a tax (at any rate) on income that has been specifically excluded from tax under domestic law.
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