Saturday, February 18, 2006

US Treaty-Based Non-discrimination: Can You See It?

Accounting issues are interrelated with tax and can give rise to interesting international tax issues, as the case below will demonstrate.

Allow me to set the grounds for the problem discussed in this US case (Square D). Under US Tax, accounting determines when a receipt becomes taxable income and when a payment becomes deductible. Individuals and corporations generally compute their tax liability based on a cash method or an accrual method. Under a cash method, which is primarily used by individuals and small businesses, transactions count as income in the year of actual receipt, and count as deductions in the year of actual payment. Under an accrual method, which is used by large businesses, a taxpayer has income when (i) all events have occurred that fix the right to the income and (2) the amount of the income can be determined with reasonable accuracy.

In general terms, Schneider, a French company (yes that one of the famous CFC case in France), acquired Square D, a US accrual basis taxpayer based in Illinois. For the purposes of acquiring the shares of this US Company, Schneider created a highly leveraged US New Co. The New Co obtained loans from Schneider and after the purchase of Square D, Schneider then merged the New Co (highly leveraged) into Square D, thus passing the responsibility for repaying the loans to Square D. In fact, an acquisition of shares of a US target by a foreign acquirer generally takes the form of (i) a merger of a newly formed US subsidiary of the foreign acquirer into the US target with the target surviving and the target shareholders receiving consideration or (ii) the purchase from the target shareholders of the target shares directly by the foreign acquirer.

In 1991 and 1992, Square D accrued large amounts of interest on loans but did not attempt to deduct these amounts in its tax returns for those years. Square D then paid off the interest on these loans only in 1995 and 1996. Under the treaty between France and the US, interest payments were exempt from US withholding tax. During an audit procedure, Square D argued that it should be allowed to deduct the loan interest amounts in the years in which they accrued, i.e. 1991 and 1992. The US IRS considered that such deductions had to be taken only when the interest payments were actually made, not when they accrued. Until here, every thing clear. Interest accrued and the taxpayer was thereby attempting to deduct such amounts on the basis of the accrual method and not the cash method.

The problem was that US rules restricted the possibility to deduct such interest in case of interest accruing to foreign persons. The US Tax Law allows a taxpayer to take a deduction on all interest paid or accrued within a taxable year on indebtedness, with certain provisions of the code determining which of these two alternatives apply. Differently than in a situation of interest payable to a US taxpayer, a US Treasury Regulation (1.267(a)-3) In general, provides for the cash method of accounting when claiming interest deductions for payments to a related foreign person.

Using an example from the said regulation, assume that FC, a company incorporated in Country X, owns 100 percent of the stock of C, a domestic company. C uses the accrual method of accounting in computing its income and deductions, and is a calendar year taxpayer. In Year 1, C accrues an amount owed to FC for interest. C makes an actual payment of the amount owed to FC in Year 2. Regardless of its source, the amount owed to FC by C will not be allowable as a deduction in Year 1 and deduction will only be allowed in Year 2.

Square D went first to the US Tax Court (2002) and later to the Seventh Circuit Court of Appeals (13 February 2006) against the denial to take the mentioned deductions for interest payments to its French parent company. Square D argued that Treasury Regulation § 1.267(a)-3 was invalid as it went beyond section 267 and in alternative that it violated the non-discrimination clause contained in the 1967 Tax Treaty between the US and France.

I am not a US tax lawyer and therefore I will skip the first plea, which amounts to a statutory interpretation of the internal revenue code, and focus on the second plea that relates to non-discrimination issues. Just for reference, both courts rejected the first plea.

With regards to the second alternative plea, Square D refers to Article 24(3) of the Treaty that provides that a U.S. company owned by French residents shall not be subjected to U.S. taxation that is “other or more burdensome” than the taxation to which a U.S. corporation owned by U.S. residents (U.S.-owned corporation), “carrying on the same activities” as the French-owned corporation, is subjected.

Article 24(3), which follow closely Art. 24(6) of the OECD Model, reads as follows:
“A corporation of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned Contracting State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which a corporation of that first-mentioned Contracting State carrying on the same activities, the capital of which is wholly owned by one or more residents of that first-mentioned State, is or may be subjected.

In that regard, Square D argued that being a French-owned corporation it is subjected to other or more burdensome taxation than a US-owned company would be. In fact, Treasury Regulation § 1.267(a)-3 by requiring a taxpayer owned by a French corporation to use the cash method for deducting interest payments to its parent, rather than the more advantageous accrual method would contravene the non-discrimination clause of the treaty. More specifically, Square D argues that different treatment is connected to the residence of the owners since Square D is denied an accrual basis deduction for interest amounts owed to its foreign owner while a hypothetical U.S.-owned company (using the accrual method) would be permitted accrual basis deductions for interest amounts owed to its U.S. owner.

The Tax Court and the Court of Appeals rejected such arguments, stating that the US regulation in scrutiny operated independently of the residence of the owners of the payor of the interest and that the fact that such payments might be treated differently from payments to a comparable US owner is merely incidental. The Courts relied on the IRS arguments that “the basis for deferring the interest deduction is dependent entirely on the U.S. tax treatment of the payment in the hands of the foreign corporation, not the identity or nationality of the owner of the payor”. In the Courts view, if a US company is making a payment of interest to a related foreign person, the accounting method for deducting the amount depends on whether the interest is or is not effectively connected income, and on whether the payee uses the accrual method, not on the residence of the owners of the U.S. corporation. Thus, both Courts ruled that there was no violation of Article 24(3).


Generally speaking, discrimination arises when different rules are applied to comparable situations or when the same rules are applied to different situations. In this case, where different rules are applied to comparable situations, it is crucial to determine which comparative scenario should be taken into consideration when evaluating whether there is a discriminatory treatment. Art. 24(3) of the Treaty cited above refer that the comparative scenario here is between a US company owned by foreign shareholders and a US domestically owned company. And in this case the subsidiary that is held by the French parent appears to be subject to a more burdensome taxation.

With regards to the line of argumentation of the US Courts, I have personally my doubts. My doubts rest in the fact that, to my knowledge, non-resident companies are taxable on their U.S. source income and, in certain limited situations, on foreign source income that is effectively connected (ECI) with the conduct of a trade or business in the United States (i.e. ECI or effectively connected income). I

In this case, the French company did not derive ECI from the US and therefore was not taxable in the US. Therefore saying that the accounting requirement depends on whether the interest is ECI or not is in my view connected to the fact that non-ECI is generally income derived by non-residents. As such, one can argue that the connection between the said regulation and the residence of the owners exists! One can see it or one can prefer to ignore it! The Court simply preferred to ignore it!

Another point I would like to add relates to the potential bridge between Art. 24 and the European Community non-discrimination rules, as developed by the ECJ. The European Community is a new legal order of international law established for the benefit of nationals of the various Member States. In essence, the provisions of the EC Treaty (just as those of a Treaty) are capable of subjugating domestic provisions incompatible with EC law. In a recent article, Van Raad provides a useful analysis on the comparison between the non-discrimination rules of Article 24 OECD Model and the rules developed by the EC Court of Justice on the basis of the non-discrimination and freedom of movement provisions in the EC Treaty (in: A tax globalist, IBFD Publications, 2005, p. 129-143).

Just give you an example of the difference in the analysis under the two principles, consider the recent decision by the ECJ on the Bouanich case (C-265/04). The first issue on that case was whether or not it was compatible with the free of movement of capital (Arts. 56 and 58 of the EC Treaty), a tax rule wherby income derived by a non-resident shareholder from the repurchase of own shares by a Swedish resident company is taxed as dividends without the right to deduct the acquisition cost of those shares, whereas such income in the case of a resident shareholder is taxed as capital gains with a right to deduct the acquisition costs. There were additional questions that related to the connection between treaties but we will skip them for now.

In relation to this first issue, the ECJ observed that the right to deduct the acquisition costs of shares on the occasion of their repurchase by the issuing company constitutes a tax advantage, which is reserved solely to resident shareholders under the challenged Swedish domestic rules. In the ECJ's view, the effect of such rules is that it is less attractive for investors to make cross-border transfers of capital such as buying shares in companies resident in Sweden and, consequently, the opportunities available to Swedish companies to raise capital from non-resident investors are therefore restricted. Consequently, the ECJ held that the differential treatment of non-resident and resident shareholders in the case of a repurchase of shares constitutes a restriction on the movement of capital within the meaning of Art. 56 EC.

As to the possible grounds of justification (which is a particularity of the EC rules when compared with the OECD Model), the ECJ found that, as the cost of acquisition of the shares is directly linked to the payments made in respect of their repurchase, there is no objective difference between the situations of resident and non-resident taxpayers when receiving such income. No other grounds of justification were relied on by Sweden. Consequently, the Swedish domestic legislation constitutes an arbitrary discrimination against non-resident shareholders in as far as it taxes them more onerously than resident shareholders in an objectively comparable situation.

The question that remains is if a rule (such as the one described above), whereby a cash method of accounting would be required when claiming interest deductions for payments to a related foreign person, would be enacted by a EU Member State - would such rule be in line with the freedom of movement provisions of the EC Treaty?


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