Unilateral Responses to Tax Treaty Abuse: A Functional Approach

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Unilateral Responses to Tax Treaty Abuse: A

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UNILATERAL RESPONSES TO TAX

TREATY ABUSE: A FUNCTIONAL

APPROACH

Omri Marian

INTRODUCTION........................................................................ 1158

I. THE HIERARCHICAL VIEW OF UNILATERAL RESPONSE TO

TREATY ABUSE........................................................................ 1160

II. THE UNITED STATES’ EXPERIENCE IN RESPONDING TO

TREATY ABUSE........................................................................ 1161

A. Treaty Overrides............................................................. 1161

B. Renegotiations................................................................ 1164

1. Extensive Renegotiations........................................... 1164

2. Targeted Renegotiations ............................................ 1167

C. Turn-off Provisions ........................................................ 1168

D. Terminations.................................................................. 1169

1. The Termination of the British Virgin Islands Extension

in the U.K. Treaty........................................................... 1169

2. The Mid-1980s Terminations of Caribbean and African

Territorial Extensions .................................................... 1171

3. The Netherlands Antilles Treaty Termination ......... 1173

4. The Malta Treaty Termination.................................. 1175

III.

A FUNCTIONAL CATEGORIZATION OF UNILATERAL

RESPONSES TO TREATY ABUSE............................................... 1175

A. A Matrix of Responses.................................................... 1176

1. Treaty Shopping Across Multiple Treaties: Renegotiate

All .................................................................................... 1177

* Assistant Professor of Law, University of California, Irvine School of

Law.

1158 BROOK. J. INT’L L. [Vol. 41:3

2. Particular Types of Abuse Across Multiple Treaties:

Overrides......................................................................... 1178

3. Particular Abuse in One Treaty: Renegotiation or “Turn

Off” Provisions .......... .......... .................... .......... .............. 1179

4. Systemic Abuse of a Single Treaty: Renegotiation or

Termination .................................................................... 1180

B. Government Abuses Vers us Taxpayer Abuses ............... 1181

ONCLUSION ........................................................................... 1182

INTRODUCTION

ilateral tax treaties are the backbone of the international

tax regime.

At least in broad strokes, the substance of this

international tax regime has been remarkably consistent.

Re-

cent years, however, have seen a dramatic increase in treaty

abuse by taxpayers

to such an extent that the Organisation for

Economic Co-operation and Development (OECD) expressed

concern that “the bilateral structure of the international tax re-

gime has lost its integrity.”

Jurisdictions have the right to terminate tax treaties, subject

to minimal procedural constraints.

Nonetheless, even in the

face of overwhelming evidence of treaty abuse, tax treaties are

1. See REUVEN AVI-YONAH, INTERNATIONAL TAX AS INTERNATIONAL LAW: AN

ANALYSIS OF THE INTERNATIONAL TAX REGIME 3 (2007) (“The claim the interna-

tional tax regime exists . . . rests mainly on the bilateral tax treaty network . .

. .”).

2. According to Avi-Yonah, this regime is comprised of two principles. The

first principle is the single tax principle, which states that income from cross

border transactions is taxed once (not more, but also not less than once). Id. at

8. The second principle is the benefits principle, which states that the source

jurisdiction gets primary right of taxation on active income and the residence

jurisdiction gets the primary right of taxation on passive income. Id. at 11.

3. The Organi sation for Economic Co-operation and Development (OECD)

identified treaty abuse as one of the target areas of the project to prevent base

erosion and profit shifting. See ORG

. FOR ECON. CO-OPERATION & DEV. [OECD],

PREVENTING THE GRANTING OF TREATY BENEFITS IN INAPPROPRIATE

CIRCUMSTANCES, ACTION 6 - 2015 FINAL REPORT (2015).

4. Yariv Brauner, What the BEPS?, 16 FLA. TAX REV. 55, 92 (2014).

5. For model termination articles, see MODEL CONVENTION WITH RESPECT

TO TAXES ON INCOME AND ON CAPITAL art. 31 (ORG. FOR ECON. CO-OPERATION &

DEV. 2014) [hereinafter OECD MODEL CONVENTION].

2016] Treaty Terminations 1159

rarely terminated. The reason for rarely terminating tr eaties

seems to be that potential resp onse s to abusive treaty-based tax

schemes are perceived to be hierarchical.

Jurisdictions are ex-

pected to respond to abusive schemes in an escalating manner,

adopting harsher measures if previously adopted methods failed

to solve the problem. In this context, a termination of a tax

treaty is viewed as a last resort measure, only to be adopted if

all other policy responses fail.

This article argues that the hierarchical view of unilateral re-

sponses to treaty abuse is misguided. Unilateral responses to

treaty-based abuse are not hierarchically ordered. Rather, the

approach to treaty abuse should be functio nal and adopt specific

types of unilateral responses based on the type of treaty abuse

at issue. In order to advance this argument, this article develops

a taxonomy of tax-treaty abuses based on two factors: a geo-

graphical breadth of abuse, and a substantive breadth of abuse.

The geographical breadth of abuse considers the number of trea-

ties being abused. Namely, whether there are only a few treaties

being abused, or whether there are many treaties that are con-

sistently being abused. The second factor—namely, the substan-

tive breadth of abuse—considers whether there are only one or

two provisions consistently being abused, or whether the treaty

as a whole is used as an instrument of abuse.

Different combinations of geographical and substantive

breadths of abuse ultimately call for different unilateral re-

sponses. Within this context, treaty termination should not be

viewed as a “l as t resort” measure. Sometimes it is si mpl y a first-

best (i f not the only) solution. Specifically, if the abuse is geo-

graphically narrow (meaning, only one treaty is abused), but

substantively broad (meaning, the treaty as a whole is primarily

used for abusive purposes), a treaty should be terminated. In

such circumstances, termination is the most cost-effective way

to solve the abuse problem. On the other hand, termination

might be an irrelevant response in other instances, for example,

when multiple treaties are narrowly abused.

This article proceeds as follows: Part I explains the resistance

to treaty termination. Part II explores the different types of

available unilateral responses to treaty abuse (including termi-

nations), by surveying past unilateral responses by the United

States to treaty abuse. Part III categorizes the U.S. responses

6. See discussion infra Part I.

1160 BROOK. J. INT’L L. [Vol. 41:3

based on geographical breadth and substantive types of abuse,

and explains the circumstances that warrant each type of re-

sponse.

I. THE HIERARCHICAL VIEW OF UNILATERAL RESPONSE TO

TREATY ABUSE

Asserting that the abuse of bilateral treaties threatens the in-

tegrity of the international tax regime

may seem paradoxical at

first: since tax treaties are bilateral instruments, treaty abuse

can theoretically be easily and efficiently dealt with, without

threatening the bilateral structure of the international tax re-

gime.

If a bilateral tax treaty is heavily abused, the offended

jurisdiction can simply exercise its right to terminate the treaty.

The termination of such treaty would solve the abuse problem in

that specific context, while sending a strong message to taxpay-

ers, as well as other treaty partners, that abuse will not be tol-

erated. Moreover, a termination of one trea ty (or even dozens)

out of thousands of bilateral treaties currently in place world-

wide, should not threaten the systemic integrity of the interna-

tional tax regime.

Tax treaties are rarely terminated, however, even when

clearly abused by taxpayers. For example, the United States has

unilaterally terminated bilateral tax treaties only on very few

occasions.

Recently, notwithstanding the mounting evidence of

treaty abuse, the U.S. Department of Treasury (the “Treasury”)

strongly resisted the idea of treaty terminations , referring to it

as a “nuclear weapon.”

The resistance to treaty termination is not unique to the

United States. The OECD recently adopted a set of recommen-

dations following the massive Base Erosion and Profit Sharing

7. Brauner, supra note 4.

8. Id. Generally, treaty abuse is viewed as an issue best addressed by

changes to domestic law, for example, by adding domestic anti-abuse rules that

address treaty-based abuse. Id. Changes in the domestic laws of one or a few

countries, or terminations of a few treaties by one country, are unlikely to have

an immediate systemic effect on the network of bilateral tax treaties. Id.

(“[T]reaty abuse generally has been considered a domestic law issue.”).

9. Treaties typically contain termination articles. See OECD

MODEL

CONVENTION, supra note 5.

10. See Brauner, supra note 4.

11. See discussion infra Part II.D.

12. Lee A. Sheppard, News Analysis: Who’s Willing to Sign New U.S. Tr eaty

Provisions?, 79 T

AX NOTES INT’L 192, 194 (2015).

2016] Treaty Terminations 1161

Project (“BEPS Project”) aimed at curtailing tax avoidance.

Ac-

tion 6 of the OECD’s BEPS Project is specifically aimed at com-

bating treaty abuse.

This effort is quite remarkable in the

sense that addressing treaty abuse has been historically viewed

as a domestic issue, and the project marked the first coordinated

international attempt focused on treaty abuse. But even though

Action 6 recognizes that “each country has the sovereign right”

to terminate a treaty,

it forcefully states that treaty termina-

tion is a “last resort” option in responding to treaty abuse.

Thus, it seems that developed jurisdictions take the view that

the termination of a tax treaty should be taken as a final meas-

ure when other responses to treaty abuse have failed. This

paints unilateral responses to treaty abuse as a set of hierarchal

options, gradually escalating in severity, with termination being

the last available option. This article puts unilateral responses

to treaty terminations in coherent policy terms, and suggests

that there is no such hierarchy. Instead, different responses are

suitable for different types of abuse.

II. THE UNITED STATES’ EXPERIENCE IN RESPONDING TO

TREATY ABUSE

This Part offers a menu of unilateral responses available for

treaty abuse through case studies involving the United States.

The unilateral responses to treaty abuse discussed herein in-

clude: overr ide s, renegotiations, turnoff provisions, and termi-

nations. This Part explains the different circumstances under

which the United States adopted each of the four policy instru-

ments. The survey indicates that these policy instruments were

not part of a hierarchical set of responses.

A. Treaty Overrides

A treaty override is domestic legislation that has the effect of

undoing treaty provisions.

In the United States, treaties and

13. For more information and access to BEPS Project documents, see Base

Erosion and Profit Shifting, ORG. FOR ECON. CO-OPERATION & DEV.,

http://www.oecd.org/ctp/beps.htm (last visited May 22, 2016).

14. See generally OECD, supra note 3.

15. Id. at 15.

16. Id. at 103.

17. In at least one instance, the Treasury overrode treaties by administra-

tive action in the context of conduit financing arrangements. See Treas. Reg. §

1.881-3 (2012). However, the regulations were promulgated under the broad

1162 BROOK. J. INT’L L. [Vol. 41:3

legislation have the same authoritative power.

It is well estab-

lished that, where two equally authoritative rules contradict

each other, the rule enacted later-in-time takes precedent.

This

interpretative doctrine gives Congress the ability to override

treaties by a later- in-t im e law. The United States has been quite

active in legislating treaty overrides,

a practice that has drawn

some criticism.

The Branch Profits Tax (“BPT”) example can

help to illustrate the United States’ use of overrides.

All treaties to which the United States is a signatory specify

that a treaty resident’s busin ess income shall only be taxed in

the United States if the income is attributable to the resident’s

“permanent establishment” in the United States.

A domestic

corporation, wholly owned by such foreign resident, is generally

not considered to be a permanent establishment.

Income at-

tributable to a permanent establishment is thus taxed once to

the foreign resident.

If, in the alternative, a foreign resident operates in the United

States through a wholly owned domestic corporation, the domes-

tic corporation is subject to the usual corporate tax in the Unite d

States. Upon repatriation of dividends from the corporation to

the foreign resident, the dividend is subject to a gross withhold-

ing tax (the rate of which varies among treaties).

The income

is thus taxed twice.

This U.S. treaty system closely follows the U.S. domestic sys-

tem of taxation: proprietors are taxed once on income they gen-

erate directly, while corporate income is subject to two levels of

authority of I.R.C. § 7701(l), which itself may be understood to instruct the

Treasury to override treaties.

18. U.S. CONST. art. VI, cl. 2.

19. For a discussion of the later-in-time rule in the context of tax treaties,

see Anthony Infanti, United States, in TAX TREATIES AND DOMESTIC LAW ¶

13.1.2 (Guglielmo Maisto ed., 2006).

20. Id.

21. For a summary of the negative view of treaty overrides, see Reuven S.

Avi-Yonah, Treaty Overrides: A Qualified Defense of U.S. Practice, in TAX

TREATIES AND DOMESTIC LAW ¶ 4.2 (Guglielmo Maisto ed., 2006).

22. U.S. MODEL INCOME TAX CONVENTION art. 7(1) (U.S. DEP’T OF THE

TREASURY 2006).

23. In such a case, the domestic corporation itself is a tax resident in the

United States under the treaty. Id. art. 4(1). As such, the domestic corporation

is subject to corporate taxes in the United States.

24. Id. art. 10.

2016] Treaty Terminations 1163

tax, once at the corporate level and another at the shareholder

level upon distribution or disposition.

Before 1986, foreign residents with active business in the

United States generally operated through wholly owned corpo-

rate subsidiaries in order to enjoy limited liability.

This meant

that foreign investors from treaty jurisdictions were usually sub-

ject to two levels of tax. This status quo was disrupted with the

rise of the Limited Liabil ity Comp any (LLC) dur ing the early

1980s.

While a LLC accords its members all the benefits of limited

liability, a wholly owned LLC is generally disregarded for tax

purposes.

During the 1980s, foreign residents from treaty ju-

risdictions started to use LLCs instead of domestic corporations

in conducting their U.S.-based activities. Because the LLCs were

disregarded for tax purposes, the foreign residents were only

taxed in the United States on profits generated by permanent

establishments. Repatriation of funds was not taxed again be-

cause a LLC was not a corporation, and repatriation from a LLC

was not a “dividend” subject to withholding under any of the tax

treaties then in force. Operating through a LLC, thus, enabled

foreign residents to operate in the United States with the bene-

fits of limited liability, but without the need to incorporate a do-

mestic subsidiary, which enabled the avoidance of the dividend

withholding tax.

The United States, however, never intended

treaties to be used as an instrument to avoid the second level of

tax on corporate distributions. In 1986, the United States re-

sponded by adding to its tax code section 884, known as the BPT.

The BPT creates a withholding mechanism on branch earnings

repatriated from the United States to a foreign parent.

The

25. For a discussion about the historical background of the enactment of the

Branch Profits Tax, see, for example, Omri Marian & Yariv Brauner, United

States, in DEPARTURES FROM THE OECD MODEL AND COMMENTARIES:

RESERVATIONS, OBSERVATIONS AND POSITIONS IN EU LAW AND TAX TREATIES 537,

549–50 (Guglielmo Maisto ed., 2014); Reuven S. Avi-Yonah, supra note 1, at

92–96.

26. Under the default rule prescribed in the regulations, a single-owner LLC

is disregarded for tax purposes. See Treas. Reg. § 301.7701-3(b)(1)(ii) (2012).

27. For further discussion, see supra note 25.

28. Generally, under the mechanism prescribed by I.R.C. § 884, a reduction

in a foreign corporation’s net U.S. assets is treated as a “dividend equivalent

amount.” Such amount is subject to a 30 percent gross taxation, unless a tax

treaty modifies that rate.

1164 BROOK. J. INT’L L. [Vol. 41:3

BPT was intended to fi x the discrepancy between foreign corpo-

rations operating in the United States through LLCs, and those

operating through domestic corporate subsidiaries. The BPT ef-

fectively functions as a proxy to a second level of tax on corporate

distributions from the foreign parent to its shareholders. The

problem, however, was that U.S. treaties did not prescribe any

tax on business income except from the taxes imposed on perma-

nent establishments. In fact, some U.S. treaties at the time ex-

plicitly prohibited a second level of tax on foreign corporate dis-

tributions to foreign shareholders.

The BPT has effectively

overridden the treaties then in effect. Subsequently, the United

States renegotiated all of its tax treaties to insert a BPT provi-

sion.

B. Renegotiations

The United States has renegotiated its tax treaties on various

occasions. Broadly speaking, such renegotiations take one of two

forms. The first, referred to as “extensive renegotiations,” occurs

when there is a renegotiation of many tax treaties to address a

problem shared by all renegotiated treati es. The other form of

renegotiation refers to the renegotiation of a particular provision

or a particular treaty. Each of the two types of renegotiations is

separately discussed below.

1. Extensive Renegotiations

Over the years, the United States experienced many instances

in which taxpayers from non-treaty jurisdictions “bought” their

way into treaties through a process known as “treaty shopping.”

In the past, if a resident from a non -treaty jurisdiction wished to

invest in the United States but wanted to enjoy treaty benefits,

the foreign resident could incorporate a shell corporation in a

treaty jurisdiction, and make the U.S. investment through such

corporation. As a tax resident in a treaty ju risdiction, the wholly

owned corporation (and by extension, the non-treaty owner)

would reap treaty benefits. The result was that “[in] the most

extreme case of treaty shopping, it mean[t] we ha[d] a treaty

29. See Marian & Brauner, supra note 25, at 550 (“[T]he BPT effectively

imposed a second level of tax on the branch in lieu of second level of tax on

distribution, where treaty provisions were specifically drafted to prevent a sec-

ond level of tax on such distributions.”).

2016] Treaty Terminations 1165

with the world.”

This was not a desirable result, since “third

country nationals’ use of the U.S. treaty network reduce[d] the

incentive to governments outside the U.S. treaty network to ne-

gotiate treaties with the United States that offer[ed] concessions

to U.S. nationals.”

The main innovation of U.S. tax treaty policy in this context

was the introduction of Limitation on Benefits (“LOB”) article in

all U. S. treaties. This has been achieved through extensive re -

negotiations of all existing treaties.

The LOB provision is re-

garded as the “ultimate anti-abuse rule.”

LOB provisions pre-

scribe qualification rules that are intended to prevent corporate

taxpayers who lack sufficient connections to the treaty jurisdic-

tions from receiving treaty benefits.

The creation of the LOB policy is commonly attributed to Aiken

Industries v. Commissioner.

In Aiken Industries, a Bahamian

parent corporation made a loan to its U.S. subsidiary. Under

U.S. law at the time, interest paid to a foreign resident was sub-

ject to gross withholding at a rate of 30 percent.

Such withhold-

ing is many times relieved by tax treaties. The United States

and the Bahamas, however, did not have a tax treaty in place.

In order to avoid withholding, the Bahamian parent assigned its

rights to receive interest under the loan to one of its other sub-

sidiaries, a Honduran corporation. The United States did have a

tax treaty with Honduras at the time under which interest pay-

ments were exempt from withholding.

The U.S. subsidiary paid a deductible interest to the Honduran

subsidiary, thus eliminating some of the U.S. tax base. The Hon-

duran subsidiary immediately turned and made a back-to-back

payment to the Bahamian parent. The U.S. subsidiary cla imed

it was not required to withhold on the deductible payments made

to Honduras under the Honduran treaty then in effect. The Tax

30. Jeff Gerth, U.S. is Opening Talks on Tax Haven Treaty, N. Y. TIMES (Jan.

15, 198 2), http://www.nytimes.com/1982/01/15/business/us-is-opening-talks-

on-tax-haven-treaty.html?pagewanted=1 (quoting Alan W. Granwell, the

Treasury Department’s international tax counsel at the time).

31. R. Eliot Rosen, U.S. Files Notice of BVI Treaty Termination, 16 TAX

NOTES 77, 78 (1982).

32. See Marian & Brauner, supra note 25, at 559–60.

33. Id. at 559.

34. Aiken Indus., Inc. v. Comm’r, 56 T.C. 925 (1971).

35. I.R.C. § 871 (1986).

1166 BROOK. J. INT’L L. [Vol. 41:3

Court rejected this argument, concluding that the Hondur an cor-

poration “was merely a conduit for the passage of interest pay-

ments from [the U.S. subsidiary] to [the Bahamian parent], and

it cannot be said to have received the interest as its own.”

The case, however, was a Pyrrhic victory for the IRS. The de-

cision provided taxpay er s with a roadmap to avoid the classifi-

cation as a “conduit.” In Aiken, the back-to-back amounts were

identical. After Aiken, taxpayers engaged in similar intermedi-

ary financing arrangements that withstood court scrutiny,

among others, by allocating a small margin of profit to be kept

by the conduit intermediaries that were incorporated in treaty

jurisdictions.

One well-known example is SDI Netherlands v.

Commissioner.

In SDI, a Bermudian corporation that owned

certain IP rights protected in the United States licensed such

rights to an affiliate in the Netherlands, which relicensed them

to a U.S. affiliate. The U.S. affiliate paid royalties to the Neth-

erlands, which made a back-to-back payment of royalties to Ber-

muda. Had the U.S. affiliate paid the royalties directly to Ber-

muda, they would have been subject to a 30 percent withholding

tax. The payment to the Netherlands, however, was exempt un-

der the treaty in force at the time between the United States and

the Netherlands. The IRS failed to convince the Tax Court that

the arrangement was a sham because, among other reasons, the

Dutch entity did keep a small taxable spread in the Nether-

lands.

The immediate response of the Treasury was to renego-

tiate the tax treaty with the Netherlands to include a strict LOB

provision.

However, the treaty-shopping pr oblem was much wider than

just the Netherlands or the Honduras treaties. Over the years,

the IRS made several administrative attempts to address treaty

36. Aiken Industries, 56 T.C. at 934.

37. Since then, the IRS has promulgated regulations to combat such per-

ceived abuse as well. See supra note 17.

38. See, e.g., SDI Netherlands v. Comm’r, 107. T.C. 161 (1996).

39. Id. at 175–76 (“The schedules of royalty payments provided for a spread,

. . . which compensated petitioner for its efforts . . . . Under the circumstances

herein, we think these arrangements should be accorded separate status with

the result that, although the royalties paid by petitioner to SDI Bermuda were

derived from the royalties received by petitioner from SDI USA, they were sep-

arate payments.”).

2016] Treaty Terminations 1167

shopping,

but faced an uphill battle due to the fact that treaties

explicitly granted benefits, but did not impose speci fic residency

qualification requirements. The United States therefore had no

choice but “to battle treaty-shopping head-on by negotiating it

away in its tax treaties.”

Each treaty signed after Aiken in-

cluded a LOB provision, and existing treaties have since been

renegotiated to include such provisions.

2. Targeted Renegotiations

Renegotiations of treaties can also be targeted to a particular

provision in the context of a specific treaty. For example, in 2007

the United States and Canada signed a protocol to the U.S.-Can-

ada treaty amending the treatment of hybrid entities. Hybrid

entities are entities that are treated as corporations by one ju-

risdiction, but as a ta x-t ransparent entities in the other jurisdic-

tion.

Until then, taxpayers were able to use hybrid entities to gen-

erate deductions in one jurisdiction with no corr esponding inclu-

sions in the other.

For example, a U.S. parent corporation

would make a loan to a wholly owned Canadian Unlimited Lia-

bility Company (“ULC”). The ULC would be treated as a corpo-

ration for Canadian purposes, but as a disregarded entity for

U.S. purposes. Thus, interest payments made from the ULC

were deductible in Canada, reducing tax liability in Canada. Un-

der the treaty, the ULC was not required to withhold on the in-

terest payment made to the United Stat es . In the United States,

however, the payments did not create income to the parent, be-

cause being made from a disregarded entity, the payments never

functionally happened from a U.S. point of view. From a U.S. tax

perspective, the payments looked like a transfer of money be-

tween two bank accounts owned by the same entity. This type of

40. The IRS issued several rulings aimed at denying treaty benefits in abu-

sive circumstances. See, e.g., Rev. Rul. 84-152, 1984-2 C.B. 381; Rev. Rul. 84-

153, 1984-2 C.B. 383.

41. Marian & Brauner, supra note 25, at 560.

42. Protocol Amending the Convention Between Canada and the United

States of America with Respect to Taxes on Income and on Capital, Can.-U.S.,

Sept. 21, 2007, S.

TREATY DOC. NO. 110-15 (2008).

43. See STAFF OF J. COMM. ON TAXATION, 110TH CONG., JCX-57-08,

EXPLANATION OF PROPOSED PROTOCOL TO THE INCOME TAX TREATY BETWEEN THE

UNITED STATES AND CANADA 40–41 (2008).

1168 BROOK. J. INT’L L. [Vol. 41:3

planning was available due to unique differences between Cana-

dian and U.S. entity classification rules, and it made sense to

address them through renegotiation.

C. Turn-off Provisions

In many instances, it is possible to deal with particular issues

in advance. For example, if specific provisions of a tax treaty are

more prone to abuse than others, it is possible to rig the treaty

with “fail-safe” mechanisms that automatically “turn off” treaty

benefits if specific conditions are met. The United States had

done so on a few occasions.

For example, the treaty between the United States and Lux-

embourg provides special anti-abuse provisions for “triangular

permanent establi shmen ts.” Generally, if a U.S. resident oper-

ates in Luxembourg through permanent establishment, Luxem-

bourg gets the primary right to tax such profits.

The Un ited

States, ho we ve r, agrees to give up taxation of its residents under

the assumption that Luxembourg will tax them.

Yet, it is possible for a taxpayer to make deductible payments

out of the Luxembourg permanent establishment to another

Luxembourg treaty partner (not the United States), thus elimi-

nating the tax in Luxembourg without necessarily creating a

corresponding inclusion. In order to prevent that, the treaty with

Luxembourg contains a provision that “turns off” treaty benefits

for a permanent establishment if the permanent establishment

is not subject to a minimum threshold of taxation where it oper-

ates.

The United States recently introduced a similar concept into

its proposed revisions to the U.S. Model Treaty.

Under the

44. The United States previously overrode treaties due to concerns regard-

ing the use of hybrid entities. See I.R.C. § 894(c). This rule, however, was not

broad enough to address some of the same concerns in the context of the U.S.-

Canada Treaty.

45. Convention Between the Government of the United States of America

and the Government of the Grand Duchy of Luxembourg for the Avoidance of

Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes

on Income and Capital, Lux.-U.S., art. 9, Apr.

3, 1996, S. TREATY DOC. NO. 104-

33 (1996).

46. Id. art. 22.

47. U.S. MODEL INCOME TAX CONVENTION (U.S. DEP’T OF THE TREASURY 2016)

[hereinafter U.S. MODEL]. For discussion of such fail-safe mechanisms, see Al-

lison Christians & Alexander Ezenagu, Kill-Switches in the New U.S. Model

Tax Treaty, 41 BROOK. J. INT’L L. 1043 (2016).

2016] Treaty Terminations 1169

Model Treaty, certain treaty benefits are “turned off” if, after the

treaty has entered into force, the other contracting state intro-

duces a “Special Tax Regime” (“SPR”).

A SPR is “any statute,

regulation or administrative practice that provides a preferen-

tial effective rate of taxation to such income or profit, including

through reductions in the tax rate or the tax base” which results

in certain tax benefits such as preferential tax rates or a perma-

nent deduction.

This provision expresses the belief that treaty

benefits in one country (in this case, the United States) should

only be granted under the premise that the benefited stream of

income will be taxed in the other jurisdiction.

D. Terminations

Occasionally, the United States has terminated tax treaties

unilaterally for political reasons, such as terminating a tax

treaty with South Africa during the Apartheid period.

Such

terminations are not responding to treaty abuse, and as such are

not discussed. Terminations due to treaty abuses are few and far

between. Several such instances are explored below.

1. The Termination of the British Virgin Islands Extension in

the U.K. Treaty

In 1979, the Treasury announced that it intended to renegoti-

ate the territorial extension of the U.K. treaty to the British Vir-

gin Islands (BVI)

and in early 1981 a new treaty was an-

nounced. In September of 1981, however, the Treasury asked the

Senate to suspend its consideration of the ratification of the

newly negotiated treaty.

According to the Treasury, the pend-

ing treaty was designed to prevent, or at least limit, the extent

to which residents of third countries could access U.S. treaty

benefits. In reviewing the newly negotiated treaty, the Treasury

concluded that the opportunities for such an abuse remained

“too great to tolerate.”

48. U.S. MODEL, supra note 47, art. 3(1)(1).

49. Id.

50. See Comprehensive Anti-Apartheid Act, 22 U.S.C. §§ 5001–5117 (1986)

(repealed 1993).

51. Letter from John E. Chapoton, Assistant Sec’y for Tax Policy, Treasury

Dep’t, to Charles H. Percy, Chairman, Senate Comm. on Foreign Relations

(Sept. 15, 1981), reprinted in 13 T

AX NOTES 645 (1981).

52. Id.

53. Id.

1170 BROOK. J. INT’L L. [Vol. 41:3

The Treasury’s fears of the BVI treaty being used for treaty-

shopping schemes were well-grounded. For example, during the

1970s, non-treaty investors in U.S. real estate structured their

investments using BVI shell corporations.

The BVI entity

would finance the U.S. real estate investment with debt, interest

on which would be deductible in the United States. This elimi-

nated some of the U.S. tax base. No income would be subject to

tax in the BVI, since the BVI was a tax haven. The BVI shell

corporation would pay the interest receipts from the United

States back-to-back to the non-treaty jurisdiction. Had such pay-

ments been made directly to the non-treaty jurisdiction, they

would have been subject to a 30 percent gross withholding tax.

Moreover, being a tax haven jurisdiction with strict bank secrecy

laws, it was possible for U.S. taxpayers to “round trip” their do-

mestic investment through the BVI corporation (meaning, a U.S.

person would invest in the United States through a wholly

owned BVI corporation) without the IRS ever knowing about it.

In effect, it enabled U.S. taxpayers to enjoy treaty benefits in a

purely domestic context.

Consequently, the Treasury reopened negotiations with the

BVI with the key issue being an anti-abuse provision that was

intended to prevent non-treaty residents from avoiding U.S.

withholding taxes by claiming BVI-treaty residency. The rene-

gotiation eventually reached an impasse after the BVI resisted

the insertion of an anti-treaty-shopping provision.

In response,

the Treasury decided to terminate the treaty.

54. For a discussion of tax planning schemes involving real estate invest-

ment financed through the BVI, see Richard L. Reinhold, What Is Tax Treaty

Abuse? (Is Treaty Shopping an Outdated Concept?), 53 TAX LAW. 663, 665–67

(2000).

55. On February 24, 1982, the Chief Minister of the BVI issued a statement

indicating that the negotiations were at an impasse. According to the Minister,

the United States insisted on including an anti-abuse provision in the treaty

to prevent treaty shopping by third country nationals, but the BVI resisted

that step. See Rosen, supra note 31, at 77.

56. In a U.S. Department of State letter dated June 23, 1982 to the Senate

Foreign Relations Committee informing it of Treasury’s decision to terminate

the extension of the U.S.-U.K. tax treaty to the BVI, Daniel W. McGovern, the

Deputy Legal Adviser, noted the decision to terminate was ultimately

grounded in the Treasury’s report following review that the current treaty in-

dicates potential for tax abuse. On June 30, 1982, the U.S. Department of State

filed an official notice with the British Embassy in Washington, indicating that

the United States would terminate the extension of the U.S.-U.K. income tax

treaty to the BVI effective January 1, 1983. Speaking on June 24, 1982 at the

2016] Treaty Terminations 1171

2. The Mid-1980s Terminations of Caribbean and African Ter-

ritorial Extensions

On January 1, 1983, the Treasury announced that it will ter-

minate, as of January 1, 1984, the extensions of old tax treaties

to over a dozen British and Belgian jurisdictions, primarily lo-

cated in the Caribbean.

According to the press release, the ter-

minations occurred because the existe nce of the territorial ex-

tensions did not reflect the economic relationship between the

United States and these respective jurisdictions, and were sus-

ceptible to abuse.

Responding to congressional inquiry, the Treasury reasoned

that, given the earlier termination of the treaty with the BVI (as

well as renegotiations that resulted in the inclusion of anti-

abuse provisions in other treaties), there was a concern that the

territorial extensions at issue would replace the recently termi-

nated BVI treaty as instruments of tax abuse.

Unlike the BVI

case, however, the Trea sury did not attempt to renegotiate the

territorial exten sions at issue, but immediately terminated

them. The reasoning was that “[f]or the mos t part these treaties

were not being used; there [was] very little investment flow be-

tween the United States and these jurisdicti on s. ”

The minimal flow of true investment between the United

States and these jurisdictions, combined with the fact that such

Fourth Annual Institute on Multinational Taxation, the Treasury’s Interna-

tional Tax Counsel, Alan W. Granwell, said that a tax treaty is a “bilateral

relationship between the contracting jurisdictions,” and if persons who are not

residents of the jurisdictions can obtain benefits under the treaty, “it creates

tensions between the law on the books and treaty use.” Id. at 78.

57. I.R.S. News Release R-2222 (July 1, 1983). The territories with which

territorial extensions were terminated were Anguilla, Rwanda, Barbados, St.

Christopher, Belize, Nevis, Burundi, St. Lucia, Dominica, St. Vincent, Falk-

land Islands, the Grenadines, the Gambia, Seychelles, Grenada, Sierra Leone,

Malawi, Zambia, Montserrat, and Zaire. Id.

58. Id.

59. Treasury Secretary Donald T. Regan explained why the Treasury termi-

nated the BVI treaty by responding to inquiries from a member of the Senate’s

Finance Committee. See Secretary Regan On Termination of Caribbean Tax

Treaties, 22 TAX

NOTES 640, 641 (1984) (“The Treasury Department’s action

was intended to address current abuse and, significantly, the potential for fu-

ture abuse following the termination of the British Virgin Islands treaty and

the renegotiation of the Netherlands Antilles treaty.”).

60. Id.

1172 BROOK. J. INT’L L. [Vol. 41:3

jurisdictions were de facto tax havens, led the Treasury to be-

lieve that such jurisdictions might become dependent upon in-

come derivin g from abusive activities. The concern, in other

words, was that the treaties would be used primarily for abuse,

rather than for legitimate investments.

Under such circumstances, renegotiations were viewed nega-

tively. The Treasury reasoned that past experience in renegoti-

ating treaties “has shown that if the existing treaties remain in

force during renegotiations, the treaty partner will underesti-

mate the seriousness of the U.S. concern and will also lengthen

the renegotiation process as long as possible. This has the ad-

verse consequences of allowing treaty abuses to continue.”

Re-

negotiation is called for, according to the Treasury, only in cases

where “est ab li sh in g a treaty relationship . . . promotes real eco-

nomic activities of residents of the two jurisdictions.”

The Treasury also explained that the treaty terminations may

serve a purpose beyond eliminating the particular abuse at is-

sue. Termination “sends the clearest possible signal to present

or potential treaty partners . . . that the United States is serious

about its intent to curtail treaty shopping.”

61. In hearings, which took place throughout September 1987 before the

House of Representatives’ Subcommittee of the Committee on Government Op-

erations, Assistant Secretary for Tax Policy of the Department of Treasury,

Donald Chapoton, submitted prepared statements and responses to subcom-

mittee requests. When questioned about the reasons for terminating the 1945

Income Tax Convention between the United States and the United Kingdom,

and the 1948 Income Tax Convention between the United States and Belgium,

Chapoton stated:

Moreover, there was apparently little use of the treaties by residents

of these jurisdictions. In addition, the treaties did not contain safe-

guards against use by third country residents to obtain U.S. tax ben-

efits. Although these treaties had not yet been widely used by third

country residents, there was an indication that such use was growing.

See International Tax Evasion/Tax Treaty Issues: Hearing Before the Sub-

comm. on Gov’t Operations, 100th Cong. 60 (1987) (statement of Donald

Chapoton, Acting Assistant Sec’y on Tax Policy, Treasury Dep’t) [hereinafter

Chapoton Statement].

62. Supra note 59.

63. Id.

64. Id.

2016] Treaty Terminations 1173

3. The Netherlands Antilles Treaty Termination

On June 29, 1987, the Treasury announced that the United

States delivered notices to the Netherlands of the termination of

the extension of the 1948 income tax treaty as it applied to the

Netherlands Antilles. In accordance with the terms of the treaty,

the termination was to be effective as of January 1, 1988.

In a

letter, J. Roger Mentz, Assistant Secretary of Tax Policy, wrote

that the termination of the treaty “represents a positive step in

this Administration’s efforts to eliminate opportunities for abuse

of the United States income tax treaties through treaty shop-

ping, the pr actice by which residents of third countries establish

or use entities in a treaty country to derive income from United

States investments under the treaty’s favorable tax terms.”

At the time, the Antilles functioned as an offshore center for

foreign inves tmen t in the United States. The Antilles also played

a crucial role in U.S. companies’ Eurobond financing.

Although

the Antilles levied only nominal taxes on the tax haven business,

“the volume of U.S. financing through the Antilles was so great

that it produced 25–30% of [the] islands’ total tax revenues.”

Meanwhile, the amount of U.S. revenue lost through this haven

was estimated to be between $700 million to $1 billion.

For eight years prior to the termination of the treaty, the

Treasury tried to renegotiate a more restrictive treaty with the

Antilles, premised on the anti-treaty-shopping criteria in the

U.S. Model Income Tax Treaty, as well as an exchange of infor-

mation mechanism s.

The negotiations failed due to “the unwill-

ingness of Treasury to tolerate an increase in treaty shopping

for which the Antilles lobbied.”

65. U.S. Tax Treaties Rep. (CCH) 457.01, Aruban Income Tax Treaty:

Treaty Background (2016).

66. U.S. Tax Treaties Rep. (CCH) 458.80, Annotations: Termination (2016).

67. Gerth, supra note 30.

68. David R. Francis, US Tries to Stem Flow of US Tax Revenue Through

Antilles ‘Haven,’ CHRISTIAN SCI. MONITOR (Jan. 10 1984), http://www.csmoni-

tor.com/1984/0110/011047.html.

69. Id.

70. Frith Crandall, The Termination of the United States-Netherlands An-

tilles Tax Treaty: What Were the Costs of Ending Treaty Shopping, 9 N

W. J.

INT’L L. & BUS. 355, 378 (1988).

71. Mark F. Johnson, Antilles Treaty Termination Favored, but Period of

Uncertainty in Bond Market Lies Ahead, 36 TAX NOTES 127, 129 (1987).

1174 BROOK. J. INT’L L. [Vol. 41:3

Two months after the termination of the treaty, O. Donaldson

Chapoton, the Acting Assistant Treasury Secretary for Tax Pol-

icy, discussed the termination of the Netherlands Antilles treaty

at a Congressional hearing. He cited the primary reason for

seeking to renegotiate the Netherlands Antilles treaty related to

its potential for abuse by treaty shopping third-country inves-

tors.

Mr. Chapoton noted that the principal objection to treaty

shopping was that it undermined th e leve ra ge th e Unit ed St at es

would otherwise bring to negotiations for new or revised treaties

with the countries of residence of the treaty shoppers. It there-

fore posed a serious obstacle to the United States’ efforts to bar-

gain with trading partners for concessions, like low withholding

tax rates on income derived by U.S. persons from those jurisdic-

tions, which are so important to the international competitive

standing of U.S. multinationals. He also noted that the Antilles

treaty had been used by third-country residents for treaty shop-

ping more extensively than any other U.S. income tax treaty. He

presented data from IRS forms reporting income payments to

nonresidents for 1983 and 1984 to highlight the massive extent

to which third-country residents channele d their investments

into the United States through entities established in the Antil-

les.

72. See Chapoton Statement, supra note 61, at 27 (“The primary reason for

seeking to renegotiate the Netherlands Antilles treaty related to its potential

for abuse by treaty-shopping third-country investors.”).

73. Id. Chapoton provided the following data regarding payments channeled

through the Antilles:

Payments of all types of U.S. source income subject to withholding to

residents of the Netherlands Antilles (a jurisdiction of approximately

one-quarter million people) were $2.1 billion, or 19 percent of the total

U.S. payments to all countries, in 1983. In 1984, payments to Antilles

residents were $2.8 billion, or 16.4 percent of such payments to the

world. With respect to interest, the comparable figures are even more

striking. In 1983, U.S. source interest payments of almost $2 billion,

or 33.4 percent of the total interest payments to the world of $5.9 bil-

lion, were made to residents of the Antilles. In 1984, this figure had

increased to $2.6 billion, or 26.2 percent of the total payments of $10

billion. This percentage decline for the Antilles probably reflects the

effect of the introduction, during 1984, of the U.S. exemption for port-

folio interest, which has lessened the need for use of the Antilles as a

route for issuing Eurobonds by U.S. companies.

To further highlight these interest figures, in 1983 interest pay-

ments to the Antilles exceeded the sum of interest payments to Can-

ada, Germany, the United Kingdom, and France by $120 million. In

2016] Treaty Terminations 1175

4. The Malta Treaty Termination

On November 16, 1995, the United States announced it had

delivered a notice of termination relating to the tax treaty with

Malta.

The reason was the “lack of a provision dealing with

limitation of benefits in the treaty.”

The Treasury also stated

that the termination “provide[d] an example of Treasury’s com-

mitment to prevent misuse of income tax treaties by third coun-

try residents even if it means termination of long-standing rela-

tionships.”

At the time , Malta changed its domestic tax law to allow “for-

eign-owned companies in Malta . . . to derive income from the

U.S. at a reduced tax rate specified in the double taxation treaty

and, therefore, effectively pay no tax in Malta.”

This created a

strong incentive for treaty shopping. Aside from treaty shopping,

the Unite d States was also concerned “that Malta was unable to

obtain and exchange tax information held by financial institu-

tions.”

Under these circumstances, “the continuation of the

treaty with Malta was [regarded as] not consistent with U.S. tax

treaty policy.”

III. A FUNCTIONAL CATEGORIZATION OF UNILATERAL

RESPONSES TO TREATY ABUSE

This Part offers a functional matrix of unilateral responses to

treaty abuse based on the U.S. experience, which is not based on

a hierarchy. In the alternative, it suggests that response to

1984, Antilles interest payments were 82 percent of the sum of the

interest payments to these four countries.

Id. at 28.

74. The Malta treaty has since been renegotiated, and the new tre aty en-

tered into force on November 23, 2010. See Convention Between the Govern-

ment of the United States of America and the Government of Malta for the

Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Re-

spect to Taxes on Income, Malta-U.S., Aug. 8, 2008,

S. TREATY DOC. NO. 111-1

(2009) (entered into force Nov. 23, 2010) [hereinafter Tax Convention with

Malta].

75. Sindhu G. Hirani, U.S. Terminates Tax Treaty with Malta over Limita-

tion of Benefits Provision, DAILY TAX REP. (BNA) (Nov. 17, 1995).

76. Id.

77. Malta and the U.S. Start Talks to Terminate Double Tax Accord, 95 TAX

NOTES INT’L 244 (1995).

78. Tax Convention with Malta, supra note 74, at vi.

79. Hirani, supra note 75.

1176 BROOK. J. INT’L L. [Vol. 41:3

treaty abuse should be categorized based on the identity of the

abuser, namely wheth er the abuser is a taxpayer or a treaty sig-

natory.

A. A Matrix of Responses

The U.S. experience of unilateral responses to treaty abuse is

telling. The survey in Part II does not paint a clear picture of a

hierarchy of responses. For example, one might expect negotia-

tions to be a “first step” that would precede any “harsher” re-

sponse, such as an override or termination. But, renegotiations

do not precede overrides. If anything, renegotiations come after

an override. This was the case with the BPT. Only after the

adoption of the BPT did the United States engage all of its treaty

partners to renegotiate BPT provisions into the treaties. Even

terminations are not always preceded by negotiations, as was

the case of the 1980s terminations of the Caribbean territorial

extensions. In that case, termination was the first and only re-

sponse.

Can this mixture of responses be explained? This article sug-

gests that U.S. responses to treaty abuse make a lot of sense once

a functional approach is adopted. Rather than a simple hierar-

chical view, the U.S. experience demonstrates that different

measures are adopted in response to different types of abuses,

and in different contexts. Specifically, the type of observed uni-

lateral responses seem to depend on two factors: the geograph-

ical breadth of the abuse, and the substantive type of the abuse.

Geographical breadth refers to whether the abuse is prevalent

across multiple treaties or whether it is confined to a particular

treaty (or very few treaties). The breadth of the substantive

abuse refers to wheth er the abuse makes use of specific treaty

provisions (for example withholding provisions), or whether tax-

payers abuse the treaty in general (that is, by treaty shopping,

where the treaty can be used in multiple schemes to avoid taxa-

tion). Based on the two factors, it is possible to build a matrix of

observed U.S. responses to treaty abuse.

80. Obviously, a treaty can be abused in more than one way. The quadrants

above are a simplistic depiction of reality, and assume that the different types

of abuse are independent of one another, which is not necessarily the case. In

reality, since different types of abuse may occur simultaneously within the

same treaty or set of treaties, it is possible that one policy response is available

to address the abuses.

2016] Treaty Terminations 1177

Figure 1: Categorization of Unilateral Responses to Treaty

Abuse

Categorization of Unilateral Responses to Treaty Abuse

Geographical Breadth

Systemic

(all/most trea-

ties)

Particular (one/few

treaties)

Substantive

Breadth

Systemic

(treaty

shopping)

Renegotiate all

(example: LOB

provisions)

Termination (example:

Netherlands Antilles

termination)

Particular

(specific

provisions)

Overrides (ex-

ample: BPT)

Renegotiations/turn-

offs (example: Canada

treaty’s hybrids entity

rules SPR in the new

proposed U.S. model)

The matrix shows that available policy responses to treaty

abuse are taken under different circumstances. For example,

reference to treaty terminations as a “last resort” option is some-

what of a misnomer. Sometimes termination is simply the only

relevant response. In other instances; it is irre levant. This is an

important observation, since viewing treaty termination as a

“last resort” option may instill an inherent bias against its use

as a policy instrument, even when termination is the correct ap-

proach to take. In the following sections, this article briefly dis-

cusses the quadrants of the matrix presented above. It explains

why each policy instrument may be preferable over other avail-

able choices in specific contexts.

1. Treaty Shopping Across Multiple Treaties: Renegotiate All

In a sense, this type of a problem is a worst case scenario: all

treaties are prone to abuse in ways we cannot really anticipate.

Renegotiation of all existing treaties to include LOB provisions

was the U.S. course of action once it became apparent that treaty

shopping was a systemic problem.

The main argument against such an approach is its cost. Re-

negotiation is time consuming and difficult to achieve. Addition-

ally, in the meantime, abus e may con tinue. There is no viable

alternative to systemic abuse (or the potential of systemic

1178 BROOK. J. INT’L L. [Vol. 41:3

abuse), however, across multiple treaties. For example, one the-

oretical alternative would be to terminate all treaties (either by

way of termination notices or through overrides that comprehen-

sively deny treaty benefits), and to hope to renegotiate new ones.

The cost for such an action would be enormous, both economi-

cally and politically. From an economic point of view, such an

across-the-board move would surely be overkill. Most cross-bor-

der transactions are probably legitimate rather than abusive.

Multiple terminations, or a broad override, would deny treaty

benefits to many taxpayers that are legitimately engaged in

cross-border transactions involving treaty jurisdictions. The eco-

nomic result would likely be disastrous. Moreover, a one-swoop

cancellation of multiple treaties would completely tarnish the

reliability of the United States as a tax treaty partner (and

maybe even as a treaty partner in general).

Another alternative is to terminate a few particularly “bad”

treaties. This is unlikely to solve the problem because abusers

could simply replace terminated treaties with other treaties still

in effect that do not contain LOB provisions.

2. Particular Types of Abuse Across Multiple Treaties: Over-

rides

Could the United States have addressed the BPT issue differ-

ently? What other actions could the United States have taken in

response to the rise of the LLC, which in turn denied the United

States’ collection of dividend withholding taxes?

The option of treaty termination seems extreme in such a con-

text. First, since this was a problem for all treaties in place at

that time, it would require the termination of all treaties result-

ing with the problems noted above. In addition, treaty termina-

tions in such a case would be overbroad within the context of

each treaty. If the treaty generally functions properly, and there

is only one dysfunctional article prone to abuse (in that case, the

dividend withholding article), it seems extreme to terminate a

treaty and deny all other intended benefits that have nothing to

do with dividend withholding.

The United States could potentially renegotiate all treaties to

include BPT provisions (which the United States eventually did

after the enactment of the BPT). However, unlike in the context

of systemic abuse schemes discussed above, an override can be

targeted to address the specific abuse at issue, and be made im-

2016] Treaty Terminations 1179

mediately applicable to all treaties. This seems to provide a rel-

atively low cost way to quickly solve the problem and stop the

abuse.

There is still a political cost, of course, in overriding treaties.

The United States has indeed been criticized for its override

practices.

But, given that the override addresses abuse, mean-

ing, instances where the treaties are used in unintended man-

ners, the poli tical costs seem to have been bearable.

In many

instances, overrides also address problems shared by the other

jurisdictions.

In such circumstances, little resistance is ex-

pected.

3. Particular Abuse in One Treaty: Renegotiation or “Turn Off”

Provisions

A particular type of abuse in a specific treaty probably repre-

sents the easiest case for tax authorit ie s. When one provision of

one treaty is consistently abused by bona fide residents of the

treaty jurisdiction, the obvious course of action is a targeted re-

negotiation of that specific provision.

Termination of the treaty seems extreme, as it denies all other

benefits of the treaty that are not associated with the particular

abuse. An override is also inapt, since it seems impossible to

draft legislation so narrow so as to target one type of abuse in

one treaty, without affecting other treaties.

If a particular treaty is known to be susceptible to abuse in

particular circumstances, it might be helpful to include safe-

guard mechanisms that automatically “turn off” treaty benefi ts

in response to a particular type of abuse. This can be tailored to

the particular context of each treaty, as was the case with the

Luxembourg treaty.

81. See generally, e. g., Anthony C. Infanti, Curtailing Tax Treaty Overrides:

A Call to Action, 62 U. PITT. L. REV. 677 (2001).

82. Avi-Yonah, among other scholars, supports treaty overrides based on

the ar gument that treaty partners usually face the same abuse problems and,

therefore, may be amenable to the override. See Avi-Yonah, supra note 21, at

65.

83. Id.

84. See supra Part II.C.

1180 BROOK. J. INT’L L. [Vol. 41:3

4. Systemic Abuse of a Single Treaty: Renegotiation or Termi-

nation

The U.S. experience in treaty terminations tells a very partic-

ular story: treaties are terminated when, in the context of a par-

ticular treaty, two factors converge. The first factor involves

when the treaty is systematically abused (or has the potential

for systematic abuse). In some cases, such as in the BVI and the

Netherlands Antilles Treaties, the abuse seems to have been

supported (if not encouraged) by the treaty partner. The second

factor is that the abuse (or the potential for it) is large in com-

parison to any legitimate uses of the treaty. In such context, the

treaty functions primarily as an avoidance instrument, and not

as an instrument that alleviates double taxation and supports

investment.

It may be reasonable to renegotiate a treaty before terminat-

ing it. But, it does not seem necessary. In fact, negotiation may

only prolong the period of abuse. If it is apparent that a treaty

can only serve as an instrument of abuse, why have it at all?

Termination solves the problem immediately. At the same time,

few innocent taxpayers are harmed by the termination, since lit-

tle (if any) legitimate cross-border dealing is ongoing between

the treaty jurisdictions. For example, in the context of the Car-

ibbean extension terminations, the Treasury reasoned that

because of the minimal flows of investment between the United

States and these jurisdictions and because abuse of these trea-

ties by third country residents had not yet become widespread,

the economic impact would not be great. If, however, termina-

tions were delayed, and treaty shopping abuses became wide-

spread, there could be a far more severe impact.

Not only that, the termination sends a strong message to both

taxpayers and treaty partners that abuse will not be tolerated.

There is, of course, a potential political cost to termination.

When the United States terminated the BVI treat y, some mem-

bers of Congress were critical. It was suggested that the Treas-

ury’s decision “to request a renegotiation of the terms of the

treaty it agreed to only a few months earlier br[ought] into ques-

tion the country’s adherence to bilateral agreements whic h

85. See Regan, supra note 59.

86. Supra note 64.

2016] Treaty Terminations 1181

might have reperc ussions far beyond the circumstances of this

tax treaty.”

Such fear is unfounded. The United States is hardly the only

country in the world that has to deal with tax avoidance and

evasion through tax havens. Other jurisdictions face the same

problem. It is more likely that such jurisdictions would view

treaty terminations with tax ha vens favora bly, as it prevents

U.S.-based investors from using tax havens to avoid taxes in

other industrialized jurisdictions. The United States’ economic

relations with non-haven jurisdictions are much more substan-

tial than its relations with tax havens. The political gains of fa-

vorable perception by non-haven jurisdictions—appreciating the

fact the United States takes the lead in engaging a shared prob-

lem—likely outweighs any political repercussions.

B. Government Abuses Versus Taxpayer Abuses

Another way to functionally categorize unilateral respons es to

treaty abuse is based on the identity of th e main offender.

Clearly, in all instances of abuse, taxpayers benefit from lower

tax bills. But in some instances, the abuse is encouraged, or even

facilitated, by the treaty partner (as thought to be the case of the

Netherlands Antilles treaty).

If taxpayers take advantage of a treaty in a manner that is

inconsistent with the intention of the treaty partners, the re-

sponse should be taxpayer focused. The idea here wou ld be to

close loopholes, for example, through an override. However,

when a problem is persistent across multiple treaties and also

broad in scope, an override might not solve the problem. In such

a case, there is a need to renegotiate the treaties with all treaty

partners, such as in the case of the LOB provision. Since the in-

terests of the negotiating parties are largely aligned, there is a

good chance that the effort will be successful.

If a treaty partner facilitates or encourages the abuse, the re-

sponse should target the treaty partner, and not taxpayers who

simply take advantage of opportunities provided by the treaty

87. Letter from Guy Vander-Jagt, Ways and Means Comm. Member, to Don-

ald T. Regan, Treasury Sec’y (Oct. 6, 1981), reprinted in 13 TAX NOTES 1200

(1981).

88. Some industrialized jurisdictions have even foll owed suit. For example,

Norway terminated its own treaty with BVI in 1988––though a new treaty was

concluded in 2009, and entered into force in 2011––as did Denmark, and Japan

in 2001.

1182 BROOK. J. INT’L L. [Vol. 41:3

partner. Termination can thus be categorized as a government-

centered response. These ideas are illustrated in the flowchart

below.

Figure 2: A Flowchart of Unilateral Responses to Treaty Abuse

The main idea prescribed by the flowchart is that termination

is a correct solution in instances where the abuser is the treaty

jurisdiction rather than taxpayers. Termination is not a last re-

sort response to treaty abu se. It is simply the correct response to

abuse of a treaty by a signatory state.

ONCLUSION

Recent years have seen a dramatic increase in the attention

given to abusive tax schemes using double-taxation treaties. The

ensuing discourse tends to view potential responses to treaty

abuses as a hierarchical set of options, gradually escalating,

where treaty termination is a last resort option.

This article explains that responses to treaty abuse are a func-

tion of the type of abuse, and that they are not hierarchically

ordered. Additionally, this article also offers a taxonomy of po-

tential unilateral responses to treaty abuse. The argument

brought forward is that the nature of the response depends on

2016] Treaty Terminations 1183

the geographical breadth of the abuse, and the breadth of sub-

stantive abuse.