Clarification from Dr. Walby on Section 905
Joshua forwarded this response from Dr. Walby:
There was a post regarding section 905 on your blog. Here is an explanation and reason for it being included in the FairTax Act. Karen
Karen Walby, Ph.D.
Research Economist
SEC. 905. WITHHOLDING OF TAX ON NONRESIDENT ALIENS AND FOREIGN CORPORATIONS.
(a) IN GENERAL- All persons, in whatever capacity acting (including lessees or mortgagors or real or personal property, fiduciaries, employers, and all officers and employees of the United States) having control, receipt, custody, disposal, or payment of any income to the extent such income constitutes gross income from sources within the United States of any nonresident alien individual, foreign partnership, or foreign corporation shall deduct and withhold from that income a tax equal to 23 percent thereof.
(b) EXCEPTION- No tax shall be required to be deducted from interest on portfolio debt investments.
(c) TREATY COUNTRIES- In the case of payments to nonresident alien individuals, foreign partnerships, or foreign corporations that have a residence in (or the nationality of a country) that has entered into a tax treaty with the United States, then the rate of withholding tax prescribed by the treaty shall govern.
Explanation — Under current law, there is a 30 percent withholding tax on dividends, interest and other periodic payments to foreign individuals (non-resident aliens) and foreign corporations. Most foreign countries have similar taxes. However, the U.S. has entered into treaties with virtually every major trading partner. These treaties reduce this tax from 5 to 15 percent and in some cases to zero on a reciprocal basis. Thus, U.S. corporations and U.S. individuals investing abroad pay lower taxes to foreign governments and foreigners investing here pay lower taxes to the U.S. government. [See the text of a press release from the Treasury Dept announcing the signing of one of these treaties at the end of this email.]
If the FairTax were put in place, and there was no withholding tax on nonresident aliens and foreign corporations, foreign governments could be expected to withdraw from their tax treaties with the U.S. Retaining them would be of virtually no value to their residents or corporations and withdrawing would enable them to collect higher taxes on the U.S. residents and the U.S. corporations who have invested in those markets. The withholding tax provision in HR25 gives them a reason to keep their tax treaties in place and their taxes on U.S. businesses low.
In regard to Sec. 905, it is not an income tax, it is a tariff (in the form of a gross receipts tax) on payments to non-resident aliens and foreign corporations that is reduced by treaties with most industrialized countries to 5 or 10 percent. If this section were omitted from HR25, there is every reason to believe that other countries will revoke their existing treaties with the U.S. and try to impose confiscatory taxes on U.S. businesses trying to return capital to the U.S.
The US Constitution gives the federal government the power to make treaties. The 16th amendment is not necessary.
—–Original Message—–
From: bounce-2252114-1432965@lists.treas.gov [ mailto:bounce-2252114-1432965@lists.treas.gov] On Behalf Of treas-taxes
Sent: Wednesday, May 03, 2006 11:35 AM
To: US Treasury Release: Taxes
Subject: [US Treasury] United States and Denmark Sign Protocol to Income Tax Treaty
UNITED STATES AND DENMARK SIGN PROTOCOL TO INCOME TAX TREATY
This Department of Treasury press release may be viewed at:
http://www.treas.gov/press/releases/js4231.htm
Washington – Today the Treasury Department announced that U.S.
Ambassador James P. Cain and Danish Tax Minister Kristian Jensen
signed a new Protocol to amend the existing bilateral income tax
treaty, concluded in 1999, between the two countries. The Protocol
was signed Tuesday.
The agreement significantly reduces tax-related barriers to trade and
investment flows between the United States and Denmark. It also
modernizes the treaty to take account of changes in the laws and
policies of both countries since the current treaty was signed. The
Protocol brings the tax treaty relationship with Denmark into closer
conformity with U.S. treaty policy.
The most important aspect of the Protocol deals with the taxation of
cross-border dividend payments. The Protocol is one of a few recent
U.S. tax agreements to provide for the elimination of the
source-country withholding tax on dividends arising from certain
direct investments and on dividends paid to pension funds. The
Protocol also strengthens the treaty’s provisions preventing so-called
treaty shopping, which is the inappropriate use of a tax treaty by
third-country residents.
Despite the very clear wording in the HR25 bill that section 905 deals with an income tax, and despite the fact that most of the tax treaties with our trading partners are called income tax treaties, the AFFT Director of Research, Dr Walby, wrote that it wasn’t an income tax after all, but a tariff. That’s fine with me, but it then raises a question as to just why Section 905 is needed at all. Why not just leave the present system of “tariffs” in place? Let the State Department negotiate the treaty terms, and let the residual IRS organization implement, monitor, and enforce the treaty provisions in just the same way they do today. The Fairtax does not propose to replace revenue sources such as excise taxes, tariffs, or customs duties. Why garbage up the consumption tax bill with these pseudo income tax provisions? It’s unnecessary, and, because Kotlikoff didn’t include any revenue from this source in his base/rate study, the rate would not change.
Hank
I will agree with you unless wording in the current Internal Revenue Code specifies a base tax rate that can be amended by treaty. If the base rate is zero after elimination of the current IRS code, there is no starting point for negotiations. Foreign governments would have no incentive to reduce their tax rates on similar items to the level of US rates.
The current law states 30% and that is the default unless you amend via treaty. Most other countries do similar things, essentially imposing a traiff on all foreign business.
If we just completely dropped our tariffs, we would almost certainly find those treaties protecting our business’s ability to operate overseas tossed out.
However, Milton Friedman believed and many other Austrian economists believe that zero tariffs would actually do a lot of good for our economy even if other countries did not follow suit.
Somewhat off topic, but still unfortunate:
The three presidential candidates running for president with the most support and highest likeliness of winning (debatable, yes, but close enough) are against Fair Tax; Clinton, Obama, and Giuliani. One knows what Fair Tax is and is against it, and will remain against it. One knows nothing about it, probably thinks she does, and could possibly change position on the issue once she is informed by someone who actually knows what they are talking about. The third one has spoken little about the issue but shows no support. Even if Fair Tax passed through the House and the Senate, it is guarenteed to be set back at the very least 4 more years if one of these candidates win.
James/Marvin,
Let me try again. From your comments it seems that you have forgotton that the Internal Revenue Code is not going to be eliminated by HR25. All HR25 does is remove sub-title A (income tax), B (estate/gift tax), C (payroll taxes), and also H (Financing Presidential Elections). I think that there will still remain seven of the eleven current sub-titles in the IRC. These include all excise taxes, Administration, Trust Fund Code, Joint Committee on Taxation, Coal industry health benefits, and group health plan portability.
My point in commenting on Dr Walby’s clarification on
Section 905 was that if the treaty taxes are not income taxes, but instead are tariffs, then it seems to me that the Code changes in HR25 might not affect the current tariff implementation and enforcement actions by the IRS or whatever the appropriate government agency might be?
On the other hand, if the tax is a tax on gross income as HR25 so states, and the treaties seem to indicate, then Section 905 would certainly be necessary, Milt Friedman notwithstanding.
I’m still curious as to why no revenue from this source is identified in the Kotlikoff studies? Or is it just a small amount caught up in Corporate Income taxes?
Probably not worth nattering about, particularly in light of the gloomy forecast by Brendan regarding our next President?
Brendan is right there is a lot of ignorance about the Fair Tax amongst politicians. You will be amazed at how enlightened they will become when a politically meaningful mass of voters supports the plan. I doubt that any preesident would veto a tax bill that was passed by both houses of congress with popular support from the people.
You may well be right that it will take another 4 years of grass roots activism to force the politicians to accept the tax. This fight is a marathon not a sprint.
Hank
I plead guilty to making an assumption without thorough research. I believe you are right that the sections of the IRS code mentioned will remain intact. I don’t understand the reference to gross income. Don’t they mean net income? Isn’t the amount of tax on foreign corporations related only to the gross amount of dividends to the parent company?
If any corporation were taxed at 23% or 30% of gross income, they would soon be out of business.
Marvin,
Well, this quote from the bill: ” –any income to the extent such income constitutes gross income from sources within the United States–” isn’t ambiguous and isn’t limited to just dividends. But then again, the Walby clarification said the tax was just a tariff? There is a disconnect here somewhere.
If it’s a tariff, then Sec. 905 isn’t required. Leave the status quo alone! If it’s an income tax, then the bill needs rewriting.
Stay tuned!
I think you’ve misunderstood Dr. Walby here.
The current law withholding tax of 30% on payments to foreign individuals and corporations is NOT a tariff today, it is an income tax, and it is part of an intentional plan to have ammunition to encourage lower taxation with foreign countries (i.e. leverage in tax treaties).
However, the Internal Revenue Code post-FairTax would not include these taxes on foreign corporations and individuals anymore if Section 905 was not included. The law in question in the current code exists in Subtitle A, Income Taxes, Chapter 3, Sections 1441-1464 and is specifically repealed by HR25 by Section 101, which repeals the entirety of Subtitle A of the Internal Revenue Code of 1986.
Sans Section 905, this would mean that for a foreign corporation there would be no tax in the USA to operate there, and therefore no reason to be in a tax treaty with the USA, and further, no reason to give US corporations a tax break within their borders.
With Section 905 in place, it maintains the framework of existing tax treaties without significant disruption.
Not disputing what HR 25 says. Just find it hard to believe they are using the same definition of gross income that I understand. To me Gross income means Sales minus sales returns less cost of goods sold. It does not include all other expenses such as interest, income taxes, selling and administrative expenses. This will truly be enough to force any country into negotiations or the corporation into bankruptcy.
I should add that the Section 905, FairTax idea is a tariff, not the original income tax code withholding income from foreigners.
Marvin, that’s pretty much the idea. Virtually every country has very high income tax rates levied against foreign corporations no matter where they are from, and the tax treaties have risen up to bring it down to a reasonable level for all involved.
This section should be easier to negotiate with as it is already lower than the current law, but makes sure not to change any existing treaty amounts.
Effectively, this should result in there being no significant change in tax for any treaties country, and that’s the desired result.
Hmm… might it not be even better to write into law that we will set tax rates on foreign corporations in a reciprical manner. In other words, whatever tax rate is applied on our corporations in a foreign country will be applied on theirs here.
That is effectively what happens via the tax treaties today, I believe.
I couldn’t understand some parts of this article cation from Dr. Walby on Section 905 :: The Fair Tax Blog, but I guess I just need to check some more resources regarding this, because it sounds interesting.