Cross-border investments and operations have become commonplace for many multinational corporations and investment funds. In fact, the United States was the largest direct investor abroad in 2016, with foreign investments that year totaling $312 billion, according to the Department of Commerce.
In addition, expenditures by foreign direct investors to acquire, establish, or expand U.S. businesses totaled $260 billion (preliminary) in 2017, according to the Department of Commerce, and such “inbound” investment may increase as a result of recent U.S. tax reforms.
The U.S. and countries around the world have put into force more than 3,000 treaties aimed at encouraging and protecting foreign investment. Investment treaties protect foreign investors from certain actions by host countries that might seek to improperly undermine or even seize their investments. International tax treaties, on the other hand, mitigate the tax burden of cross-border operations and investments.
The international treaty landscape is changing. That means companies that make cross-border investments have to be increasingly vigilant about treaty planning. If you have invested or are considering investing cross-border, here are some things you need to know:
What are investment treaties?
Investment treaties are agreements between two or more countries whereby the countries agree to meet particular standards on how they will handle investments by investors from each other’s country. These agreements typically include an agreed framework for resolving disputes between the investor and the host country, usually giving an investor a direct right of action in arbitration against the country itself.
A company might be more amenable to investing in a foreign country if that country has an investment treaty in place.
“Investment treaties have become an important method by which investors in foreign countries can protect themselves from political and legal risks and regulatory abuses by giving them specific protections and the right of direct claims against the host country,” said James Loftis, the head of V&E’s International Dispute Resolution practice.
What are some types of investment treaties?
The vast majority are bilateral investment treaties (BITS). BITS are signed by two countries and protect companies from one country that invest in the other country.
Multilateral investment agreements (MIAs), involve multiple countries and are often focused on a particular geographic area, or industry. Examples of MIAs include the North American Free Trade Agreement (NAFTA) and the Energy Charter Treaty.
What types of protections do investment treaties provide?
Each treaty is specific to the parties involved and while most are based on model treaties, they do differ, so it is important to fully understand the protections that are offered and the investment to which these protections apply.
Generally speaking, treaty protections extend to qualifying investments made in a country by investors from another country. Treaties typically cover a broad range of forms of investment, such as locally incorporated entities, rights in minerals, licenses, contractual rights, shareholdings, rights to money, and intellectual property rights.
Protections offered by treaties include: fair and equitable treatment, treatment at least as good as a host-country company would receive, full protection and security (such as protection from riots or from the military destroying a company’s facilities), and expropriation. Typically, the right to expatriate capital is also guaranteed, as well as the right to use expatriate staff in management positions.
“A treaty may protect you from the consequences of certain legal and political risks such as expropriation, nationalistic economic policies, and targeted discrimination against foreign investors,” Loftis said.
What is involved in investment treaty planning?
With the help of an attorney, companies should analyze the protections available to them before making an investment in a foreign country.
Even if a particular host country does not have a treaty with the U.S., a company might still be able to secure protection by investing through a company organized in a country that does have such a treaty with the intended host country.
For example, a party investing into Nigeria might use a Dutch subsidiary, held in turn by a United Kingdom company, which in turn may be held by an ultimate investor resident in a jurisdiction that does not have a treaty with Nigeria. If Nigeria were to expropriate the investment, causes of action could be made under both the Nigeria/U.K. BIT and the Nigeria/Netherlands BIT, even though the country of the ultimate investor does not have a BIT with Nigeria. Such a structure is beneficial because the two BITs offer slightly different protections and each may be more helpful depending upon the situation.
What are some important new developments related to investment treaties?
Countries that have been the subject of claims have been trying to renegotiate or even rescind their treaties.
“Treaty planning has been so successful, in some respects, that some countries are now trying to back away,” Loftis said.
“Some countries have said, ‘Enough, I don’t want to be sued anymore,’ and have renounced their treaties. Some have demanded waivers of treaty rights. Some refuse to comply.”
“Even countries that are not normally thought of as major risks are trying to limit the abilities of these treaties to circumscribe their freedom to act in ways that affect foreign investors,” Loftis added. “Sorting the wheat from the chaff is an increasingly complex problem.”
Keep in mind, investment treaty planning should not be done in a vacuum, rather companies need to consider tax consequences as well.
“Taxes always matter, investment treaties only sometimes matter,” Loftis said. “Clients do the tax planning first, and then, within the context of a favorable tax structure, will try to find a favorable investment treaty structure.”
What are international tax treaties?
Tax treaties are agreements whereby two or more countries, in an effort to promote cross-border investments and trade between the countries, agree to share authority to tax a value chain in a manner that is sensible and efficient.
“The entire purpose of tax treaties is to avoid subjecting a stream of income to an overly burdensome amount of tax, to try to reduce or eliminate double or, even in some cases, triple taxation of the same stream of income,” says V&E tax partner Jason McIntosh.
How do international tax treaties work?
Tax treaties typically focus on the movement of capital or income from one treaty country to the other, such as a dividend or a payment of interest from a foreign subsidiary to its parent company or the recognition of gain from the sale of stock of a foreign subsidiary.
Such treaties often reduce or eliminate any tax that the foreign country might impose on such repatriation of the income, based on the theory that the taxpayer will be subject to tax on the repatriated income in its home country and the foreign subsidiary will be subject to tax on the underlying operations in its home country.
“For example, when a Mexican subsidiary distributes cash back to its U.S. parent as a dividend, generally the U.S./Mexico treaty would be focused on reducing any Mexican withholding tax on the dividend,” McIntosh said.
What are some important new developments related to international tax treaties?
Tax treaty planning has undergone a dramatic shift over the last few years.
The Tax Cuts and Jobs Act, enacted by the U.S. in late 2017, includes significant reforms related to international taxation. Among other things, the new tax law moved the U.S. closer to a “territorial” tax system and added new rules designed to combat perceived abuses of treaties and the international tax system. Those perceived abuses include structures that use “hybrid” instruments and entities that obtain favorable treatment because the two countries are not on the same page about how to treat them from a tax perspective.
In addition, the traditional tax treaty paradigm, in which a pair of countries would negotiate tax treaties between themselves, is shifting toward a more coordinated approach. In an effort to mitigate “treaty shopping,” the Organization for Economic Cooperation and Development (OECD) decided there needed to be a more cohesive way for countries to agree on how to grant treaty benefits in particular situations. In 2017, the OECD introduced the Multilateral Instrument, and as of June 29, 2018, 82 parties had signed. For many of those countries, the MLI will come into effect in 2019.
“When a country signs the MLI, it is essentially entering into a treaty with all the other signatories of the MLI to establish some common ground rules as to when and how a taxpayer can take advantage of tax treaties between those countries,” McIntosh says.
Has the U.S. signed the MLI?
As of mid-July 2018, the U.S. had not signed the MLI. The Treasury Department has indicated that the MLI is consistent with U.S. tax treaty policy that the Treasury Department has followed for decades and seems to view the MLI as unnecessary where the U.S. is concerned.
In light of these changes, what action should companies take?
If you are engaging in cross-border investments or operations, you need to be mindful of the provisions within the MLI, some of which set a higher bar for obtaining treaty benefits than under previous bilateral treaties. Companies should consider the impact the MLI might have on their current tax treaty structure, and if necessary, make adjustments. In addition, U.S. investors making investments abroad and non-U.S. investors investing in the U.S. should consider the impact of recent tax reforms, which could significantly impact their treaty structures.
“Treaty structures you already have in place will need to be reevaluated and may not achieve the goals that they achieved when you originally put them in place,” McIntosh said “Similarly, future investments will need to be setup under a new set of rules, and traditional wisdom and ways of doing things may no longer apply.”