Should The United States Terminate Its Tax Treaty With Russia?

Given the exceptional circumstances of the Russian invasion of Ukraine, all weapons at our disposal are likely to be scrutinized, including changes in tax law.

Should the United States terminate its treaty with Russia? And should the United States deny tax credits for income taxes paid to the Russian government?

To the tax community already overwhelmed with myriad U.S. and OECD international rule changes, both proposed and recently instated, mixing tax and foreign policy isn’t a welcome prospect — especially if it is questionable that tax changes would promote nontax policy goals.

A May 2021 report from the Atlantic Council on possible sanctions against Russia stated: “The West has two great weapons in its reserve, which are better kept there, but could be used in an all-out war. One is freezing Russia’s Central Bank reserves . . . as happened with the central bank reserves of Iran and Libya. Another ultimate weapon is to take Russia out of the SWIFT payment system, as was done with Iran.”

On February 26 in response to the Russian invasion, the United States and its allies announced their commitment to deny Russia’s largest banks access to SWIFT and to prevent the Central Bank of Russia from deploying its $600-plus billion of international reserves.

“In one fell swoop, the U.S. and Europe have rendered Putin’s war chest unusable,” said the former State Department lead on Russian sanctions, Edward Fishman, about the reserve freeze. “Just 72 hours ago a step like this was unthinkable,” he added.


But why on one hand impose punitive trade and financial sanctions on countries considered bad actors, while at the same time provide favorable tax treatment to those countries?

In 2020 Benjamin M. Satterthwaite highlighted a discrepancy that is even more glaring in light of current developments. “Russia is a terrific example of a country where U.S. income tax law provides few barriers to investment, but several difficulties are imposed in other areas of the law. The majority of foreign capital investment in Russia is American, and an active tax treaty further facilitates financial outflows. Yet possession of Russian assets is heavily penalized under an array of sanctions affecting large swaths of the Russian economy.”


Sometimes the U.S. government provides tax benefits to promote foreign policy goals. In its epic post-World War II struggle against communism, the United States used tax treaties to reduce double taxation as part of its overall program to promote economic growth in Western Europe and Japan.

And in 1954, the IRS issued GCM 28595, which stated, “The maintenance and continuation of a supply of oil from the Middle East is a vital military necessity for the preservation of the Western World,” thereby approving the creditability of Saudi Arabian “taxes” under section 901.

In 1962 when President Kennedy tried (unsuccessfully) to enact a general termination of deferral of U.S. tax on unrepatriated foreign profits, he included an exception for developing countries. “The free world has a strong obligation to assist in the development of these economies, and private investment has an important contribution to make,” he stated. “Continued tax deferral for these areas will be helpful in this respect.”

Following the collapse of the Soviet Union, President George H.W. Bush sought to promote economic growth in former Soviet republics and made tax treaty negotiations with Russia, Ukraine, and Kazakhstan a priority.

In their formal submissions of tax treaties for Senate approval, Bush (in August 1992 for Russia) and President Clinton (in September 1994 for Ukraine and Kazakhstan) expressed their hope that the treaties would be an important impetus to each country’s “emergence as a market economy by encouraging and facilitating greater U.S. private sector investment” in those countries.

In other circumstances, instead of providing tax benefits, the United States imposed new tax burdens to promote foreign policy goals.

In the Omnibus Budget Reconciliation Act of 1986, Congress added section 901(j). Under this law, foreign tax credits cannot be claimed for taxes paid to governments with which the United States does not conduct diplomatic relations or that the secretary of state has determined have repeatedly provided support for acts of international terrorism: Currently, Cuba, North Korea, Iran, and Syria are so designated.

Per-country limitations on the foreign tax credit are applied to these listed countries so credits from other countries’ taxes cannot be used to reduce the burden of listed country taxes. Iraq and Libya were on that list but have since been removed.

Examples of the United States unilaterally terminating a tax treaty are few and far between. In June 1987 the Treasury Department announced the termination of the tax treaty with the Netherlands Antilles. The issues in that incident have little in common with the tensions of the international crisis we see today.

Probably the most relevant historical precedent is the anti-apartheid sanctions that the United States imposed on the Republic of South Africa during the 1980s. With a 313-83 vote in the House and a 71-21 vote in the Senate, Congress overrode the veto by President Reagan to enact the Comprehensive Anti-Apartheid Act of 1986.

Make no mistake, the more numerous and significant sanctions in that legislation — for example, on trade and financial institutions — had nothing to do with tax. However, section 313 of that law directed the secretary of state to immediately take steps to terminate the South Africa-U.S. income tax treaty that had been in force for nearly 40 years.

Adding to the tax disincentives for investment in South Africa, the Omnibus Budget Reconciliation Act of 1987 designated income taxes paid to the government of South Africa (under section 901(j)(2)) ineligible for the foreign tax credit and expanded subpart F to deny deferral of U.S. tax on profits generated by U.S. multinationals in South Africa.

The Joint Committee on Taxation estimated the denial of those credits would raise $57 million over three years. That was a burden not on the South African government but on U.S. companies doing business there.

The tax sanctions on South Africa did not last long. In July 1991 Bush issued Executive Order 12769. Having concluded that the government of South Africa had met all the conditions specified in the 1986 law, including the release of all political prisoners and repeal of the ban on political parties, Bush announced the termination of all sanctions.

In 1993, finding that “economic sanctions toward the apartheid government of South Africa . . . helped bring about reforms in that system of government,” Congress enacted the South African Democratic Transition Support Act of 1993. That act reinstated the foreign tax credit for South African income taxes and authorized Clinton to negotiate a tax treaty with South Africa. A new tax treaty between the United States and the Russian Federation took effect January 1, 1994.

Several experts at Tax Analysts expressed doubt about the advisability of denying foreign tax credits to Russia. Although the hoped-for long-term effect would be to reduce investment in Russia, which would pressure the government to change its course of action in Ukraine, the immediate adverse financial effect could be on U.S. companies. And worse still, distressed U.S. companies might sell their businesses to Russian investors at a discount.

Marcia Field, a former Treasury official who participated in the negotiation of the Russian treaty, pointed out that abrogating the treaty would raise other countries’ doubts about the reliability of U.S. tax treaty negotiators.

She added, “I don’t think revocation would cause Putin to blink an eye.” As a purely symbolic matter, she suggested we might give notice of our intention to terminate the treaty in accordance with its terms, but that would be a long process, with limited immediate effect.

Without treaty protection, Russian investors in the United States would be subject to 30% of the U.S. withholding tax on U.S.-source dividends and related-party interest paid to residents of Russia. That could be a setback for Russians investing in U.S. real estate.

Under section 897, any gain recognized by a foreign person on the disposition of a U.S. real estate is treated as gain from an effectively connected U.S. trade or business and is therefore subject to U.S. federal income tax.

However, as explained by Jeffrey L. Rubinger and Bilzin Sumberg, Russian investors can shield that gain from U.S. tax if the investment takes the form of a loan with an equity kicker. Under U.S. regulations, the gain on disposition is considered interest and not capital gain. Under the Russia-U.S. treaty, all interest income is exempt from U.S. withholding tax.

Beyond withholding treatment, termination of the treaty would trigger other detrimental consequences such as loss of the more favorable threshold for what constitutes a permanent establishment and loss of the competent authority mechanism for dispute resolutions.

Moreover, termination of the Russian-U.S. treaty would do nothing to harm Russians investing in the United States who are able to circumvent limitation on benefits provisions in U.S. treaties with other foreign nations. The Cypriot offshore sector isn’t nicknamed “Moscow on the Mediterranean” for nothing.

Robert Goulder contributed to this article.

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