Weaponizing Tax Treaties: Time To Get Tough With Russia And Cyprus

David Morse of the Coalition for a Prosperous America and Martin A. Sullivan of Tax Notes discuss what the United States’ tax response to Russia’s invasion of Ukraine should be.

This transcript has been edited for length and clarity. Watch the shortened video here. For the full interview, watch the video below.

Robert Goulder: Hello everyone. I’m Bob Goulder, contributing editor with Tax Notes. Welcome to the April edition of In The Pages, where we take a closer look at some of the recent content from our print and online publications.

This month we have two featured articles. The subject matter will be familiar to you. We’re looking at the Russian invasion of Ukraine. Should the package of U.S. economic sanctions extend to tax policy? Specifically, should the Biden administration terminate the U.S.-Russia tax treaty?

To help us sort through this, we have some exceptional authors. First we’ll talk to David Morse, tax policy director with the Coalition for a Prosperous America. His piece is titled, “Going Beyond a Simple Treaty Withdrawal.” Later in the segment we’ll be joined by Martin A. Sullivan, economics contributor to Tax Notes. His piece asks the question “Can Cypriot Conduit Companies Provide Treaty Benefits to Russians?”

With that in mind, let’s get started. David Morse, welcome to In The Pages.

David Morse: Thank you very much, Robert.

Robert Goulder: The readers of Tax Notes are going to think that tax treaties are pretty important things. So do the corporate multinationals who rely on them. They can reduce withholding taxes, they can relieve double taxation, and in our little world these are important things. Something tells me that Vladimir Putin just doesn’t care about tax treaties.

With that in mind, what is the argument for terminating the tax treaty? If it’s not going to deter Putin’s aggression, why do it?

David Morse: I have to agree with you. It’s not going to affect Putin.

If you look at what he’s been willing to sacrifice for a military victory and the unfortunate and horrific death on the part of Ukrainian civilians, to think that a simple tax treaty withdrawal will even blip on his radar is incredible. I don’t think it’s something that will have an effect on him, but that doesn’t mean that we have to fund Putin’s war.

You’re absolutely right, as you explained it. Tax treaties smooth the system, they make trade and financial transactions easier between the two countries. But in my opinion, it’s like a trade benefit. And certain trade benefits don’t need to stay around when you have an aggressor, a nation that invades an ally, destabilizes a region, and commits atrocities.

If you look at it, you’re looking first at the idea that you’re signaling the rest of the world. You’re telling them we do not accept this, even if we have a preexisting agreement. There is something that we expect out of you, out of that agreement. There was a promise, it’s implicit. In the Russia-U.S. tax treaty, the promise was that Russia would be a peaceful partner in the global economy. We encouraged production in Russia, by American companies, to produce goods that ended up getting sold back to the United States.

Now, I have my own issues regarding that, considering reshoring. But we thought that would be enough to check the authoritarian tendencies. Obviously, we were wrong and you have to deal with those consequences.

If you go beyond that symbolism, as the end of the treaty comes around, the tax benefits on U.S.-source dividends and related-party interest will end for Russians. Now, when you think about who in Russia is actually investing in our country, these are probably the kleptocrats; they are the most likely beneficiaries of these tax benefits as they currently stand. We’re not talking about the Russian middle class mostly. That’s a rare thing for economic sanctions.

Many times, unless you specifically target and name a person, the generalized economic sanctions hit the everyday person. Geopolitically, I think this is a wise policy. It means less money flowing into the upper echelons of the Russian government. I think that’s a good thing.

Robert Goulder: Right now today, if you had President Biden’s ear, what would you tell him about countering Putin’s aggression in terms of tax policy? One thought.

David Morse: My temptation here is to immediately run sales-factor-apportionment by him, and to argue that taxation on a pure destination-based territorial system would remove most of the underlying issues for tax policy.

Realistically, Ukraine is not a problem that will be resolved with just tax or trade policy. I’m not sure Russia is ready for a prolonged NATO war. I will admit that I’m worried the U.S. isn’t ready either. Ukraine needs a strong U.S. and a strong NATO to keep them armed, and to help the Ukrainian refugees supplied, fed, and housed.

So, I think that I’d start with the following: Mr. President, you campaigned on Build Back Better. You realized there was inherent weakness in our capabilities and COVID-19 proved you right with the bridled supply chains.

Please prioritize a return to the arsenal of democracy. Tax policy, trade policy, and economic policy that prioritizes domestic companies and domestic production.

Arsenals are not just weapons. They’re also the support structures for food, supplies, and the supply chains for critical resources. Right now, we do have inherent weaknesses if we were cut off from critical resources. We’d have to prioritize ourselves over Ukraine.

Now that would be my statement. I think the administration actually sees these issues. I think they’re actually working on them, but I think they’re also trying to resort to half measures, and not jolt the system.

If a recession is coming, as people are predicting, higher domestic production with a purpose can only be a good thing. Increasing American production to provide for Ukraine seems like a strategic and beneficial investment to me. I’d advise them, and the rest of Congress, to emphasize and speed up reshoring of critical supply chains, especially from potential adversaries.

Robert Goulder: David, thank you for joining us. Moving on to the second of our featured articles, I am joined by economics contributor Martin Sullivan. Marty, thanks for being on the show.

Martin A. Sullivan: Thanks for having me, Bob.

Robert Goulder: Marty, all this news about Russia and Ukraine. It’s terrible stuff. What can we do? Terminate the tax treaty, right?

But the first time I mentioned that to somebody they shook their head and said, no, you don’t get it. It’s not going to do any good because the Russians use conduit entities. They’ll go through some other nation, maybe a host nation that’s a member of the European Union. Maybe a host nation with its own U.S. tax treaty.

Now, you sat down and did some research. You crunched some numbers, as you typically do. What did you discover when you scrutinized the data?

Martin A. Sullivan: Two things. One is that the Cyprus economy and the Russian economies are very intermingled. You can’t really talk about one without acknowledging the other.

The second thing is that a lot of it is just conduit activity, not real economic activity. That was a real eye-opener for me. I must have read 50 posts on the internet about Cyprus being “Moscow on the Mediterranean,” and how the two economies are intermingled. But until I saw the data, it didn’t really hit home. It’s absolutely incredible.

Robert Goulder: Why Cyprus? Does it have strange tax rules, or lax banking rules? Does it have a light touch in terms of the regulatory environment? You could say that about a lot of countries, but is there something here where Russia got their hooks into Cyprus, and Cyprus became dependent and fell into the Russian sphere of influence?

Martin A. Sullivan: Well, I can’t answer your question of why Cyprus. But I can give you some background, which is that Cyprus used to be a dependency of the United Kingdom and in 1960 it became independent. Take a look at a map of the Mediterranean when you have nothing else to do. Cyprus is all the way on the eastern side, close to Syria. So, that’s one thing.

Their agricultural sector is not very well developed. As you know, when the Berlin Wall came down in 1989, the Soviet Union came apart. That’s when the Russians came to Cyprus with lots of money, buying real estate, buying yachts, in some cases buying citizenship. It transformed that little Cypress economy from agrarian, tourism, and shipping into more of a financial hub.

Then, what made it even more attractive, was in 2004 Cyprus became part of the European Union. In 2008 it adopted the euro, and don’t forget that they use British law. Apparently, from some sources I’m reading, what really attracts Russians to Cyprus is that the legal system gives them property rights they may not enjoy in Russia or other jurisdictions. And you mentioned the light regulation. And, of course, Cyprus has very low tax rates.

It has a not-undeserved reputation of being a little bit dicey when it comes to the rules and regulations. There are other things. It’s sort of like Naples, Florida, is to a Minnesotan. I imagine Russians really enjoy living in Cyprus. There are an estimated 40,000 Russian residents in Cyprus.

Robert Goulder: There you have it. Stay tuned for more coverage of this issue in future editions of Tax Notes. Marty, thank you for joining us.

Martin A. Sullivan: Thank you, Bob.