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Territorial-based Income Taxation as International Ostracism

Tax­es not only serve to raise pub­lic rev­enues but also to shape the behav­ior of tax­pay­ers, and thus of the econ­o­my as a whole.  The tax neu­tral­i­ty of Adam Smith is, there­fore, the most hyp­o­crit­i­cal aspi­ra­tion of any tax pol­i­cy.  Impor­tant­ly, gov­ern­ments today not only seek to shape the behav­ior of its res­i­dents, but also of the for­eign­ers who inter­act with the country—thereby trans­form­ing the ter­ri­to­ri­al­i­ty of tax juris­dic­tion into anoth­er hypocrisy.  And the effects of this phe­nom­e­non have an increas­ing impact on inter­na­tion­al pol­i­tics, as well as cer­tain trade poli­cies did in oth­er not so far times.

On Octo­ber 26, 2011, the Com­mit­tee on Ways and Means of the U.S. House of Rep­re­sen­ta­tives issued a dis­cus­sion draft for a “com­pre­hen­sive tax reform” of the U.S. inter­na­tion­al tax­a­tion sys­tem.  The issuance’s pur­pose is to seek feed­back from inter­est­ed pro­fes­sion­als and stake­hold­ers in order to improve the pro­pos­al.  And this pro­pos­al, usu­al­ly called “The Camp Tax/Territorial Pro­pos­al” due to the fact that Con­gress­man Dave Camp pre­sides the Com­mit­tee on Ways and Means, is very impor­tant to be ignored.  This reform, in fact, posits a mod­i­fi­ca­tion that we could con­sid­er a kind of “rev­o­lu­tion” in the U.S. income tax sys­tem.  It pro­pos­es a change from a “world­wide tax sys­tem” to a “ter­ri­to­r­i­al tax sys­tem,” and offers a reduc­tion of the cor­po­rate tax rate (from 35% to 25%) and, as an accom­pa­ny­ing and instru­men­tal ben­e­fit, a “repa­tri­a­tion tax hol­i­days.”

In a few words, a world­wide tax sys­tem (also know as res­i­dence-based tax sys­tem) impos­es tax­es on any income regard­less its phys­i­cal ori­gin (source), both domes­tic and for­eign.  Instead, a ter­ri­to­r­i­al sys­tem only tax­es the domes­tic (res­i­dence) source income while exempt­ing the for­eign one.  In both sce­nar­ios, the income is typ­i­cal­ly taxed first in its source coun­try and, in a cross-bor­der arrange­ment, after­wards in the taxpayer’s res­i­dence coun­try.  So, to alle­vi­ate the con­tin­gent dou­ble tax­a­tion, the world­wide sys­tem grants a cred­it for for­eign tax­es paid (the so-called “for­eign tax cred­it,” which oper­ates as an advance of domes­tic tax­es) where­as the ter­ri­to­r­i­al sys­tem sim­ple exempts the for­eign source income.  Also, in a world­wide sys­tem such as the U.S. sys­tem, tax­a­tion on for­eign income derived from busi­ness (“active income”) is nor­mal­ly deferred until brought to the U.S. (“repa­tri­a­tion”) where­as for­eign income derived from invest­ments (“pas­sive income”) is gen­er­al­ly taxed as soon as it is earned through a num­ber of quite com­plex mech­a­nisms, such as the U.S. Sub­part F rules (Con­trolled For­eign Cor­po­ra­tions or “CFC”) and oth­ers.  The accom­pa­ny­ing ben­e­fit to this reform, the “repa­tri­a­tion tax hol­i­days,” attempts pre­cise­ly to incen­tive U.S. investors to rapid­ly repa­tri­ate their active income earned abroad through a very appeal­ing tax treat­ment, which con­sists basi­cal­ly in a reduced tax rate along with a com­fort­able install­ment peri­od to pay the tax­es (for details, click here).

Although at a first sight (and as many are today argu­ing), this reform would favor allo­cat­ing of U.S. invest­ments abroad through exempt­ing for­eign source income, a more thought­ful con­sid­er­a­tion reveals the con­trary.  Impor­tant­ly, the first goal at hand is to repa­tri­ate U.S. invest­ments cur­rent­ly invest­ed abroad, and that is actu­al­ly an objec­tive with empir­i­cal sup­port from the expe­ri­ence of oth­er coun­tries which have imple­ment­ed a ter­ri­to­r­i­al tax sys­tem such as The Nether­lands and notably, the U.K. (for fur­ther infor­ma­tion, see links below).  On the oth­er hand, noth­ing in this pro­pos­al indi­cates that the Com­mit­tee on Ways and Means attempts to decrease the U.S. rev­enues by exempt­ing for­eign source income that, as argued, would be gen­er­at­ed by U.S. invest­ments that would move abroad by virtue of this reform.  To the oppo­site, the reform also aims to increase the U.S. tax rev­enues just as it has hap­pened in The Nether­lands and U.K.  So, this pol­i­cy has actu­al­ly worked so far.  Con­se­quent­ly, we may con­clude that the pro­posed reform assumes that, in the long-term, the income gen­er­at­ed by U.S. invest­ments will then be pro­duced only in the U.S. and not abroad.  Why?


Rea­sons for change
The pro­pos­al open­ly announces that its goals are: to get “Amer­i­cans work­ing again and our econ­o­my back on track”, to gen­er­ate “one mil­lion jobs in the first year alone,” and to enable “a more com­pet­i­tive, pro-job cre­ation ‘ter­ri­to­r­i­al’ tax sys­tem that puts our com­pa­nies on a lev­el play­ing field with for­eign com­peti­tors.”  Stat­ed dif­fer­ent­ly, the Com­mit­tee believes that today there is not a same lev­el play­ing field with for­eign competitors—investors and coun­tries as alike—and this leads the U.S. to lose jobs and become less com­pet­i­tive.  So, what is specif­i­cal­ly the prob­lem?

Among a num­ber of com­plex rea­sons, we can iden­ti­fy two key fac­tors that may offer suf­fi­cient­ly expla­na­tion, from a strict tax stand­point, to such sit­u­a­tion and the proposal’s posi­tion.

The first fac­tor is tax com­pe­ti­tion.  Small and devel­op­ing coun­tries com­pete with oth­er coun­tries for attract­ing invest­ments by offer­ing a more friend­ly tax treat­ment.  Tax havens are the extreme case in point.  This real­i­ty leads investors, espe­cial­ly large multi­na­tion­al cor­po­ra­tions, to prof­it from diverse tax treat­ments in dif­fer­ent juris­dic­tions through a typ­i­cal­ly abu­sive prac­tice known as tax arbi­trage.  As a result, the afore­men­tioned mech­a­nisms of the for­eign tax cred­it and the defer­ral of for­eign active income can be eas­i­ly maneu­vered as instru­ments of tax plan­ning under a world­wide tax sys­tem by drain­ing for­eign source income through coun­tries with dif­fer­ent tax treat­ment.  In fact, until not so far the for­eign tax cred­it used to be increased by label­ing the income earned in low tax juris­dic­tions as income earned in high tax juris­dic­tions; and any pas­sive income, which is gen­er­al­ly tax­able in the U.S. on a cur­rent basis through the afore­said CFC rules, may be sim­ply trans­formed into active income through sim­ple con­tracts and, this way, deferred until repa­tri­a­tion.

More­over, a world­wide sys­tem also allows investors to reduce their U.S. tax base by deduct­ing expens­es relat­ing to for­eign oper­a­tions through the mech­a­nism of “expense allo­ca­tion” and, thus, to use today a deduc­tion relat­ed to an income that would be taxed, and hope­ful­ly, in the future.  Who even­tu­al­ly wins?  Investors.  Who clear­ly loss­es?  Main­ly the investors’ res­i­dence coun­try, whose rev­enues are reduced through hard to con­trol cross-bor­der schemes.  This lat­ter is the posi­tion of the U.S. with respect to its investors, prin­ci­pal­ly multi­na­tion­als enter­pris­es (“MNEs”).

Here we find the sec­ond fac­tor: inter­na­tion­al tax mon­i­tor­ing inef­fi­cien­cy.  In effect, the tax arbi­trage abuse is fur­ther facil­i­tat­ed due to a lack of an inter­na­tion­al­ly coor­di­nat­ed tax mon­i­tor­ing sys­tem.  Despite the fact that there exists a large net­work of tax treaties and oth­er inter­na­tion­al instru­ments all of which include cer­tain mech­a­nisms to pre­vent cross-bor­der tax eva­sion, most or all of these mech­a­nisms fall into bureau­crat­ic holes relat­ed basi­cal­ly, and nat­u­ral­ly, to juris­dic­tion issues.  Thus, investors take broad advan­tage from both tax com­pe­ti­tion and inter­na­tion­al tax mon­i­tor­ing pre­car­i­ous­ness.

I think these two fac­tors direct­ly harm the U.S. tax rights and are actu­al­ly the ene­my at hand.  Notably, such both fac­tors clear­ly reveal a vir­tu­al dis­con­nec­tion among the gov­ern­ments since a bet­ter coor­di­na­tion would allow to mit­i­gate tax com­pe­ti­tion and to enhance inter­na­tion­al tax com­pli­ance.  So, an appro­pri­ate recourse should be a move toward a bet­ter coor­di­na­tion among coun­tries, not a move towards a self-solu­tion, which implies, to some extent, inter­na­tion­al iso­la­tion.

I believe a ter­ri­to­r­i­al tax sys­tem, there­fore, does not seem to be in the right way.

 

Why ter­ri­to­r­i­al-based tax­a­tion implies inter­na­tion­al iso­la­tion
A world­wide tax sys­tem requires tax­pay­ers (and gov­ern­ments) to coor­di­nate their efforts so that they can make accu­rate deci­sions when trad­ing and invest­ing (and tax­ing) at inter­na­tion­al lev­el.  On the one hand, the tax­pay­ers’ inter­est is on max­i­miz­ing prof­its through busi­ness oppor­tu­ni­ties and avoid­ing a dou­ble tax bur­den.  Cor­re­spond­ing­ly, the gov­ern­ments’ inter­est is on pro­mot­ing the for­mer while reliev­ing the lat­ter.  This dynam­ic enables a high lev­el of inter­na­tion­al con­nec­tions by tax­pay­ers and gov­ern­ments alike, such as MNEs and trade treaties, respec­tive­ly.  How­ev­er, I believe that a move to a ter­ri­to­r­i­al base sys­tem tends to neu­tral­ize this dynam­ics since it iden­ti­fies pro­mo­tion of busi­ness oppor­tu­ni­ties with tax com­pe­ti­tion, and it solves dou­ble tax­a­tion sim­ply by exempt­ing for­eign source income.

I think this solu­tion may be worse than its prob­lem.  Actu­al­ly, it does not resolve the com­bined prob­lem of an aggres­sive tax com­pe­ti­tion and a weak inter­na­tion­al tax mon­i­tor­ing, as explained above.  In fact, a ter­ri­to­r­i­al tax sys­tem does not shut the door of maneu­ver­ing invest­ments to take advan­tage of appeal­ing tax regimes of oth­er coun­tries.  Nor does it pre­vent cross-bor­der tax eva­sion because, as usu­al­ly when fac­ing any new leg­is­la­tion, tax­pay­ers rapid­ly devel­op new schemes to con­ve­nient­ly “exploit” such new order by, for exam­ple, drain­ing earn­ings from the ter­ri­to­r­i­al tax juris­dic­tion to a for­eign (and exempt­ed) tax juris­dic­tion through deductible inter­ests, roy­al­ties or fees.

As a num­ber of prac­ti­tion­ers argue, I believe this reform will deep­en tax com­pe­ti­tion, and in addi­tion, will increase cross-bor­der tax eva­sion.

But there is even some­thing worse.  The reform attempts to dis­cour­age U.S. invest­ments and busi­ness abroad.  Pre­sent­ed as an open state­ment, this goal would be achieved by allow­ing a tax-friend­ly repa­tri­a­tion process of for­eign source income already earned and cur­rent­ly invest­ed abroad, and by reduc­ing the local U.S. tax bur­den in order to main­tain invest­ed in the U.S. the future income.  As a result, U.S. invest­ments abroad would lack “tax sense” since the tax bur­den on the impor­tant mar­kets will gen­er­al­ly be high­er abroad than in the U.S. (see fig­ure below).  Invest­ing abroad from a sub­stan­tial per­spec­tive (in Europe, in India, in Brazil) would thus be more “tax-expen­sive” than invest­ing in the U.S.  Ulti­mate­ly, the mes­sage for U.S. investors would sim­ply be “why invest abroad?”  And this mes­sage implies, to some extent, “why deal with abroad?”—that is, iso­la­tion.

I think this pol­i­cy, imple­ment­ed by the most impor­tant econ­o­my of the world, would lead nec­es­sar­i­ly to cause the oth­er coun­tries to adopt a sim­i­lar iso­lat­ing pol­i­cy in a spi­ral of mutu­al with­draw­al.  Is this a prop­er achieve­ment from the view­point of the inter­na­tion­al law?

 

A call for reflec­tion 
Rather than only con­sid­er­ing the numer­i­cal effects of tax rev­enue, I believe the polit­i­cal effects in the long-term should also be tak­en into con­sid­er­a­tion when debat­ing on the pro­posed draft.

The actu­al rea­sons to adopt this reform are tax arbi­trage (allowed by tax com­pe­ti­tion) and cross-bor­der tax eva­sion, both evils that would prop­er­ly be com­bat­ed through a bet­ter coor­di­na­tion among the coun­tries.  Nev­er­the­less, this reform seems to open, from the first econ­o­my of the world, a path toward inter­na­tion­al dis­af­fec­tion.  If being com­pet­i­tive implies to con­cen­trate the invest­ments with­in the bor­ders to cre­ate jobs in the U.S., as open­ly stat­ed here, then the next ques­tion is: how to make the invest­ments returns attrac­tive for investors?  Thus, I think the fol­low­ing step would like­ly be to adopt a pro­tec­tion­ist pol­i­cy, main­ly through cus­toms duties, in order to safe­guard the future invest­ments’ out­come.

Arguably, this move would also be sup­port­ed by the appeal­ing idea of pro­tect­ing U.S. jobs.  Oth­er coun­tries would also reply that this pol­i­cy towards pro­tec­tion­ism, just as the ter­ri­to­r­i­al tax sys­tem.  Then, in a world where the main mar­kets will be attempt­ing to con­cen­trate their invest­ments and pro­duc­tion with­in their bor­ders through a ter­ri­to­r­i­al tax sys­tem, how could their pro­duc­tion sur­vive with­out ensur­ing such mar­kets?  At least from a the­o­ret­i­cal point of view, this process would final­ly estab­lish an inter­na­tion­al order where cap­i­tal export­ing coun­tries will not longer export their invest­ments nor pur­chase for­eign man­u­fac­tured prod­ucts; a world where the con­cept of “mar­ket” would lead to envi­sion the need to expand the bor­ders and to elim­i­nate, even lit­er­al­ly if need­ed, any com­peti­tor; a world that West­ern Civ­i­liza­tion, after a num­ber of bloody episodes that range from the so-called Civ­il War in the U.S. to the Colo­nial­ism from Europe to the world, seemed to have left behind.  Does it look fic­tion­al?  It is actu­al­ly His­to­ry.

Because of that, it is mean­ing­ful to remem­ber that one of the crit­i­cal rea­sons for the cre­ation of the League of Nations, pre­de­ces­sor of the Unit­ed Nations, was to facil­i­tate com­mu­ni­ca­tion and coor­di­na­tion among the coun­tries in a hope to con­trol con­flicts and pro­mote peace.  If com­mu­ni­ca­tion and coor­di­na­tion pre­vents con­flicts, then we should con­clude that any step towards inter­na­tion­al isolation–as, in my view, a pro­pos­al to intro­duce a ter­ri­to­r­i­al-based tax sys­tem is–would involve soon­er or lat­er a threat to these long-stand­ing aspi­ra­tions of the inter­na­tion­al com­mu­ni­ty.

I respect­ful­ly believe that a com­pre­hen­sive dis­cus­sion on the draft should include this per­spec­tive.

 

Appen­dix of gen­er­al infor­ma­tion
1.  The fol­low­ing is the 2011 OECD report (avail­able online) on tax bur­den on cor­po­ra­tions for OECD coun­tries:

Coun­try

Com­bined cor­po­rate income tax rate

>25%

Coun­try

Com­bined cor­po­rate income tax rate

<25%

Japan*

39.5

Korea

24.2

Unit­ed States

39.2

Israel

24.0

France*

34.4

Switzer­land*

21.2

Bel­gium*

34.0

Esto­nia*

21.0

Ger­many*

30.2

Chile

20.0

Aus­tralia*

30.0

Greece

20.0

Mex­i­co

30.0

Ice­land*

20.0

Spain*

30.0

Slove­nia*

20.0

Lux­em­bourg*

28.8

Turkey*

20.0

New Zealand*

28.0

Czech Repub­lic*

19.0

Nor­way*

28.0

Hun­gary*

19.0

Cana­da*

27.6

Poland

19.0

Italy*

27.5

Slo­vak Repub­lic*

19.0

Por­tu­gal*

26.5

Ire­land

12.5

Swe­den*

26.3

Fin­land*

26.0

Unit­ed King­dom*

26.0

Aus­tria*

25.0

Den­mark*

25.0

Nether­lands*

25.0

* Home coun­try tax regime of for­eign-source div­i­dend income received by res­i­dent cor­po­ra­tions.  (Source: PwC)

The table shows that, as intend­ed, the reform would put the U.S., the first econ­o­my of the world, below the plain aver­age tax rate (25.48%) and much below if com­pared with an aver­age pon­dered, for exam­ple, accord­ing to Gross Domes­tic Prod­uct.  Thus, the U.S. would leave the group of the devel­oped coun­tries to join the group of the devel­op­ing coun­tries.  Can any­one cast doubt that this may be the begin­ning of a great change in the inter­na­tion­al eco­nom­ic order?

Inter­est­ing­ly, the table also shows that most of the largest economies of the world, typ­i­cal­ly cap­i­tal export­ing coun­tries, have already adopt­ed a ter­ri­to­r­i­al tax sys­tem.  The U.S. is, by now, the unique excep­tion.  There are oth­er excep­tions among the largest economies, such as Chi­na, Rus­sia, India, and Brazil, which are not OECD coun­tries.  Yet, these coun­tries are today, and by now, cap­i­tal importers.  Can any­one doubt the incom­ing and fierce tax com­pe­ti­tion caused by the reform?

2.  Infor­ma­tion about the dis­cus­sion draft at hand pro­posed by the Com­mit­tee on Ways and Means of the U.S. House of Rep­re­sen­ta­tives, along with fur­ther infor­ma­tion about U.S. inter­na­tion­al tax laws, can be found here.

3.  PwC has a com­pre­hen­sive tech­ni­cal analy­sis on the pro­pos­al.

4.  Peter Mullins pre­pared A vision­ary Inter­na­tion­al Mon­e­tary Fund Work­ing Paper that was issued in 2006 on the sub­ject.

5. Although many aca­d­e­mics spec­u­late that this pro­pos­al will not become a leg­is­la­tion, Prof. R. Avi-Yon­ah envi­sions the oppo­site in his paper, Vive La Petite Dif­fer­ence: Camp, Oba­ma, and Ter­ri­to­ri­al­i­ty Recon­sid­ered.

6.  Fur­ther analy­sis and dis­cus­sion can be found here.

 

Juan A. Farias is a Chilean stu­dent in the LL.M. Inter­na­tion­al Tax­a­tion pro­gram at New York Uni­ver­si­ty School of Law, Class of 2012.  In Chile, Juan is a CPA, tax attor­ney, and Assis­tant Pro­fes­sor of Law.   Cur­rent­ly, he works for the Inter­nal Rev­enue Agency of his home coun­try.

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