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:

* 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.