International Taxation on the Road to Economic Recovery
Clemens Fuest
University of Oxford
IFA Trilateral Meeting London, November 3rd, 2010
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Summary:
•
In international taxation, there is a danger that unilateral tax reforms
increasingly undermine the consistency and efficiency of the international
tax system.
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It is necessary to rethink the principles underlying the taxation of border
crossing economic activity.
•
Agreement on these principles can then be a basis for more tax
coordination.
•
Example: Reform of UK Controlled Foreign Companies (CFC) legislation
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1. Unilateral tax reforms increasingly undermine the consistency and
efficiency of the international tax system
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Main objectives driving tax reforms:
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Increasing competitiveness of the corporate income tax system
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Protection of the national tax base.
Policies:
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Increasingly countries unilaterally restrict the deductibility of interest
payments.
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Unilateral transfer pricing policies.
•
Unilateral policies on exit taxation.
Result: Double taxation or ‘white income’, distortions of international
investment flows, uncertainty
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2. Rethinking the principles underlying the taxation of border crossing
economic activity. The example of UK Controlled Foreign
Companies (CFC) legislation
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Why do we tax corporations at all?
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Corporate tax as a proxy for income tax of domestic residents:
ownership principle (but: firm ownership increasingly internationally
diversified)
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Corporate tax is a tax on economic activity which takes place in the
country and benefits from public services: territorial principle
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Implications for corporate taxation in the UK
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Ownership principle requires taxation of foreign source income of UK
residents
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Territorial principle requires exemption of foreign source income of UK
residents
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Principles guiding UK corporate taxation of foreign source income:
HM Treasury and HMRC, Reform of Controlled Foreign Companies (CFC)
Policy Principles Document (July 2009):
‘A move towards a more territorial approach, whilst retaining ownership as an
underlying principle seems to be the optimal solution’(29)
How can this work?
‘This can be achieved by refocusing CFC rules on artificial diversion of profits
from the UK,…’(ibid.)
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Implications:
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Main objective: Implement taxation based on territorial principle
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Role of CFC Legislation: National tax base has to be protected against
artificial profit diversion
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CFC rules will not tax ‘profits that are genuinely earned in overseas
subsidiaries’
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How can this be implemented?
It is helpful to consider some examples, taken from Devereux (2010):
Example 1: A UK company uses retained earnings to finance a CFC which
produces goods in a country with a lower tax rate than the UK, for
example Poland. The profits are distributed to the UK as dividends.
UK CFC principles suggest exemption.
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Example 2: The same UK company uses retained earnings to equity finance a
finance company located in a tax haven. The finance company lends to
the same Polish CFC in the first example. The Polish company pays
interest to the finance company, which in turn pays dividends to the UK
company.
UK CFC principles seem to suggest taxation of the financing company
although there is no substantial difference to the first example.
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How can this be implemented?
Example 3: As example 1, except that the UK company borrows in the UK to
finance the equity injection into the Polish company.
Here deductibility of interest payments in the UK would imply that the UK
subsidises investment in Poland. This is incompatible with territorial
taxation (denying deductibility would raise EC law issues, though).
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Example 4: The same UK company uses retained earnings to equity finance a
finance company located in a tax haven. The finance company now lends
to a UK subsidiary. The interest paid to the finance company reduces UK
profits.
Here it seems that profits are artificially diverted from the UK. However,
the financing structure of the UK subsidiary could be identical to that of
any other UK subsidiary of a foreign company.
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Key Issue: To a large extent, the difficulties of dealing with these cases arise
because debt and equity financing are treated differently. This can be
overcome by either granting deductions for equity costs (ACE) or by
introducing source taxes on interest payments (or other limitations to
interest deductibility.
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3. Conclusions
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There are good reasons to place more emphasis on taxing corporations
on the basis of the territorial principle
•
Many issues of tax base protection are caused by the deductibility of
interest on debt (and royalties as well as other financing costs)
•
It is helpful that the policy debate about UK CFC legislation is conducted
with reference to tax principles, although sometimes the implications of
territorial taxation are not fully taken into account
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One way of implementing territorial taxation would be to extend the use
of source taxes on financing costs, royalties and so on
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Implementing the territorial principle would also mean that foreign losses
cannot be set against domestic taxable income (HM treasury discussion
document on Foreign Branch Taxation does suggest that loss relief
should be granted)
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Thank you very much.
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