Tax Jurisdiction, State Sovereignty and International Law

11 G LOBAL B USINESS AND I NTERNATIONAL F ISCAL L AW

1. Tax Jurisdiction, State Sovereignty and International Law

The substance of state sovereignty is jurisdiction: the scope within which the effective and acceptable power of a state can be exercised. The modern state is defined in terms of territory: it consists of public authorities governing a defined territorial space. Thus, in modern international law, sovereignty is defined territorially, as `the right to exercise in regard to a portion of the globe to the exclusion of any other state the functions of a state ¶Island of Palmas, Netherlands v. U.S.A., 1928, p.92. However, such exclusive territorial state rights are essentially institutional and formal. Since economic activities and social relations are international or global, the reality of state power is not unlimited exclusive sovereignty, but interrelated and overlapping jurisdictions. It is formally true that the only tax officials who have the right to assess and collect taxes within British territory are those of the British government. However, although other states have no formal right to enforce their taxes by taking official action against persons or assets physically located in Britain, such action may take place either by tacit consent or by formal agreement, as we have seen in the previous chapter. More importantly, even if states exercise only their own exclusive territorial competence, this could produce overlapping and conflicting effects, due to the multiple geographic contacts of individuals and of interrelated economic activities. From the point of view of formal sovereignty, there is no restriction on a states right to tax, and it may be exercised without regard to its effects on other states. Thus, many tax and international lawyers have asserted that there is no rule of general international law limiting a states right to tax, pointing to the lack of any decisions in international or domestic courts or tribunals invalidating or restricting the assertion of such a right Chretien 1955; Norr 1962; Knechtle 1979; Tixier and Gest 1985, p.18. However, even from a formalist viewpoint, it must be conceded that a state cannot claim a right to a tax which could only be collected by action outside its territory Albrecht 1952, p.153; Qureshi 1987, p.21. In opposition to formalism, normative approaches stress the need for a basis of legitimation for state sovereignty, since without such legitimacy state power is ineffective. The scope of such legitimate power and its allocation and coordination is normally referred to as jurisdiction Brilmayer 1989, ch.1. Since legitimate state power is normally exercised by legislation, adjudication and administration, these are normally cited as the forms of jurisdiction. It has also become common to distinguish between jurisdiction to prescribe and jurisdiction to enforce: since a state may only exercise its monopoly of legitimate compulsion within its own territory, there is a territorial limitation on enforcement. Thus, official acts of investigation, the service of judicial process, requirements to provide evidence or information, the arrest of individuals or the seizure of assets to enforce an order, cannot be carried out within the jurisdiction of another state except under its authority or by consent. On the other hand, a states jurisdiction to prescribe is not territorially limited, but may be asserted in relation to persons or transactions having a valid nexus with that state. In the liberal approach expressed most famously in the Lotus case 1927, since international law emanates only from the free will of states, they are free to assert any jurisdiction not explicitly prohibited by formal international agreement or a generally agreed positive principle ibid. at p.35. Once again, however, those who accept that states, like individuals, exist within a normative framework and are subject to economic and political constraints, look to the bases of legitimacy that can justify a valid assertion of jurisdiction Martha 1989, ch.2. Nevertheless, even the requirement of such a valid nexus necessarily produces a pattern of overlapping and even conflicting jurisdictions, as we have seen quite clearly in relation to taxation. Even if states assert a claim to jurisdiction founded only on territoriality, this justifies taxation both of income which can be defined as having a source within the territory, and of residents on their worldwide income. 1 Thus, the important question in relation to jurisdiction is how far overlapping jurisdiction can be tolerated, and what means can be developed for its coordination. International taxation provides a fascinating example of how the political and economic constraints on sovereignty have been expressed in the legal forms developed for the coordination of tax jurisdiction. The first, and perhaps primary means of such coordination has been by national limitations of the scope of taxation. Such limitations have resulted from national political pressures, for example from business groups representing international investors; but perhaps more importantly, from the underlying economic pressures. 1 See the dictum of Lord Herschell in Colquhoun v. Brooks 1889, p.499 cited in Chapter 2 section 2d above. The greatest constraint on a states assertion of its right to tax business stems from the international mobility of capital. Consideration of the tax burden is by no means the only factor taken into account by investors, especially in the case of direct investments made as part of business strategy. Nevertheless, it is a factor, and fears of loss of investment creates a potent pressure on governments, especially in states which have fewer location­specific advantages. Hence, there has been a broad similarity in the patterns of development of national taxes on international business, at least between states with similar levels of development and socio­economic backgrounds. 1 However, significant differences have remained, often motivated by attempts by governments to attract capital in order to develop or support a particular economic sector or social group. In particular, as we have seen in earlier chapters, interest in a financial services sector has led many states to offer facilities which have constrained the effective tax jurisdiction of others, especially by assisting TNCs to develop legal structures enabling them to expand through largely untaxed funds. Although counter­measures in the form of taxation of Controlled Foreign Corporations were taken nationally by states, there have been considerable similarities due to emulation, and the limits of the validity of such measures were generally understood, and later articulated by the OECD Fiscal Committee, so that the potential dangers of excessive jurisdiction were largely avoided, as we have discussed in detail in Chapter 7 above. The second major means of coordination, resulting from international political pressures, has been the development of the network of bilateral tax treaties. The strengths and limitations of the approach developed in these treaties to the allocation of tax rights have been explored in previous chapters, and the next section of this chapter will consider in some detail the interaction of treaty provisions and domestic law. The treaty system has provided a mechanism for the negotiation and definition of national jurisdiction; this has however been based on the reciprocal bargaining of what have been perceived as national interests, which has in many ways hindered the emergence of a global perspective on equity in the taxation of international income. Bilateral treaties aim at prevention of international double taxation, and provide no mechanism for ensuring that international investment actually bears a reasonable tax burden. The growth of offshore finance, based on the exploitation of loopholes in the tax treaty network, has created glaring inequities in the taxation of both international portfolio and direct investment. The measures taken by the tax authorities in response have been increasingly coordinated on a multilateral basis, but they have nevertheless remained seriously limited. The lead has been taken by the OECD Fiscal Committee, thus excluding the 1 As we have seen in earlier chapters, all states generally tax income at source, while those which assert a right to tax residents or nationals on foreign income have largely accepted exemption for some, via deferral for unremitted income at least if i WLVIURPDQCDFWLYH¶EXVLQHVVDQGDOORZDWOHDVW a credit for foreign taxes paid on repatriated income. Thus there has been a significant degree of CXQLODWHUDOFRKHUHQFH¶3DOPHUDOWKRXJKWKHOLPLWVRIXQLODWHUDOLVPVKRXOGEHFOHDUPXFKFDQEH done in encouraging greater uniformity of tax laws: Vann 1991, p.158. vast majority of states, not only the poorer underdeveloped countries, but also those with major economies and those attempting rapid economic growth; and yet even the OECD grouping is regarded as too large to deal with sensitive matters, which are confined to even more secretive meetings such as those of the Group of Four. The main difficulty is that international taxation has been regarded as a matter for inter­ state coordination of national sovereignties. The issues raised by the increasingly wide area of overlappping jurisdictions have thus been treated as technical or administrative matters, while legitimation has been sought purely nationally. While the major TNCs have protested at some aspects of this, notably the lack of taxpayer rights in international tax decisions such as the arbitration of transfer price adjustments, they too have generally resisted the politicization of international tax issues. Yet it has become increasingly clear that a piecemeal and spatchcock approach will prove inadequate.

2. Tax Treaties and Domestic Law