The Campaign against International Double Taxation

subsidiaries to be credited against the tax of their US parent, in relation to dividend remittances from them see further Chapter 5 below. Although the Netherlands had allowed a tax credit from 1892 for traders deriving income from its then colonies in the East Indies, the American measure seems to have been the first general unilateral foreign tax credit Surrey 1956, p.818.

3. The Campaign against International Double Taxation

The introduction of direct taxes on business income, and the rise in their rates after 1914, immediately brought home to businessmen the relative incidence of such taxes as a factor in their competitive position. To those involved in any form of international business, the interaction of national taxes became an immediate issue, and led to the identification of the problem of `international double taxation ¶ 3.a Britain and Global Business This was perhaps most acutely felt in Britain, due to the way taxation of residents had come to cover the worldwide income of all companies `controlled ¶from Britain. As the rate of tax rose steeply in Britain, and other countries also introduced income taxes, globally­active businesses based in the UK quickly became conscious of their exposure to multiple taxation. Although there had been some complaints when an income­tax was introduced in India in 1860, which were renewed after other countries within the Empire also did so in 1893, it was not until 1916 that a temporary provision for partial relief was introduced UK Royal Commission 1919­ 20, Appendix 7c . The Board of Inland Revenue negotiated arrangements within the British Empire to allow the deduction from the rate of UK tax of the rate of Dominion or colonial tax on the same revenue, up to half of the UK tax rate, and these arrangements were embodied in the 1920 Finance Act s.27. Nevertheless, despite strong pressure from business interests, the Revenue would not accept the exemption of foreign source income, nor even a credit along US lines. This view was approved by the report of the Royal Commission on Taxation of 1920. Business pleaded for equality in the conditions of competition with foreign firms importing into the UK. The administrators responded that tax equity required the same treatment of the income of all UK residents no matter what its source. They acknowledged that a case could be made to relieve foreign investors in companies controlled from Britain, but this would depend on international arrangements to facilitate movements of capital, and require negotiation with the foreign countries of residence. The Revenue considered that the relief arrangements negotiated with the Dominions were justified because there was hardship in contributing twice for what could be considered to be the same purpose ­ `the purposes of the British Empire;with other countries there was no such shared purpose. In addition, the differences in national tax systems, as well as language and travel problems, would make the negotiation of international arrangements very difficult. Nevertheless, the Revenue conceded, it might become expedient to grant some relief, to obtain favourable treatment from, or avoid retaliation by, foreign countries. The Royal Commission suggested that such arrangements could perhaps be negotiated by a series of conferences, possibly under the auspices of the League of Nations. To those involved in international business, the unfairness of overlapping taxation of the same income seemed plain, and the solution to the problem seemed quite simple. Sir William Vestey, the beef magnate, argued strongly in his evidence to the British Royal Commission that he should be put in a position of equality with his competitors. He singled out the Chicago Beef Trust, which paid virtually no UK tax on its large sales in Britain: not only did it escape UK income tax on its business profits by being based abroad, it also avoided tax on its sales in Britain by consigning its shipments f.o.b. to independent importers, so that its sales were considered not to take place in Britain. 1 The Vestey group had moved its headquarters to Argentina in 1915, to avoid being taxed at British wartime rates on its worldwide business, but Sir William expressed his preference to be based in London. He argued for a global approach to business taxation: In a business of this nature you cannot say how much is made in one country and how much is made in another. You kill an animal and the product of that animal is sold in 50 different countries. You cannot say how much is made in England and how much is made abroad. That is why I suggest that you should pay a turnover tax on what is brought into this country. ... It is not my object to escape payment of tax. My object is to get equality of taxation with the foreigner, and nothing else. 2 The process of lobbying on behalf of business was quickly internationalised, principally through the International Chamber of Commerce the ICC, which was set up in Paris in 1920 although its prehistory goes back to 1905. From its founding meeting the question of international double taxation was high on the ICCs agenda as it has remained ever since, and it set up a committee which began its task with a simple faith that an evident wrong could be simply righted. As its chairman, Professor Suyling put it in the committees report to the 2nd ICC Congress in Rome in 1923: If only the principle that the same income should only be taxed once is recognised, the difficulty is solved, or very nearly so. It only remains then to decide what constitutes the right of one country to tax the income of a taxpayer in 1 The Trust was of course subject to US taxes, but unlike the UK, these did not apply to subsidiaries formed abroad, e.g. in Argentina. 2 UK Royal Commission on Income Tax 1920, Evidence, p.452 Question 9460. preference to any other country. It does not seem probable that there would be any serious difference on the matter. Support for action was given by a resolution passed at the International Financial Conference at Brussels in 1920, and the matter was referred to the Financial Committee of the League of Nations. Unfortunately, however, significant differences quickly became apparent, both as to what constitutes international double taxation, and how to prevent it. 3.b National and International Double Taxation International double taxation is normally defined in the terms stated much later by the OECD Fiscal Committee: The imposition of comparable taxes in two or more states in respect of the same subject­matter and for identical periods. OECD 1963, para. 3. This definition obviously hinges on the important word `comparable ¶ As we have seen, there were significant differences between countries both in the way they taxed business profits, and in what they considered to be double taxation. The issue of international double taxation was therefore one aspect of the more general question of what constitutes double taxation. Double taxation is a pejorative term for an elusive concept. Legal or juridical double taxation only occurs if the same tax is levied twice on the same legal person. This is rare, although more frequently different taxes are levied on the same income of one person: for instance, individual income normally bears both social security contributions and general income taxes. The problem is exacerbated by the interposition of fictitious legal persons, mainly the trust and the company. If an individual invests or runs a business through a company, and income tax is levied both on the companys profits and on that proportion of those profits paid to the individual as dividends, it could be said that the same stream of income has been taxed twice, although in the hands of different legal persons. This is referred to as economic double taxation, and there are different views as to whether it should be relieved, and if so, how. A single income tax applied to both individuals and companies, as was the case in the UK from 1842 to 1965, most directly raises the question of economic double taxation. Hence, in the UK relief was given by allowing companies to deduct at source the income tax on due on dividends paid to shareholders and credit the total sums against the tax due on the companys own profits. This approach essentially treats the company as a legal fiction, a mere conduit for investment. On the other hand, under the so­called `classical approach ¶ favoured until now by the USA, the Netherlands, and other countries, the company is considered to be separate from the shareholders who invest in it, and therefore both individuals and corporations are separately taxed on their income. This means that distributed profits are taxed more heavily than those retained within the corporation. Systems which wholly or partially integrate individual and corporate income taxes aim to remove the incentive to retain profits within the company. The choice of alternatives is influenced by whether it is thought that investment decisions are more efficiently taken by the corporation or by its shareholders. When the UK adopted a separate corporation tax in 1965, it too adopted the `classical ¶ system, but it moved to the present system of partial integration through the Advanced Corporation Tax in 1973. Studies of possible integrated arrangements have been carried out within the US government to consider bringing the US system into line with other major countries. Canada moved away from the classical approach in 1949, and further towards integration in 1971. However, other systems historically treated a business profits tax or a corporation income tax as a different tax from the personal income tax, so the issue of double taxation relief did not arise so directly. Many of the countries of continental Europe, such as France, had begun from the perspective that taxes on business or commerce were levied on the activity itself, and were separate from the taxes applied to income, including taxes on investment income. From this point of view, the tax on business profits should only be applied by the country where the business activity was actually located. On the other hand, it did not matter if a tax was also levied on the return on investments in that business, whether by the country of residence of the recipient or by the country where the business was actually carried on, since it was a separate tax. Britain, however, applied its income tax both to the worldwide trading profits of companies considered to be resident in the UK, as well as to the profits from business carried on in the UK by foreign­owned companies. Countries with a separate tax on business profits logically thought it should be applied at the source, where that business was carried on. Britain and the US, which taxed companies, like other legal persons, on their income, favoured taxation based on residence, which meant that they could tax all those they defined as residents or citizens on their worldwide income or profits. Britain went furthest in espousing the view that income should be taxed by the country of residence of the investor. Coupled with the principle that the residence of a company, based on the test of central management and control, was the place where the investment decisions were taken, this meant that the profits of a business carried on abroad, whether through a branch or a foreign subsidiary, could be directly liable to UK income tax, even if not repatriated. Since British companies obtained relief from their liability for UK income tax by deduction of the tax due on dividends paid to British shareholders, they were perhaps more sensitive to the double taxation issue. By the same token, this made it easier for the Inland Revenue to take a more relaxed attitude, at least to complaints by British residents that their foreign income had already been taxed abroad. Why should the British Revenue take the responsibility for an allowance in respect of tax paid to a foreign state, especially if that foreign state did not make any such allowance to its domestic taxpayers? The issue took on a different complexion as British international investment became more predominantly direct investment by companies, and especially once the separate corporation tax was introduced after 1965. This divergence of ideological standpoint, between the residence and source principles of business taxation, to some extent reflected and reinforced national economic interests. As we have seen, Britain was by far the largest international lender in the period up to 1914, mostly in the form of fixed­interest portfolio investments, while countries such as France and Italy were net debtors. The United States was also a major source of international investment, although a higher proportion of this was direct investment by US corporations. Although US taxes covered the worldwide income or profits of US citizens and corporations, the foreign direct investments of US corporations were more leniently treated than those of the UK in two major respects. First, US taxes applied only to corporations formed under US law, or to the US trade or business of foreign­registered companies. Thus, by carrying out foreign business through subsidiaries formed abroad, no direct US taxes applied to those foreign profits. Second, a US corporation with earnings from a foreign branch could choose either to deduct foreign taxes paid from gross profits, or to credit them against the US taxes payable on that income provided the tax credit did not exceed the proportion of foreign to US income. Furthermore, the foreign tax credit was also allowed in respect of dividends paid from foreign subsidiaries, which would form part of the US parents taxable income: the foreign tax paid on the underlying foreign income could be credited, in proportion to the ratio of dividends repatriated to the gross foreign income. Thus, the foreign tax credit was designed to ensure there was no tax disincentive for US foreign investment. The question of what constitutes `double taxation ¶is part of the broader issue of tax equity. In liberal theory taxation should apply equally to all legal persons, to create the least impediment to the working of market forces and the free decisions of economic actors. However, markets are themselves created and conditioned by state regulation see Chapter 4 below. As the type and structure of economic activities become more complex, it becomes increasingly difficult to decide what constitutes `equal ¶treatment. As states come under increasing pressure in resolving the political issues posed by the question of domestic equity, arrangements for maintaining international equity come under additional pressure see below Chapter 3. In particular, the method adopted by a state for dealing with the relationship of individual and corporate income taxation has important implications for international tax arrangements see below Chapter 2 section 2d.

4. Origins of the Model Tax Treaties