The Limits of Unilateral Measures

hence reduce the US revenue gains due to the foreign tax credit. At the same time, higher US taxes on CFCs would, it was predicted, lead to a cumulative loss of competitiveness which also would produce a net reduction rather than an increase in US tax revenue from foreign income Hufbauer Foster 1977. Hence, it was not surprising that the Reagan tax reforms did not involve ending deferral; but they did include a number of measures drawing back foreign income into the US tax net, such as the `super­royalty ¶ and generally increasing pressure for adequate policing of intra­firm payment flows see Chapters 3.2 above and 8 below. However, the necessity for a more international approach to the whole question had by now become increasingly obvious.

3. The Limits of Unilateral Measures

As we have seen in this Chapter, Britain and the US, historically the main capital­ exporting countries, both responded early, but by unilateral measures, to the emergence of international avoidance; the form which it took and the issues raised for each country reflected its approach to the taxation of foreign earnings. Not only were the initial responses unilateral, they were frequently insular. While both countries accepted that the growth of foreign investment should be encouraged, their fiscal and balance of payments concerns, as well as pressures for equity for domestic taxpayers, required efforts to try to claw back into taxation at least a proportion of foreign retained earnings. Both countries tried to ensure this by strengthening their rules on taxation of residents. In addition, the US IRS began to tighten up its administration of the Arms Length rule regulating transfer prices to be considered in Chapter 8 below. What was largely lacking in the long US debate about taxation of foreign investment was an international perspective. Yet deferral, especially its exploitation through subsidiary holding companies, base companies, and tax havens, had starkly revealed the limitations of the international tax system. As we have seen, the international arrangements had given the source country the right to tax business profits, and the country of residence of the investor jurisdiction over investment profits. At the same time, the allocation of income between related enterprises of the same transnational firm was to be done as far as possible on the basis of the Arms Length principle rather than a worldwide unitary approach based on formula apportionment. International tax avoidance had exploited this approach. TNCs could earn high profits from foreign operations based on technology and know­how which had already covered their costs in the home market. Yet they could also minimize liability to tax at source on those foreign profits by allocating the maximum deductible expenses to their foreign operating subsidiaries. At the same time, by maximising the profits accumulated in or through low­tax country subsidiaries, they minimized their exposure to taxation in their own home countries of residence. However, these unilateral approaches offered only partial solutions. They were largely ineffective in stemming the growth of international avoidance, which developed illegal evasion in its wake. They were also inadequate as solutions to the national problems. These limitations were inherent in what were essentially unilateral national approaches to the international problem of allocation of jurisdiction to tax internationally­integrated business. Both countries attempted to exert control over the deployment of foreign subsidiaries so as to include in taxation by the country of ultimate residence a proportion of foreign retained earnings. Yet there were no adequate criteria to justify the allocation of such income in this way. For example, the inclusion in US taxation under Subpart F of foreign base company sales and service income assumed that such income concealed investment income, which the US was entitled to tax, rather than business profits, which would be properly attributable to the foreign source country. It might be acceptable to apply US taxes to foreign sales of goods manufactured in the US channelled via a Bermuda sales subsidiary; but where the German manufacturing subsidiary of a US TNC channels its sales via a Swiss sales affiliate, is it not German rather than US taxes which are being avoided? Furthermore, what if the US corporation is itself owned by a British or French company? See Tillinghast 1979, 262­3; Park 1978, pp.1631­­3. The unilateralism of Subpart F also limited its efficacy from the US point of view, since it excluded profits earned from the active conduct of a foreign trade or business. This exclusion was necessary once it was decided to target only the abuse of deferral, yet it left a wide scope for continued exploitation. Manufacturing companies could engage in partial assembly or processing in the CFCs base country: this led to litigation Dave Fischbein Manufacturing Co v. Commissioner 1972 and to detailed IRS rules. Much more seriously, financial and banking business could be channelled through such a foreign base country in ways which made it very hard to establish that no active business was really being carried on there see Chapter 7 below. For these reasons, neither the breadth of the UK residence rule, nor the early enactment of the US rules against CFCs, succeeded in stemming international tax avoidance. The use or abuse of tax havens continued to grow rapidly in the 1960s and 1970s, and became of increasing concern to the Revenue authorities of several of the main capitalist countries. Evidence on the extent of use of tax havens was gathered for the US Treasury and the IRS and published in a report by Richard A. Gordon, the Special Counsel for International Taxation, in 1981 the Gordon report, US Treasury 1981. More discreetly, the British Inland Revenue did not publish the special survey it carried out at about the same time, but some of the information gathered was given in its 1982 proposals on Taxation of International Business, which led to the enactment of UK provisions on CFCs see Chapter 7 below. By this time, a number of countries had enacted some provisions against foreign tax havens or tax shelters. In particular, Germany had also found its rules on company residence ineffective against tax haven intermediary companies see Chapter 1 section 2a above, and after attempting to deal with the problem administratively, enacted a comprehensive Foreign Tax Law of 1972, modelled on the US Subpart F provisions see Chapter 7 section 1a below. As the enforcement of these measures came under consideration, the limits of unilateralism became apparent, and the OECD Fiscal Committee undertook a series of studies on international avoidance and tax havens. This brought the governmental authorities into conflict with representatives of international business, which resented the increasing slur of illegitimacy being cast on international arrangements which they had developed in order to overcome what they regarded as the inadequacies of the international tax system. Yet government and business representatives were still equally reluctant to open the Pandoras box which both considered had been firmly padlocked by the historically­developed principles of international taxation. Nevertheless, these principles ­ separate accounting and arms length pricing ­ were proving increasingly inadequate to resolve the questions of international equity raised by the allocation of the tax base of internationally­operating business. 6 T AX H AVENS AND I NTERNATIONAL F INANCE The problem of international taxation has always been closely linked to that of international capital flows. We have seen that it was in order to encourage inward investment that capital importing countries were persuaded to tax at source only the business profits attributable to a Permanent Establishment or subsidiary, and to restrict their withholding taxes on outgoing dividends, interest, royalties and fees. The capital exporting countries, principally the US and UK, while claiming jurisdiction to tax repatriated income, developed the use of the foreign tax credit to ensure tax equity between home and overseas investment returns. This assumed that international investment flows were essentially portfolio investments: that the investor chose whether to place money at home or abroad, and brought home the returns on foreign investment. Some countries went further and exempted residents from tax on income from foreign investments. While this in principle conceded the primary right to tax to the source country, tax concessions to attract investment and low or no withholding taxes on investment returns could significantly reduce the tax rate on foreign investments if channelled through convenient intermediaries. As foreign investment became dominated by the direct investment of TNCs, the distinction between business profits taxable at source and investment profits taxable in the home country of the investor became harder to maintain. Policy­makers became increasingly aware that a TNC carrying on business through a foreign subsidiary, especially one that is 100 owned, has considerable flexibility in determining its capital and cost structures Lessard 1979. This gives it considerable control over the proportion of earnings declared as business profits of the subsidiary, from which dividends may be paid to the group, and the amounts payable to related companies as interest on loans, or fees or royalties for services. Since such payments may normally be deducted from gross profits before taxation, the TNC could minimize business profits taxable at source. At the same time, by choosing the forms and routes taken by payments from foreign operating subsidiaries, TNCs could also minimize their liability to taxes on investment returns. In particular, as profits from foreign investment grew, TNCs increasingly took advantage of tax deferral, by accumulating investment returns offshore ready for reinvestment rather than returning them to be taxed at home. Hence, the foreign tax credit became ineffective as a means of ensuring equity between returns on domestic and foreign investment. The argument for complete exemption of foreign profits from taxation by the country of residence of the owner was lost in the 1950s, in the US and the UK, but became a debate about the permissible limits of deferral of taxation on earnings retained abroad discussed in the previous chapter. Deferral of home country taxes on earnings retained abroad encouraged TNCs to expand their foreign operations primarily through retained earnings and foreign borrowings. This pattern became tolerated, although the authorities in the countries of origin of the TNCs attempted to impose limits on the proportion of global profits which could be spirited into low­tax limbo. An important factor in the ability of TNCs to minimize their international tax exposure has been the role they have played in international capital markets. In turn, however, the growth of these markets has stimulated others to seek the advantages of low­tax borrowing and lending. The TNCs, as international businesses, could with some degree of legitimacy organize their activities to reduce their average overall tax rate, by basing some especially financial operations in low­tax countries. This was not so for nationally­based businesses or investors. Yet, as international capital markets have grown, facilities have been developed which make it increasingly tempting for a much wider range of those with access to or need for capital to overstep the often hazy boundary between avoidance and evasion. This temptation is all the greater since the facilities and procedures involved have been pioneered for the benefit of the worlds major corporations and banks, and under the protection of the respectability they afford. Already in the 1950s, companies expanding abroad had begun to set up intermediary subsidiary companies as conduits or bases for financing foreign operations Gibbons 1956. As was mentioned in the previous section, tax avoidance by the use of convenient foreign jurisdictions had already emerged in the 1920s and 1930s, mainly to shelter private family fortunes. Thus, for Britain the Channel Islands and the Isle of Man, for the US the Bahamas and Panama, and in continental Europe the statelets of Liechtenstein and Monaco as well as the banking centres Switzerland and Luxembourg, had already become tax shelters. New locations began to offer themselves in the postwar period: the Netherlands Antilles, which had the advantage of tax treaties extended to it by its colonial mother­country Holland, announced low tax rates specifically designed to attract holding companies in January 1953. 1 1 See notes in the Bulletin for International Fiscal Documentation 1953, p.7, p.21. Other former colonial dependencies tried to follow suit, as their rulers saw that attracting financial business could prove lucrative; although the prospects of offshore status providing a basis for economic development were more remote, since brass­ plate companies are not great generators of employment. A link with a large metropolitan country provided a good basis, not only because of the possible applicability of tax treaties, but also other advantages to attract investors ­ a familiar language and legal system, and association with a hard currency. The use of intermediary companies located in such tax havens was initially somewhat discreet, due to the uncertainties in the laws of home countries such as Britain and the US on taxation of foreign retained earnings, and the discretionary nature of much of its administration discussed in the previous chapter. Subsequently, international tax avoidance arrangements became much more generalized, publicly available and discussed, due to a great extent to the emergence of the offshore financial centre.

1. Offshore Finance