The Rise of Business Taxation

partial success, but have also encountered great technical and political difficulties, reflecting continued jurisdictional problems. International arrangements for taxation of international business still assume that, subject to a reasonable right for source countries to tax genuine local business activities, the residual global profits belong to the `home ¶country of the TNC; but there are no clear criteria for the international allocation of costs and profits between home and host countries Chapter 8 below. More seriously, however, this assumption is becoming increasingly inappropriate as TNCs have become much more genuinely global, combining central strategic direction with a strong emphasis on localization and diversity, with complex managerial structures and channels aiming to combine decentralised responsibility and initiative with global planning Bartlett and Ghoshal 1989. Shares in them have become internationally traded and owned; they often draw on several centres for design, research and development located in different countries in each major region; and even their top managements are becoming multinational. Businesses such as banks and stockbrokers involved in 24­ hour trading on financial markets around the world have become especially global, and able to take advantage of even tiny price differences in different markets. While the international coordination of business taxation has come a long way, it seems still to lag significantly behind the degree of globalization developed by business itself.

2. The Rise of Business Taxation

The move towards direct taxation of income or revenue was a general trend, especially in the years during and following the first world war; but specific variations developed in different countries, in particular in the application of income or profits taxes to businesses and companies. 2.a Taxing Residents on Income from All Sources A number of states have applied their income taxes to the income derived by their residents from all sources, even abroad, although sometimes this does not apply to income as it arises, but only when remitted to the country of residence. The definition of residence, already difficult for individuals, creates special problems in relation to business carried out by artificial entities such as companies; while the formation of international groups of companies raises the question of whether a company owning another should be treated as a mere shareholder, or whether the group could be treated as resident where the ultimate control is exercised. i Britain and the Broad Residence Rule. Britain was distinctive, since it already had a general income tax, introduced by Pitt and Addington during the Napoleonic Wars. Although this never produced more than about 15 of government revenues during the 19th century, it was important in establishing a single general tax on every persons income from all sources. Increases during the Boer War led to pressures for a graduated rather than a flat­rate tax, and a supertax was instituted in 1909 in Lloyd Georges `peoples budget ¶ entering into effect only after a constitutional conflict with the House of Lords. Between 1906 and 1918 the basic rate rose from one shilling to six shillings in the £ i.e. from 5 to 30, with a supertax of 46 a top rate of 55, and the total yield increased seventeen­fold Sabine 1966. Pitts property and income tax of 1798 was levied upon all income arising from property in Great Britain belonging to any of His Majestys subjects although not resident in Great Britain, and upon all income of every person residing in Great Britain, and of every body politick or corporate, or company, fraternity or society of persons, whether corporate or not corporate, in Great Britain, whether any such income ... arise ... in Great Britain or elsewhere ¶39 Geo.3 c.13, sec. II. This broad applicability was repeated in Schedule D of Addingtons Act of 1803, and again when income tax was reintroduced by Peel in 1842. 1 It therefore applied from the beginning to bodies corporate as well as individuals, so that when incorporation by registration was introduced after 1844, the joint­stock company became liable to tax on its income like any other `person ¶ Not until 1915 were companies subjected to a special tax, the wartime Excess Profits duty, which was levied on top of income tax and accounted for 25 of tax revenue between 1915­1921. After 1937, companies were again subjected to a profits tax and then in 1939 an excess profits tax, both levied on top of income tax; from 1947 the profits tax was levied with a differential between distributed and undistributed income until 1958. Only in 1965 was a Corporation Tax introduced which actually replaced both income tax and profits tax. The personal character of the income­tax, and its early emergence, therefore established the principle of taxation of British residents on their worldwide income. The liberal principle of tax justice, which legitimised the general income tax, was thought to require that all those resident in the UK should be subject to the same tax regardless of the nature or source of their income. However, when the possibility of incorporation began to be more widely used, in the last quarter of the 19th Century, problems arose in relation to the liability to British tax of companies whose activities largely took place abroad. In 1876 the issue was 1 Schedule D contains the broadest definition of income chargeable to tax, and is the provision in relation to which the residence test has continued to be mainly relevant: for the important differences in assessment between Case I and Cases IV and V of Schedule D, see below. Repealed in 1816, the income tax was reintroduced as a limited measure in 1842, to supplement revenue lost through reduction of import duties. appealed to the Exchequer court, in two cases involving the Calcutta Jute Mills and the Cesena Sulphur mines. Both were companies incorporated in England but running operations in India and Italy respectively; each had executive directors resident at the site of the foreign operations, but a majority of directors in London, to whom regular reports were made. The judgment of Chief Baron Kelly showed an acute awareness that the cases involved `the international law of the world; but he considered that he had no alternative but to apply what he thought to be the clear principles laid down by the statutes. The court held that in each case, although the actual business of the company was abroad, it was under the control and disposition of a person the company whose governing body was in England, and it was therefore `resident ¶in Britain and liable to tax there. Aware that many of the shareholders were foreign residents, and that therefore a majority of the earnings of the company belonged to individuals not living in Britain and therefore `not within the jurisdiction of its laws ¶ the court contented itself with the thought that if such foreigners chose to place their money in British companies, they `must pay the cost of it ¶ 1 However, it was made clear that the decisions were not based on the fact that the companies were formed in Britain, but that the real control, in the sense of the investment decisions, took place in London. This was confirmed by the House of Lords decision in the De Beers case De Beers v. Howe 1906. De Beers was a company formed under South African law; not only that, but the head office and all the mining activities of the company were at Kimberley, and the general meetings were held there. Nevertheless, the House of Lords held that `the directors meetings in London are the meetings where the real control is always exercised in practically all the important business of the company except the mining operations ¶ Hence, although the company was not a British `person ¶ it was resident in Britain and liable to British tax on its entire income wherever earned. Further, in Bullock v Unit Construction Co. 1959, East African subsidiaries were held to be managed and controlled by their parent company in London and therefore resident in the UK, even though this was contrary to their articles of association. The decisions on residence still left open the question of definition of the tax base; since, although the British income­tax was a single comprehensive tax, it required a return of income under a series of headings ­ five schedules each containing separate headings or `cases ¶ On which income were UK­resident businesses liable: in particular, were they liable to tax on the trading profits of the foreign business or only on the investment returns? This distinction had important implications which were not fully clear either in legal principle or in the minds of the judges. Included in liability to tax under Schedule D were the profits of a trade carried on in the UK or elsewhere Case I of Schedule D, and the income from securities case IV or 1 Since the British income tax was considered to be a single tax, companies were permitted to deduct at source the tax due on dividends paid to shareholders and credit the amounts against their own liability: see section 3.b below. `possessions ¶ case V out of the UK. A UK resident could in principle be liable under Case I for the profits of a trade carried on abroad; but the House of Lords in Colquhoun v Brooks 1889 also gave the term `possessions ¶ in Case V a broad interpretation, to include the interest of a UK resident in a business carried on abroad because the case concerned a partnership which itself was resident abroad, although the sleeping partner was UK­resident. The distinction was significant, since under Case I profits are taxable as they arise, while income under cases IV and V was taxable only when actually remitted to the UK; the importance of the distinction was reduced after 1914, when most overseas income was brought into tax on the `arising ¶ basis. However, if a UK company or UK shareholders set up a foreign­resident company to carry on the foreign business, the courts took the view that UK­resident shareholders did not own the business itself but only the shares in the company. Even a sole shareholder was considered to have only the right to a dividend Gramophone Typewriter Ltd. v. Stanley 1908, unless the foreign company was a mere agent of the British company Apthorpe v. Peter Schoenhofer, 1899; see also Kodak Ltd. v. Clark, 1902. The UK owners would thus be liable to tax only on the dividends declared by the foreign­resident company, and not on its business or trading profits, which could therefore be retained by the firm without liability to UK tax. The tax commissioners were normally willing to find that a company operating a business abroad was liable to tax under Case I if directors in the UK took the investment decisions. However, confusion seems to have been caused by the view taken in Mitchell v. Egyptian Hotels 1914, apparently based on a misunderstanding of Colquhoun v. Brooks, that Case I only applied if part of the trade took place in the UK. Nevertheless, a majority of the judges in the Egyptian Hotels case were willing to hold that the same facts that showed a company to be resident in the UK established that part of its trade was in the UK. This was the basis of the view taken by the Inland Revenue, which in its evidence to the Royal Commission of 1953 stated that for a company to be chargeable under Case I it must be resident in the UK using the central management and control test and have part of its trade in the UK; but that `in practice the two tests coalesce ¶ Despite the fundamental confusion in the legal position, caused especially by the disagreements among the judges in the Court of Appeal and House of Lords in the Egyptian Hotels case, this important legal principle was not further clarified by test case or statute. 1 Nevertheless, British investors in a foreign business could not escape potential liability to income tax on its trading profits unless the whole of its activities and all the management and control took place abroad. This could be arranged, however, and it was even possible for a company registered in Britain to be resident abroad. In Egyptian Delta Land and Investment Co. Ltd v. Todd 1929 a British company set up in 1904 to own and rent land in Egypt had in 1907 transferred the 1 See the discussion in Sumption 1982 ch. 9 and the analysis by Sheridan 1990. entire control of the business to Cairo, and appointed a new Board whose members and secretary were all resident in Cairo, where its meetings were held and the books, shares register and company seal kept; to comply with the Companies Acts the registered office remained in London and a register of members and directors was kept there by a London agent paid by fee, but the House of Lords held that this did not constitute UK residence. Later, tax planners could set up foreign­resident companies to ensure that individuals resident in the UK could escape tax on the trading profits of a foreign business. Thus, the entertainer David Frost in 1967 set up a foreign partnership with a Bahamian company to exploit interests in television and film business outside the UK mainly his participation in television programmes in the USA; the courts rejected the views of the Revenue that the company was a mere sham to avoid tax on Frosts global earnings as a professional ­ the company and partnership were properly managed and controlled in the Bahamas and their trade was wholly abroad. 1 The decision in the Egyptian Delta Land case created a loophole which in a sense made Britain a tax haven: foreigners could set up companies in the UK, which would not be considered UK resident under British law because they were controlled from overseas, but might be shielded from some taxation at source because they were incorporated abroad. This possibility was ended by the Finance Act of 1988 s. 66, which provided that companies incorporated in the UK are resident for tax purposes in the UK. However, the control test still applies to companies incorporated outside the UK, as well as to unincorporated associations such as partnerships, and remains relevant for tax treaties. 2 This brings the UK substantially into line with many states especially European Community members, which use both incorporation and place of management as tests of residence Booth 1986, 169. The test of `central management and control ¶ developed by the British courts has never been defined by statute, despite calls for such a definition by judges and by Committees Booth 1986, p.25. In practice, the Inland Revenue has interpreted it to mean the place where the key strategic decisions of Directors are taken, as against the `passive ¶control exercised by shareholders Simon 1983, D 101­111. This provided a basis, however shaky, for the British authorities to exercise some jurisdiction over the worldwide profits of multinational company groups TNCs controlled from the UK. In the 1970s, however, as the pace of internationalization accelerated, and TNCs evolved more complex patterns, the Revenue developed doubts as to the effectiveness 1 Newstead v. Frost 1980; until 1974 income derived by a UK resident person from the carrying on of a trade, profession or vocation abroad was taxable under Case V only on remittance: ICTA 1970 s. 122 2b repealed by FA 1974 s. 23. 2 In general, Britains pre­1963 treaties use as the the test of company residence `central management DQGFRQWURO¶ZKLOHPRUHUHFHQWWUHDWLHVXVHWKH2PRGHO VSKUDVHCSODFHRIHIIHFWLYH management: see below. of the definition. In particular, the control test enabled companies to arrange financial or servicing functions in affiliates whose central management and control could be said to be located offshore, and thus reduce UK tax by deducting interest charges, management fees or insurance premiums from the UK trading profits of their related entities dealt with in Chapters 5 and 6 below. In 1981, the Revenue published a consultative document favouring a move to the test of `effective management ¶ which had been used in tax treaties and had been thought to amount to much the same in practice as `central management and control ¶ Criticism of these proposals led to their withdrawal. The Revenue restated its interpretation of the `central management ¶test, while at the same time affirming that it now took the view that the `effective management ¶principle used in many tax treaties based on the OECD model treaty involved a different test, and therefore by implication the UK would apply this different test where its tax treaties used the `effective management ¶principle, at least for the purposes of the treaty. 1 This is the chequered history to date of the principle of taxation of the world­wide profits of British­based companies, founded on the doctrine of control, viewed from the angle of the investor of capital. The original logic of the British approach flowed from the liberal principle that all British residents should be subject to the same income tax regardless of the source of their income. In view of Britains position prior to 1914 as by far the largest source of global investment funds, it was not surprising that the Inland Revenue should wish to apply the income tax to all businesses whose investment decisions were taken in London, and this view was generally backed by the courts; although there was more uncertainty about whether liability should extend to trading profits if wholly earned abroad, rather than the investment returns or dividends actually paid. At the same time, foreign­based companies were liable to tax on income arising in the UK, including that arising from carrying on a trade or business there. This potential overlap with the jurisdiction of other countries does not seem initially to have caused any significant problems, no doubt because the British tax was low until the Lloyd George budget and then the War, compliance was relatively lax, and similar taxes did not exist in other countries. In the case of foreign­ based companies manufacturing abroad and selling in Britain, the Revenue developed the distinction between manufacturing and merchanting profit, and the tax was levied on the profits from the mercantile activity actually carried out in Britain. 2 1 Statement of Practice 683, replaced in an expanded form by SP 190; see Note in [1990] British Tax Review 139. 2 Income Tax Act 1918, Rule 12 of All Schedules Rules, now Taxes Managment Act 1970, ss.80­81, see Ch. 8 section 1.d below. See also Firestone Tyre Rubber v. Llewellin I.T. 1957 for the reverse case, where contracts were concluded by a foreign parent outside the UK for the sale of tyres manufactured by its UK subsidiary: the foreign parent was held to be trading in the UK through its subsidiary as agent, since the essential element was not the place where the contract was concluded, but the manufacturing subsidiarys links with the foreign clients. ii Germany: Residence based on Management. Britain was both typical and exceptional in its approach to residence. Many countries which developed a broadly­based income tax applied it to all residents, including other capital­exporting countries such as Sweden and the Netherlands; but in the case of companies the preferred test of residence was the location of the `seat of management ¶ which placed less emphasis on ultimate financial control Norr 1962. This test meant that parent companies were less likely to be liable to taxation on the business profits of their foreign subsidiaries. Notably in Germany, the Corporate Tax Law introduced under the Reich in 1920 introduced the combined test of the `seat ¶ of a company, 1 or its place of top management. 2 However, in contrast with the British test of `central management and control ¶ the `place of top management¶ test did not include control of investment decisions, but focussed on actual business management. Thus, companies effectively managed from Germany but incorporated abroad often to avoid high German tax rates on their foreign business could be taxed in Germany on their business profits; 3 and the Tax Administration Law of 1934 explicitly provided that a foreign subsidiary whose business was integrated with that of its German parent company should be regarded as managed and therefore resident in Germany. 4 However, majority ownership was not necessarily top management, even if the majority shareholder was informed and consulted about important investment decisions. 5 The rule `required a complete financial and organizational integration ¶ and the courts finally held that it meant that the parent company must itself be carrying on a business of the same type as that of its dependent `organ ¶ and with which it was integrated. In one case, for example, the parent company coordinated four subsidiaries operating railways: it supplied them with rolling stock, and generally managed their financial, legal, investment and administrative activities. Its operations were held to constitute representation of the group to the outside world, and thus of a different type from the actual business carried on by the affiliates themselves. 6 Thus, the German residence rule did not apply to a foreign holding company, and in 1 The seat is the registered head office, which for a company formed under German law must be somewhere in Germany. 2 The tax statutes of the various German states preceding this law, dating back to the Prussian Income Tax Law of 1891 which established the liability of corporations to income­tax, were based only on the companys seat: Weber­Fas 1968, p.218. 3 Weber­Fas 1968, p. 240 provides a translation of some of the main decisions of the German tax courts on this provision; see also Weber­ DV7KHC2UJDQVFKDIW¶WKHRU\ZDVRULJLQDOO\GHYHORSHG to prevent the cascade effect of turnover tax being applied to sales between related companies, a common occurence since merged businesses often remained separately incorporated because of a high tax on mergers: see Landwehrmann 1974, pp.244­5, and the Shell decision of 1930, discussed in Chapter 8 section 1.e below. 4 Steueranpassungsgesetz s.15, Reichsgesetzblatt 1934­I p.928. 5 Reichsfinanzhof Decision III 13539 of 11 July 1939, translated in Weber­Fas 1968 p.246. 6 Decision of the Reichsfinanzhof of 1 April 1941, I 29040: [1942] Reichssteuerblatt p. 947. practice became essentially elective ¶ Landwehrmann 1974, p.249. Following concern at the rapid growth in the use of foreign intermediary companies in the 1960s to shelter the income of foreign subsidiaries, Germany enacted an International Tax Law in 1972 permitting taxation of the receipts of certain types of foreign base companies as the deemed income of their German owners see Chapters 5, 7 and 8 below. Other countries with a residence­based income tax explicitly exempted business profits either if earned or sometimes only if taxed abroad. Generally, therefore, companies could avoid home country taxation of their foreign business profits, if necessary by interposing a holding company or ensuring top management was abroad. Even if they had to set up foreign subsidiaries to do so, they did not have to go to the great lengths of ensuring the foreign companies were controlled from abroad that were necessary under British law. 2.b Taxing the Profits of a Business Establishment: France A different approach emerged in countries where taxation of business and commercial profits emerged as part of a schedular system, taxing income under a series of headings. In France, despite several attempts from 1871 onwards, the general income­tax was not introduced until 1914, as a personal tax on the income of individuals. This was followed in 1917 by taxes on other types of revenue: commercial and industrial profits, agricultural profits, pensions and annuities and non­commercial professions, but these were considered as separate and parallel schedular taxes, or impots cedulaires. These were added to the old taxes on income from land and mines, and the tax on movable property securities, loans or deposits. Not until 1948 were these separate schedular taxes replaced by a company tax. Hence, under the French system, the income tax from the beginning applied only to individuals, while business activities were always taxed separately and according to the sources of the revenue. This separation of the taxation of individual income from the schedular taxes applying to specific types of revenue gave the latter a `real ¶rather than a `personal ¶character. 1 The old property taxes were considered as arising where the land, building or mine was situated. In the case of industrial or commercial profits, liability to tax arose in respect of profits made by an establishment situated in France, regardless of whether it was operated by a company or other business entity incorporated or resident in France. Equally, a French company was not liable to tax in respect of the profits of its establishments abroad. However, France did include in the income of companies and establishments the interest and dividends received on securities considered to be movable property, whether the debtor was in France or 1 Court 1985 discusses the influence of the French and continental European schedular taxes on the early tax treaties, as well as more recent policy. abroad. Equally, the individual income tax was levied on the income of those domiciled in France regardless of its source. The emphasis in French taxation on the revenue derived from an activity or from property movable or immovable thus focussed on the place where the activity took place or the property was located, i.e. the source of the revenue, rather than the place of residence of the taxpayer. It therefore enabled a more differentiated approach to the question of tax jurisdiction, by using the concept of the earnings of an `establishment ¶. Other systems also shared this approach, including Belgium, some Central European countries, Italy and other Mediterreanean countries, and many in Latin America. In Belgium, the duty on persons carrying on a profession, trade or industry was held by the courts in 1902 to apply to the global income of a company carrying on business partly abroad. This immediately led to business pressures to exempt foreign­source income, and although this failed, the law was changed to reduce to half the duty on profits earned by foreign establishments International Chamber of Commerce 1921. In general, however, countries with this type of schedular income tax emphasised taxation of income at source, so that companies were not taxed on the business profits of their foreign establishments. However, schedular income taxes encouraged manipulation between different types of source, and the lower yields meant greater reliance for public finance on indirect taxes. Tax reforms following the second world war generally introduced an integrated income tax; although corporation and individual income taxes were usually kept separate, usually the tax paid by companies on the proportion of profits distributed as dividends could be at least partially imputed to shareholders as a credit against their personal income tax liability see below section 3. 2.c The USA: the Foreign Tax Credit In the United States, the constitutional limitation of the Federal taxing power meant that no general revenue tax was possible until the 16th Amendment was ratified in 1913, although a 1909 `excise ¶tax on corporate profits had been held valid by the courts. The ratification of the 16th amendment finally enabled federal taxation to switch from indirect to direct taxes, and a sharp reduction of import duties was accompanied by the introduction of a graduated individual income tax. The Revenue Act of 1917 introduced a tax on corporations of 6 of net income, which was doubled a year later, plus an excess profits tax. This was a graduated tax on all business profits above a `normal ¶ rate of return; by 1918 US corporations were paying over 2.5 billion, amounting to over half of all Federal taxes which constituted in turn one­third of Federal revenue. This led to a rapid growth of the Bureau of Inland Revenue, and the institutionalization of a technocratic bureaucracy with a high degree of discretion in enforcing tax law, in particular in determining what constituted `excess profits ¶ Equally, the high corporate taxes turned the major corporations into tax resisters Brownlee 1989, 1617­1618. Both the individual and the corporate income tax in the US were based on citizenship: US citizens, and corporations formed under US laws, were taxed on their income from all sources worldwide. Companies formed under the laws of other countries were, however, only liable to tax on US­source income. Thus the place of management or control of a corporation was irrelevant under the US approach. Profits made abroad were therefore not liable to US tax if the business were carried out by a foreign­incorporated company, but all corporations formed in the US were subject to tax on their worldwide income, including dividends or other payments received from foreign affiliates. However, this was mitigated by the introduction into US law of a novel feature, the provision of a credit against US tax for the tax paid to a foreign country in respect of business carried on there Revenue Act 1918, ss.222 238. The foreign tax credit was introduced following complaints by American companies with branches abroad that high US taxes disadvantaged them in relation to local competitors. It seems to have been the suggestion of Professor Adams of Yale, at the time the economic adviser to the Treasury Department, who accepted the concept that a foreign country had the prior right to tax income arising from activities taking place there. A foreign tax could previously be deducted as an expense before arriving at taxable income. To allow it to be credited not only meant a greater reduction in US tax liability, it entailed an acknowledgment of the prior right of the foreign country to tax profits earned there at source. However, in order to prevent liability to US taxes being pre­empted by other countries, this was quickly subjected to limitations, in the 1921 Revenue Act. The credit was amended to prevent it being used to offset tax on US­source income, by providing that it could not exceed, in relation to the US tax against which it was to be credited, the same proportion that the non­US income bore to US income. The extent to which foreign taxes may be credited has been subject to different limitations at various times: initially the credit was `over­all ¶ allowing combination of all income from foreign jurisdictions; but in 1932 a `per­country ¶limitation was introduced, so that the credit for taxes paid in each country could not exceed the US taxes due on income from that country, although some carry­back and carry­forward was allowed after 1958, and taxpayer election between the overall and per­country limit was allowed from 1961 to 1976. The U.S. Tax Reform Act of 1986 introduced a new combination of the per­country and overall limitation by establishing `baskets of income ¶ to separate high­taxed and low­taxed foreign income for credit purposes. Other countries which have introduced the foreign tax credit have also used a variety of approaches to limitation. Further, in the case of alien residents of the US, the 1921 Act provided that it was only allowable if their country offered US residents the same credit. However, the tax credit was extended by allowing taxes paid by US­owned foreign­incorporated 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