The Political Campaign against WUT

4. The Political Campaign against WUT

In addition to action through the courts, TNCs began to take up the question of WUT through national and international trade associations and chambers of commerce, and other forms of lobbying. At first, this was done discreetly: large corporations prefer to explain a reasonable case directly to a responsible official than to create a public row, which can be counter­productive. Non­American TNCs took up the matter with their home governments or tax administrations. These in turn raised it with the relevant US government officials with whom they came into contact. Officials of the US federal government were on the whole sympathetic, although considering themselves relatively powerless in a situation which concerned State prerogatives. An opportunity to attempt some action against WUT arose in 1974, in the negotiation of a new US­UK double taxation treaty on Income Tax. The American federal government had initiated discussions for a new agreement to replace the historic treaty of 1945, due to the British introduction of a new system of taxation of corporate dividends in 1973. Abandoning the `classical ¶ system, Britains new Advanced Corporation Tax increased the tax on corporate profits to 52, but allowed shareholders a refund equivalent to the basic rate of income tax payable on their dividends. This created a problem for non­resident shareholders, especially foreign companies with British subsidiaries. 1 Negotiations soon produced the draft of an agreement which allowed such US parents to recover half the ACT paid, while British firms with US affiliates benefited from reduction of the withholding tax on dividends from 15 to 5. At the same time, the negotiators took the opportunity to bring the treaty in line with new formulations that had been introduced in tax treaties since 1945. However, one exceptional provision was included at the request of the British: in Article 9, which incorporated the arms length principle of the OECD model, there was added a clause 4 explicitly stating that the arms length method must be applied also in the case of taxation by political subdivisions of the Contracting States treaties normally cover only federal taxes. If the Treaty were ratified, and unless and until this provision were ruled unconstitutional by the US courts, it could prevent any American State from applying WUT to a British TNC. This provision survived the discreet consultations held by both sets of negotiators with specialists and interested persons, and the treaty was signed on 31st December 1975. In January 1977 the Treaty was approved by the House of Commons. However, its ratification by the US required the `advice and consent ¶ of the Senate, which proved to be no smooth passage. In June 1978, two years after it was sent to the Senate, that body gave its consent, but subject to a reservation tabled by Senator Church, the Foreign Relations 1 For a discussion of the problems posed by integrated corporate­personal tax systems for tax treaties see Chapter 2.2 above. Committee Chairman, eliminating Article 94: although his reservation had itself failed to gain approval either in the Committee or the full Senate, the treaty failed by five votes to gain the necessary two­thirds majority, until the reservation was resurrected. 1 Instead of providing a discreet means of nipping in the bud the threat of WUT, Article 94 contributed to the growing controversy in the US over the unitary approach and the taxation of TNCs. In June 1979, 40 British TNCs set up the Unitary Tax Campaign UTC as a lobbying grouping. However, since the US­UK treaty contained valuable benefits for both British and American TNCs, nobody gained from the delay in ratification; so despite protests from the UTC, the British government and the House of Commons accepted the exclusion of Article 94, and the treaty finally came into effect in March 1980. In place of the treaty approach, which might have prevented the application of WUT but only to British firms, the opponents of unitary taxation once again revived attempts at federal legislation, which once again ran into controversy. Not only did Senator Matthias Interstate Taxation Bill of 1979 fail, but the House Ways and Means Committee commissioned a study by the Comptroller General on the taxation of TNCs. When this appeared in 1981, it was critical of the federal tax authorities efforts in international taxation, and recommended that they study alternatives to the arms length approach US GAO 1981, discussed in Chapter 8 above. The federal government was itself caught up in the contradictions of the issue. Although President Reagan had obtained political support from many sectors of big business, his own right­radical populism had matured in California, the home of the personal tax revolt and of WUT. The continuing political steam behind unitary taxation was shown by the growing number of states which had adopted or were moving towards it. By 1984, all 45 states which levied a corporate income tax applied formula apportionment to corporations conducting interstate business; about half of these also applied it to the combined income of multi­company firms operating interstate through subsidiaries; and about half of those using the `combined ¶method required the inclusion of foreign subsidiaries involved in the same unitary business US Treasury 1984A, p.1. The Reagan governments efforts to reduce federal spending involved a New Federalism programme, which transferred many spending obligations to the states, and therefore fuelled their increasing interest in WUT as a source of revenue. The President rejected the advice of his Cabinet Council of Economic Affairs to support the Congressional legislative initiatives to curb WUT, and resisted pressures from the UTC and others to intervene with an amicus curiae brief in the Supreme Courts consideration of the Container Corporation case, discussed above. 2 At the same time, the US was coming under political pressures 1 The treaty therefore entered into force as modified by a protocol of 15th March 1979 which removed the reference to taxation by political subdivisions from Article 94, which remains in this emasculated form. 2 See Freud Tyler `M U5HDJDQ V7D[LQJ3UREOHP¶LQDQFLDO7LPHVVW1RYHPEHU from its closest allies; the issue was no longer one for technical discussions among officials, but an item on the agenda of Summit meetings. Finally, President Reagan set up a high­level Worldwide Unitary Taxation Working Group under Treasury Secretary Regan, immediately before the visit to Washington in September 1983 by Mrs Thatcher, who had written to Mr Reagan protesting against unitary taxation and was expected to raise it with him in person. 1 The Regan Working Group was immediately deluged with submissions from large corporations and other interested parties, and set up a Task Force to conduct hearings, sift the options, and try to come up with proposals which could satisfy the varied membership of the Group, which included representatives of WUT States and the Multistate Tax Commission, as well the Chief Executives of IBM, Ford, Exxon and other American corporations. Despite its best efforts, the Task Force could not come up with an agreed report for President Reagan to take to the London Economic Summit of June 1984. Here the President was berated by his allies, especially the British, not only over WUT but a wide range of assertions of regulatory powers by US bodies over TNCs and international business generally, such as the rows over the Laker case and over the US embargo against supply to the Soviet Union of equipment for the Siberia­Europe natural gas pipeline. Unilateral assertions by US regulatory bodies of jurisdiction over such different aspects of international business had led to complaints of `extraterritoriality ¶ and to political interventions at the highest levels in attempts to develop processes for the coordination of regulatory jurisdiction Picciotto 1983. When the Regan report did emerge in August 1984, it contained agreement in principle on, but disagreement on the actual method for, the introduction by states of the option of `waters edge ¶unitary combination. `Waters edge¶would limit unitary combination to US business, both for US and foreign firms; however, the worldwide combined approach could be used if separate accounting between their US and foreign business resulted in tax evasion, or failed clearly to reflect income, or if the company failed to comply with disclosure requirements. In exchange for agreeing to move away from WUT, the states obtained a promise of federal assistance with taxation of corporations, especially TNCs. The IRS agreed to put more resources into auditing international business, and to help states with disclosure from corporations, including making available to states information received from treaty partners under the information exchange arrangements of double tax treaties see chapter 10 below. No agreed way could be found, however, of reconciling the `waters edge ¶rule with the other agreed requirement, that state tax policy should maintain equality of conditions of competition between US TNCs, foreign TNCs, and purely US firms. The difficulty centred on two specific problems: i the treatment of 8020 1 Financial Times 24.9.83. corporations US firms with 80 of their business abroad; and ii the right of states to include income received from abroad in the US taxable base. 1 The lobbyists gave a cautious welcome to the Regan reports `waters edge ¶proposals, and continued political pressure, as well as well­publicised threats by foreign TNCs to disinvest from unitary tax states, gradually led to a move towards the waters edge option. The disinvestment threat was privately conceded to be an empty one, since Californias booming economy is calculated to be the 8th largest in the world. Perhaps more effective was the retaliatory amendment which the UTC had succeeded in inserting, through backbench action, into the UK Finance Act of 1985 s.54. 2 This provision allowed the withdrawal of Advanced Corporation Tax refunds on dividend payments from the British subsidiaries of US parent corporations in unitary tax states. This was a very serious threat which, if implemented, would mean a breach of the US­UK tax treaty, and it produced several Bills in Congress for counter­retaliation, and proud assertions of refusal to `bow to the British; but it may also have persuaded US TNCs, some of which had been lukewarm in their opposition to WUT since it hurt their foreign competitors far more than them, to add their voice to the protest. Nevertheless, the tabling of Administration­supported Bills in Congress to block state use of WUT persuaded the dwindling number of WUT states to take action which would preempt federal legislation. California, which was the most important state due to its booming economy, finally enacted legislation in September 1986, offering corporate taxpayers a `waters edge election ¶ but on stiff conditions. Companies opting out of worldwide unitary taxation would be locked in to that choice for 10 years ahead, would have to accept comprehensive disclosure, and to pay a fee into a special Fund. 3 8020 corporations would be included in US combined income, as would receipts from overseas subsidiaries, although with a 75 exclusion. Reactions to the Californian legislation were mixed. It was hailed as a victory by some of the anti­unitary lobby, especially the foreign TNCs, and welcomed by the British government, which announced that retaliatory action would not now be taken although the power to do so would remain. However, American TNCs objected that the inclusion of part of the income received from abroad was discriminatory as between US and foreign TNCs, and therefore failed to meet the Working Groups 1 For differing inside accounts of the Working Group see Dexter 1985 and Mattson 1986. 2 Proposals for such a measure had previously been resisted by the Government, which hoped to make headway through direct intergovernmental approaches. 3 The fee would be thirty­thousandths of one percent of its total of property, payroll and sales in California; reducible to a minimum of one­thousandth of one percent by the amount spent in the state on new plant, facilities or employment: Senate Bill No. 85, Cap.660, section 25115. The `domestic GLVFORVXUHVSUHDGVKHHW¶UHTXLUHVGHWDLOVRIWKHDFWLYLWLHVRIDOOLQFOXGLQJQRQ­US, related firms, and of the apportionment percentages reported to other US states. requirement of competitive fairness. A comment by the former Treasury official who had directed the Working Groups studies argued that on basic principle income received from abroad should be excluded under the `waters edge ¶ criterion, but equally no deduction should be allowed for interest payments on debt financing for foreign subsidiaries: state taxes are source­based, as opposed to federal taxes which are based on residence but allow a full foreign tax credit McLure 1986a, 1986b. The fee requirement was also criticised as `a ransom ¶ but despite these reservations the Reagan administration withdrew the threat of federal legislation. Californias Franchise Tax Board expected only some 350 of the estimated 1,000 TNCs in the state to take the waters edge option, due largely to the fee and the 10­year requirement. The California legislature enacted an amendment in 1988 relaxing the conditions for a waters edge election, including reducing the period of election to 5 years, but the lobby continued to press for a more satisfactory version of `waters edge ¶ both in California and in other states. 1 Nevertheless, WUT was far from dead. It was clear that if state corporate taxation based on separate US accounts were to be effective, there would have to be a significant increase in the enforcement effort. State authorities complained that their examiners lacked expertise and information, and bodies such as the MTC had inadequate resources to carry out joint audits on their behalf. However, information exchange arrangements between states were increasing. The IRS also agreed to play its part, and announced in early 1987 a 25 increase of the examiners assigned to international tax returns, both for non­resident US citizens as well as TNCs; but the increase has merely kept pace with the growth of foreign investment into the US Woodard 1988. The IRS undertaking to supply states with information on TNCs obtained under tax treaties would require changes to the treaties, and although some treaty partners were said to have indicated a willingness to consider this, it would inevitably be a slow process, and dependent on abandonment by states of WUT see chapter 10 below. Enforcement based on separate accounts not only requires more audit resources, it necessitates detailed regulations on various aspects of intra­firm pricing, which need frequent revision, as well as international coordination, as we have seen in the previous chapter. The further study of s.482 enforcement which had been recommended by the GAO report of 1981 and mandated by the Tax Reform Act of 1986 was carried out, and resulted in the controversial `white paper ¶of 1988. The attack on the `myth of arms length ¶by advocates of WUT see especially Langbein 1986 had achieved some effect: even the strongest advocates of separate accounts began to stress that the arms length criterion is only a means of establishing true or fair accounts e.g. Hunter in Competent Authorities 1986. In the view of some academic commentators, the unitary approach could have continuing, and perhaps increasing, validity and usefulness McLure 1984, McLure 1989. 1 For a summary of WUT in California see Plant, Miller and Crawford 1989.

5. The Global Apportionment Alternative