Postwar Development of the Bilateral Treaty Network

advantage of treaty provisions by `treaty­shopping ¶ The increased international mobility of capital has also made it increasingly important to ensure international coordination of tax systems, but the process of inter­state negotiation is slow and ponderous, resulting in continual problems of disjunction with domestic tax changes and reforms.

1. Postwar Development of the Bilateral Treaty Network

A turning­point in the development of international tax arrangements was the successful negotiation of a US­UK treaty in 1944­5. The agreement reached by these two powerful states, each with its own network of international relations, was the key to the development of the postwar system of tax treaties. 1.a The US­UK Treaty Negotiation In the wartime context of the Atlantic Charter and the planning of a liberalized postwar world economy, the British Treasury was manoeuvered into modifying its views and accepting a treaty based on a foreign tax credit. It seems that the British Foreign Office, in particular the then Second Legal Advisor, Eric Beckett, played a key role, mobilising pressures from commercial interests and support from the Board of Trade see PRO file FO 37138589. The general theme of the arguments made by business groups was that it was no longer possible to penetrate foreign markets purely through exports, and the operation of foreign branches or subsidiaries had been made extremely difficult by the absence of double taxation treaties and the imposition by countries such as France and the US of high taxes on remittances, which were then liable to UK taxation. In 1944 the British Chamber of Commerce in Paris, temporarily resident in London, wrote to Anthony Eden pointing out that the postwar resumption of British trade with France would require a tax treaty, since double taxation had become a serious prewar problem PRO file FO37141963. At the same time, British firms operating in the US such as Linen Thread, Spratts Dog Biscuits and J P Coats also wrote to the Foreign Office, continuing pressures made in the 1930s, pointing out that the absence of any US­UK treaty had led to the reduction of profits remitted by British­owned subsidiaries in the US, while their American competitors benefited from the foreign tax credit. British subsidiaries in the U.S. were said to have been obliged to have recourse to `unsatisfactory expedients such as invoicing goods at higher prices to the subsidiary or leaving profits to accumulate in the US ¶ because of high US taxes on profit remittances. The Foreign Office was advised that British firms with major US subsidiaries thought to number 57 had taken legal advice about ways used to circumvent this. `One method is to fix a maximum invoice price here at such a level that the American branch makes no profit. This meant showing two prices on the invoice, but even so the American customs accept the lower price to the ultimate purchaser ¶ PRO file FO37138588. However, such expedients were clearly unsatisfactory. A 1944 memorandum sent to the Treasury from the British Chamber of Commerce in the US, pointed out that the problem of international double taxation had increased with high wartime tax rates, which were unlikely to decline quickly after the war. It argued that Britain was no longer a net creditor, and should acknowledge that the attempt to make the foreigner pay for international double taxation through higher prices had failed. The costs had been borne by the trader, and there had been `a steady drift of British oversea [sic] business into oversea operations and a migration of the management overseas ¶ It argued for the exemption of foreign profit from UK tax until distributed in the UK to a UK resident. PRO file FO 37138588. It was probably with the encouragement of the Foreign Office that the American government took the initiative, proposing in January 1944 a treaty based on the recently­ concluded US­Canadian and US­Swedish treaties. This was followed up with a visit to London in April 1944 of a technical team, which hoped to return with an initialled agreement. The British Foreign Office skilfully eased the way, channelling the representations from British firms and chambers of commerce, to overcome the reservations of the Treasury and the Inland Revenue. 1 Treasury caution was expressed in the argument that American investment in Britain would have to be controlled after the war, and that the growth of British subsidiaries abroad should not be allowed to substitute overseas production for exports from Britain. In reply, the Foreign Office pointed out that since US firms already benefited from the unilateral foreign tax credit, the US proposal on double taxation was essentially a political one, in the context of the Atlantic Charter. In place of ad hoc responses to complaints from British business, there was a clear case for a comprehensive policy, which should include revision of the Dominion arrangements. The Inland Revenue took the view that new arrangements should be agreed, since international double taxation led to evasion. However, an agreement with the US should be carefully negotiated, since it would inevitably establish a baseline for future treaties. Reciprocal enforcement of taxes should therefore be omitted, and the exchange of information should be limited, as in the UK­Irish treaty, to information necessary for the enforcement of the treaty. Although both reciprocal enforcement and mutual assistance might be justifiable between the US and the UK, they would not be desirable with other countries with which the traffic would be mostly one­way. On this basis, Sir Cornelius Gregg was able to negotiate a final draft in Washington 1 Following a meeting with the Inland Revenue in 1944, Eric Beckett wrote that congratulations were due to the Foreign Office, as he doubted that any progress would have been made on the tax treaty had the Office not mobilized the Board of Trade and commercial interests: PRO file FO37138589. between November 1944 and January 1945. While final details were being agreed, approval by the War Cabinet was held up by last­minute doubts about the exchange of information provisions. These were expressed by the Minister of Information, who claimed that overseas investors would move money out of the City, fearing breach of banker­client confidentiality. These fears were allayed by a report from the Chancellor of the Exchequer that the Bank of England was strongly in favour of the treaty, and that in confidential discussions bankers had also given their support, pointing out that safeguards had been made for confidentiality in the limited information exchange provision. PRO file FO 37144585. The conclusion of this treaty was a crucial step, since it brought into alignment the US, whose policies would clearly be crucial to the postwar investment and trading system, and the UK, which still retained a major international trading and financial position. As a result, Britain adopted the foreign tax credit: the 1945 Finance No.2 Act provided for a credit for recognised taxes paid in treaty countries on a country­ by­country basis against the tax that would be due on the total income calculated under UK rules, up to the maximum UK tax that would have been payable on the foreign income. Thus, both these key international actors began negotiating their postwar international tax arrangements on a similar basis Gregg 1947. By 1948 some 66 general agreements on income and property taxes, or on the taxation of industrial and commercial enterprises, had been concluded; by 1951 120 were in force with 30 more under negotiation. By far the majority were concluded by Britain and the United States, although several European countries also negotiated some among themselves. The largest number resulted from Britains renegotiation of the Dominion arrangements: by 1951 general bilateral treaties had been concluded with 5 Dominions and 36 dependencies. Agreements were also quickly made with several European countries, as well as other countries with which Britain had links such as Israel and Burma. In addition, the UK encouraged or negotiated treaties between British dependencies or ex­dependencies e.g.Ghana­Nigeria, India­Pakistan, and wherever possible extended to the dependencies agreements made with other countries. 1 To encourage the negotiation of agreements, a unilateral relief was introduced by Britain in 1950, allowing a tax credit for income from non­treaty countries, but with a limit of three­quarters of the UK tax in the case of Commonwealth countries, and one­half for profits made elsewhere. Designed to provide a bargaining counter in negotiations, this limit was abolished in 1953 following the first report of the Royal Commission on the Taxation of Profits and Income UK Royal Commission 1953. 1 The extension to dependencies of tax treaties by Britain, as well as by some other countries such as The Netherlands and Belgium, later caused problems when those countries became independent and some came to be used as tax havens: see Chapter 6 below. 1.b International Oil Taxation The spread of tax treaties during this period was an important element in foreign economic policy, establishing a basis for the rapid growth of direct foreign investment and of transnational corporations, especially American firms setting up businesses in Europe. In establishing the regulatory framework for this process, there were often complex interactions between officials of different government departments, internally and internationally, as well as with the advisors and managers of the major transnational companies. An interesting illustration of this is provided by the changes in international oil company taxation at this time. Renewed postwar exploration in the Middle East had led to the discovery of vast new oilfields in the Gulf states, notably Kuwait and Saudi Arabia, and by 1949 the oil companies, with US State Department support, began negotiating new concession agreements. These were based on the `Aramco formula ¶ which had originated in the concession negotiated with Venezuela in 1942, and the merits of which had been pointed out to Middle East governments by a Venezuelan delegation in 1949. In place of a per­barrel royalty, the new arrangement provided for a mixture of royalties and profits taxes based on `posted prices ¶ The posted price was the transfer price for crude oil from the production companies to the downstream refiners; since most international oil was controlled by the vertically­integrated oil majors, the posted price was a largely notional price. The combination of royalties and profits taxes was supposed to amount to a 50­50 split of profits between government and companies, at the oil production stage. The level of production profits mainly depended on the posted price, but although the producer companies sometimes pressed for improvement of the 50­50 proportion, attention was not focussed on how posted prices were fixed until they were reduced by the oil companies in the late 1950s to stimulate demand from independent purchasers. The oil­exporting countries reacted strongly to the resultant fall in their revenues, and this led to the formation of OPEC in 1960 Odell 1986, p.21. A major advantage for the oil companies of the Aramco formula was that, whereas royalties were merely deductible from gross profits as an expense, the profits taxes could be credited dollar for dollar against the taxes payable by the oil companies to their home states, provided that they were accepted as income taxes qualifying for the foreign tax credit. Hence, the extra revenue payable to the host governments of the producing states would be funded in effect by the oil companies home states. The new tax laws in Saudi Arabia had been drawn up by oil company advisers, with State Department support, to facilitate their approval as eligible for tax credit. A similar law for Kuwait required British government approval, as the Protecting Power. Despite State Department support, these arrangements were viewed with suspicion by the US Treasury and the IRS, which regarded them as a means of funnelling subsidies to the Middle Eastern governments without the need for the approval of Congress. The British Exchequer was if anything more alarmed, since it was even more dependent on taxation of overseas profits for revenue. The extent of potential losses if the arrangement were emulated, not only for oil but other minerals concessions, could be enormous: in relation to Kuwait alone, the losses to the British Exchequer were estimated at £6m per year at the existing levels of output. Following informal contacts between British and American Revenue officials on the occasion of a UN Fiscal Commission meeting, the US Treasury wrote formally in October 1951 asking whether the British had yet formed a view on the oil tax credit. The British Treasury wrote a persuasive note for a Cabinet committee arguing that there was no case for the taxpayer, rather than the cash­rich oil companies, to subsidise Middle Eastern governments to ensure their stability. The oil state host governments themselves could have no special interest in the way they obtained their revenues whether by a general company profits tax or a specific oil tax but only in the amounts. The proposed Kuwaiti tax, for example, could hardly be said to qualify for credit as a general income or profits tax, since it had been specially devised and tailored to the costs of the oil concessions and applied to only a handful of companies; provided the British government took a firm line on disallowing the oil states tax for credit, it was in the Americans interests to follow suit. However, both the Foreign Office and the Ministry of Fuel and Power took a different view. It was not merely a matter of not hampering the British oil companies in their competition with the Americans for new concessions. Both the British government and the oil companies were reliant on US support in relation to world oil arrangements: for example, in trying to re­establish British interests in Iran after the nationalization of the Anglo­Iranian Oil Company. Furthermore, following the sterling crisis of 1949, the British government had asked for cooperation from the American oil companies in measures to reduce the dollar costs of oil. Although they had not been able to agree to a proposal to reduce oil imports by their British subsidiaries by substituting sterling­area oil, they had rearranged their sales so that their UK companies would show disproportionate profits: it was estimated that in the case of Caltex alone this would produce £4.5m additional tax revenue, as well as the beneficial dollar inflows. Continued cooperation with such arrangements would clearly be endangered if the companies should hear that the British government was opposing the `tax route ¶for boosting oil state revenues. Foreign Office objections and procrastination prevented any response at all being sent to the American Treasurys inquiry. In due course, the oil taxes were approved in the US for credit, and the British Inland Revenue was obliged to follow suit. See PRO files T2364234­4239. This episode is a good illustration of the complex geo­political strategic issues that could be raised by international tax questions. Although the oil industry is a special case, it is a very important one. Occuring in the early days of development of the tax treaty network, this example clearly shows that the taxation of transnational companies involved a transnational politics: divisions within national governments, and alliances between parallel departments of different governments, with the advisers and consultants of TNCs, often themselves former state officials, playing a ubiquitous role. In such a situation, it was perhaps not surprising that the Foreign Office officials and transnational company representatives proved more adept at international manoeuvering, and formed a sort of alliance, which in the event defeated the Treasury and Revenue departments cf. Cox 1981, Picciotto 1991. However, the allowability of upstream oil taxes for tax credit downstream became built in to the politics and economics of the oil industry. Once the principle was conceded, it was very hard to take away or even limit. Thus, when the North Sea oil fields were first opened up, the British Department of Trade and Industry apparently did not realise until the late 1960s that there would be little if any British tax revenue under the existing tax system, since foreign tax credits could largely wipe out profits on the North Sea fields UK House of Commons 1971­2, esp. p.275. Parliamentary pressure led to the complex `ring fence ¶system for North Sea oil taxation. In the US, there has been continual criticism of what some consider to be the concealed subsidization by the American taxpayer of the oil producer states Engler 1961; Odell 1986, 35­6. This led to some renewed attempts to deny allowability of foreign oil production taxes for credit, for instance when Indonesia introduced production­sharing arrangements in 1976, and again in 1979 for Saudi Arabias participation­oil arrangements. The oil companies have defeated these attempts only by adroit international manoeuvres and determined lobbying. According to one account, Indonesia asked the US IRS to draw up a tax that would be allowable for credit in the US; although the IRS refused, the same result was produced by US law firms producing versions which were submitted to the IRS and amended until an acceptable one was found Kingson 1981 p.1265. Nevertheless, restrictions on allowability against non­oil income were approved by Congress in 1975 and 1976. Reporting to Congress following further reform proposals, the US Comptroller­ General took the view that the credit was not a suitable energy policy instrument; this report pointed out that 75 of the total foreign tax credit was claimed by the oil industry, an average of 15­17 billion annually in 1974­76, 95 of which was claimed by the 12 largest oil firms US General Accounting Office 1980. Although Congress has continued to snipe at the credit, the oil industrys lobbying power has protected it from complete withdrawal of the advantage. 1.c International Investment and Tax Equity Despite the spread of bilateral treaties, the postwar period saw considerable disagreement and uncertainty about the principles on which international tax arrangements should be based. Although bilateral treaties were quickly developing into an extensive network, there were still considerable unevenness of coverage and variations of substance which reflected the divergences and lack of clarity in aims. As we have seen in the previous chapter, pressures from business for measures to prevent international double taxation had achieved limited results in the period between the wars. In particular, the UK, with extensive income from foreign lending and exports of goods and services, had been concerned to maintain equality of taxation of its residents on income from all sources, and reluctant to give up tax revenue on income from abroad. However, capital­importing countries were reluctant to exempt non­ residents from taxation on locally­earned business income, or even on returns on local investments such as interest and dividends. These differences of perspective on equity for taxpayers were inter­woven with the issue of inter­state equity: the principles adopted for the allocation of tax rights could significantly affect state revenues since some states were predominantly net importers and others net exporters of investment capital. The US­UK treaty, and the introduction by the UK of the foreign tax credit, had established a common position for these two states, which dominated the world economy, especially in foreign investments. They both maintained the overriding, ultimate right of the home state to tax the income of its residents from overseas business. However, they conceded that the host state had the prior claim to tax the business profits attributable to a permanent establishment, and this tax should be credited against the tax levied by the home state on the total global profits. Taxes at source on investment income, such as interest on loans or dividends on shares, should be minimal or zero. In this way, although the host country could tax the business profits made through a fixed local base, the free international flow of investments would not be hampered by high source taxes on foreign­owned business or on remittances. At the same time, home countries could maintain the same level of taxation on all their residents, whether their investments were made and profits came from at home or abroad. This allocation of tax rights, however, did not directly establish any principles of equity in the allocation of the tax base of international business between states, or inter­state equity. It therefore made it very hard, if not impossible, to reconcile equity from the point of view of both the home and the host states. In the postwar climate of concern to encourage international investment while not damaging domestic investment, this question was posed as the problem of reconciling tax equity from the point of view of capital­export and capital­import. From the point of view of a capital­importing host country tax equity between those active in the same market requires that their tax burden should be the same regardless of the country of origin of the investor. From the point of view of a home country, equity means equal tax treatment of domestic and foreign profits, to ensure that capital is not diverted from domestic to foreign investment, and residents do not escape taxation by making their investments abroad. Economists often go beyond the question of tax equity and speak of neutrality, in the sense that a tax system which affects different investment decisions in an equal way should produce the least distortion and therefore the most efficiency in the allocation of economic resources. However, the concept of neutrality depends on the abstractions derived for the purposes of economic theory. In practice it must be considered in relation to the characteristics of different types of investment and the definition of taxable income or the tax­base: in particular, direct investment differs from other capital movements, and the taxation of company profits is not equivalent to taxation of other returns on capital Alworth 1988, 30­32. 1 Capital­export equity favours residence­based taxation, while capital­import equity favours source­based taxation. The main capital­exporting countries, the US and the UK, had only conceded primacy of taxation at source for business profits: they still retained the right to tax the returns from foreign investment, subject only to a credit for allowable foreign taxes. This residual overall right to tax investment returns meant that the foreign investor paid the higher of the home or host country tax rates. The strongest argument of the capital­exporting countries was that the unilateral abandonment of their jurisdiction to tax overseas investment would not lead to fairness in international taxation. Competition to attract inward investment would mean exemptions and tax holidays or ineffective taxation at source; in such a situation, exemption of foreign­source profits by residence countries would mean inefficient international allocation of investment, and inequitable international taxation. Certainly, the countries of origin of investment at that time had generally higher and more effective business taxes than the capital­hungry countries which were willing to offer tax privileges to attract investment. On the other hand, both capital­importing countries and international investors combined to argue that the stimulation of international investment was needed to establish the foundations of growth in the postwar world economy, and this required the exemption of foreign investment profits from residence taxation. These arguments were debated in the 1950s in particular in the US and the UK see Chapter 5 below. The US debate clarified that the citizenship basis of US taxation meant that only individual citizens and corporations formed in the US were directly liable to US taxes on foreign investment profits. For the bulk of foreign investment, which took the form of foreign direct investment channelled through 1 For these reasons I prefer the concept of equity or fairness. On the other hand, to an economist, the notion of fairness is imprecise, and merely means what is acceptable to government, or according to `arbitrary political judgment: Devereux and Pearson 1989, p.16. subsidiaries incorporated abroad, US taxation only applied to profits remitted to the US parent, and could therefore be deferred if profits were retained abroad. In practice, the US system allowed both exemption of retained foreign earnings and a credit in respect of that proportion of the tax paid on on the repatriated profits. Thus, the credit approach could be very similar in practice to exemption. Countries which exempt foreign source business profits may tax as income in the hands of the parent company the net profit repatriated as dividends, or other payments such as fees and royalties. Furthermore, they may take into account the foreign income in determining the tax rate applicable to the remaining income exemption with progression. In the UK, the taxation of overseas profits had been a matter of some political sensitivity since the rejection by the Royal Commission report in 1920 of the pressures to modify it. The Annual Reports of the Commissioners of Inland Revenue from 1925 carried figures on the foreign investment income taxed in the UK, although no estimate was possible of the proportion of the trading profits of UK residents attributable to overseas business. Following renewed pressures from business, the matter was given extended consideration by the Radcliffe Commission the Royal Commission on Taxation in 1953­55. Its final report stressed that the taxation of overseas income was not a purely domestic matter, but must be considered `in the light of the taxing systems and principles of other countries and of any generally accepted understandings as to taxing jurisdiction that can be said to have international recognition ¶ para. 633. The argument for exemption of overseas earnings carried great weight, but there was insufficient consensus in the Committee to concede it completely and immediately. It recommended instead the compromise proposal of exemption of the undistributed earnings of `overseas trade corporations ¶ defined in the ensuing legislation in 1956 essentially as UK resident companies trading wholly overseas. These provisions were in force until the enactment of the Corporation Tax in 1965. 1 Thus, both Britain and the US were only willing to concede the argument for exemption, if at all, for foreign business profits produced by direct investment abroad. The overriding problem was that the international tax arrangements, negotiated between 1918 and 1948, provided an inadequate basis for discussion or negotiation of international equity. Both the procedures and principles of the arrangements assumed bilateral bargaining of national interest based on reciprocity. There had been a virtual abandonment of any attempt to agree multilateral conventions, even for mutual assistance, so that the basic procedure was the negotiation of bilateral treaties based as far as possible on an internationally­agreed model draft. This procedure inevitably gave the major role to the internationally­ dominant countries; yet they have been obliged rely either on finding an actual 1 For a discussion of the international aspects of the post­1965 corporation tax and a discussion of tax neutrality and tax bias, from a fairly abstract economic viewpoint, see Bracewell­Milnes 1971. reciprocity of interest or ideology with potential treaty­partners, or some other inducement or pressures. The substantive provisions of the model drafts reinforced this approach of reciprocal bargaining of national interest. They assumed that host country primary jurisdiction was confined to the business profits of a locally­incorporated company or a permanent establishment, so the bargaining essentially focussed on the limitation of the withholding taxes charged on the remittance of dividends, interest, fees and royalties. It certainly became increasingly clear that national approaches to equity, combined with bilateral international bargaining, provided an inadequate basis for a tax framework that could be both fair and neutral in relation to international investment. From the point of view of internationally­mobile capital, equity could not be assured by unilateral or bilateral state measures. Greater uniformity and international equity in taxation of international business must be sought through broader international agreement. Unfortunately, attempts to develop a comprehensive international approach to business taxation achieved only a limited success, as will be seen in the next section.

2. The Role of International Organizations