International Investment and Tax Avoidance.

stretched ­ or again legitimacy would be threatened. The law enforcer must consider, first whether a new pattern of activity may be tolerated; this is frequently the subject of negotiation, which might result in adaptation or modification. If the activity is considered unacceptable, a decision must be made whether to proceed against it under existing legal provisions, or to seek approval for legislative amendments. 1 The morality of transactions is often ringingly said to be quite irrelevant to their legal validity. In practice, however, the impossibility of deciding these issues of validity in purely formal legal terms inevitably raises ethical or moral issues. Most commonly, the form it takes is the requirement of openness or frankness. The taxpayer who has laid out the transactions without secrecy or any element of deceit is more likely to gain the approval both of the official and the judge. Since tax planning strategies are developed in consultation between the managers of a business and its professional advisers, considerations of professional ethics in the giving of advice also play an important part. These entail balancing the professionals duty to produce the most economical result for the client against the more general obligation to ensure that accounting and taxation regulatory systems operate fairly for all, and perhaps even in the interests of society. 2 In broad terms, therefore, the three principles on which the validity of tax avoidance rests may be summarised as follows: i the existence of a valid economic or business purpose; ii compliance with both the letter and, broadly speaking, the spirit of the law; iii openness, or at least lack of excessive secrecy. These criteria may be identified both in the advice of tax planners see e.g. Freeman and Kirchner 1945, as well as statements by officials or policy­makers see e.g. OECD 1987­A, p.9.

4. International Investment and Tax Avoidance.

International tax avoidance results from the same factors as national avoidance, but is qualitatively and quantitatively different in scale. We have seen that the opportunities for avoidance result from the problems of equity inherent in a liberal regulatory process such as direct taxation of incomes. In a system consisting of many overlapping jurisdictions, the problem of equity is magnified. To the extent that 1 Normally such amendments take effect prospectively; but it is not unknown for the government side WRWDNHDGYDQWDJHRILWVDFFHVVWRWKHOHJLVODWLYHSURFHVVWRLQWURGXFHDCFODULILFDWLRQ¶LQWKHODZZKLFK may affect pending cases: for an example, see Capon in Fordham CLI 1976 p.104, and Chapter 8 below. 2 See Cooper 1980 for an entertaining elaboration of the professsionals dilemma, and Cooper 1985 for proposals on how to regulate it. freedom of movement of individuals, commodities and funds between jurisdictions is permitted and possible, problems of international equity will arise. Immediately, this involves reconciling equity in the capital­importing or source jurisdiction with equity in the capital­exporting or residence jurisdiction. In addition, where internationally­ integrated activities are concerned, the jurisdictions themselves may have competing claims to a fair allocation of taxable capacity. At the same time, the existence of multiple, often inconsistent, national approaches to tax equity will create magnified opportunities for avoidance. Problems of coordination in enforcement will also magnify the possibilities of successful evasion. International avoidance has therefore resulted from the interaction of tax systems and the unevenness left by the methods found to accommodate and coordinate them. It has been defined very generally as `the reduction of tax liability through the movement or non­movement of persons or funds across tax boundaries by legal methods ¶ Wisselink, in Rotterdam IFS 1979, p.29. The opportunities for such avoidance result from differences between tax jurisdictions, mainly in relation to: i the scope of taxation definitions of residence and source, treatment of foreign earnings; ii the distinction between capital and revenue, and the categorization of types of revenue; iii the tax treatment and rates of tax applied to various legal persons and categories of revenue or capital. International avoidance may be prevented by the prohibition or control of movements of persons or funds, or countered by disallowing or disregarding such movements for taxation purposes. International business necessarily generates international movements of persons and funds. International tax planning entails organising international business transactions in legal forms which involve the optimal tax liability consistent with maximising the overall return. As we have seen in previous chapters, from the point of view of international business, the problem is that international transactions involve a greater likelihood of exposure to multiple taxation. Hence, the continuing demand of the business lobby has been for relief from `international double taxation ¶ During the first half of this century, multiple taxation resulted mainly from international trade and portfolio investment; concern therefore focussed mainly on defining where profits from foreign sales were deemed to be earned, and where a company financed from abroad should be considered taxable. The question of export profits was broadly resolved by developing the distinction between manufacturing and merchanting profit, and allocating the latter to the importing state if the sale was attributable to a Permanent Establishment. The problem of international investment was more difficult, and gave rise, as we have seen, to conflicts between the residence and source principles. The compromise arrangement embodied in tax treaties restricted taxation at source to the business profits of a Permanent Establishment or subsidiary, while giving the country of residence of the lender the primary right to tax investment income. This formula was inappropriate or ambiguous in relation to foreign direct investment by internationally­ integrated TNCs, which were increasingly able to take a global view on both the sources and the application of their funds. In the postwar period, as already mentioned, the major international creditor countries, the US and the UK, continued to claim the right to tax the worldwide profits of their TNCs, subject to a credit for foreign taxes paid. International business argued that the foreign tax credit was inequitable: it meant that profits earned abroad always paid the higher of the home or host country rates of tax; and if the home rate were higher, the investor did not compete on equal terms in the host country market. The Treasuries of the US and the UK argued that the tax credit offered equality of treatment between investment at home and overseas: to exempt foreign income would provide an incentive to overseas investment, as well as encouraging competition among states to attract capital by offering tax reductions. In any case, since most capital­exporting countries taxed repatriated foreign earnings, foreign investors were not disadvantaged against each other. However, since the new pattern of foreign direct investment could take place with relatively little outflow of funds, this debate had an element of shadow­boxing. The large global corporate groups were transnational, in the sense of having an identifiable national origin and corporate base, while their investment capital came initially mainly from foreign profits and then increasingly from global capital markets. The underlying problem was the equitable international allocation of the tax base generated by business activities in several countries which were internationally coordinated by a single firm. However, this issue was not addressed in any international forum for more than two decades. Instead, an international tax avoidance industry emerged. Its primary initial aim was to secure the minimization of taxes on the retained earnings of TNCs. Defenders or apologists argue that international tax avoidance has legitimately focussed on averaging international tax rates, or reducing them as far as possible to the lowest rather than highest rates Bracewell­Milnes 1980. In their view, international tax avoidance or planning is a legitimate response to the inequity of the foreign tax credit, which offers only capital­export neutrality, and imposes tax at the higher of the home and host country rates. However, tax planning has ensured that many international businesses are able to benefit from considerable reductions in average tax rates, using devices which have minimised taxable business profits at source, while routing payments through convenient channels to low­tax countries or tax havens. Furthermore, the tax planning industry, as it developed in sophistication, has become available not only to relatively legitimate international business, but also to activities that were much less legitimate and even less international. In a sense, international avoidance has helped to reduce the distortions produced by the disharmony in international tax arrangements, for the TNC itself is able to structure its global financial flows so as greatly to reduce or eliminate the effects of these distortions on its investment decisions. However, both national and international equity have been increasingly undermined by the exploitation of international avoidance opportunities by TNCs to reduce the cost of capital to them, especially by using the offshore­based international financial system see Chapter 6 below, and Bird 1988, Alworth 1988. With the initial growth of international avoidance, the issue of international equity was first treated as a problem of international avoidance of national taxes. The next chapter will trace the tensions in the policies of the two main capital­exporting countries, the US and the UK, towards the taxation of foreign investment and the problem of avoidance. It was only as the limits of unilateral approaches became clear that an international debate about avoidance emerged, and attempts have been made to coordinate action at the international level. These moves towards coordination, however, once again revived doubts about the adequacy of the international arrangements, as well as the fundamental question of international equity. 5 T HE D ILEMMA OF D EFERRAL . International tax avoidance, as was argued in the previous chapter, resulted generally from the limitations of the solutions offered by international tax arrangements to the problems of effective and equitable taxation of internationally­organised business. These limitations came increasingly to the fore as international investment more dominantly took the form of direct investment; and the problems were most acute for the tax systems of the US and the UK, the two main sources of foreign direct investment. The TNCs, which were the vehicle for this direct investment, developed sophisticated techniques essentially to exploit the deferral of taxation on retained earnings. These techniques built on devices pioneered between the wars to shelter family wealth and their increased use by TNCs consolidated the international tax avoidance industry. This chapter will consider mainly the British and US taxation of foreign direct investment, and the different ways in which they influenced and reacted to the problem of taxation of the retained earnings of TNCs. The problem was posed slightly differently for each country according to the structure of its taxation of international business, and the responses of national authorities were also different, although made with an awareness of the international context and of the measures introduced by other states. In both Britain and the US, as we have seen, when direct taxation was first introduced it applied in broad terms to the income from all sources worldwide of all legal persons considered to be within its ambit. However Britain, the first to develop an income­tax, applied it to residents, while the US law applied to citizens. This difference came to take on an increasing significance with the increased importance of international direct investment through foreign­incorporated subsidiaries. This created opportunities for avoidance of US taxation on retained earnings by channelling them into foreign­incorporated subsidiaries, and led the US to enact the first provisions for taxation of Controlled Foreign Subsidiaries CFCs. Under British law, even a foreign­incorporated subsidiary could be liable to British tax on its business profits if it was controlled from the UK, although from 1956 to 1965 British­resident companies trading wholly abroad were exempt on their retained profits. After 1965, the British authorities used administrative powers controlling the transfer of residence abroad to try to impose limits on the volume of retained earnings in foreign subsidiaries of British TNCs. The growing international interpenetration of capital, however, eventually called into question both the unilateralism of the US approach, and the direct administrative controls of the UK.

1. The UK: Controls over Residence