Person:

Shay, Stephen

In this Editorial, the authors explain the context of this special issue of the Bulletin for International Taxation. The fundamental premise of the BEPS project is that a coordination of national responses to BEPS can both eliminate double non-taxation and protect against material unrelieved double taxation. The articles in this issue further a dialogue among tax policymakers, taxpayers, advisors and academics that is critical to achieve this objective.

The United States has a worldwide system that taxes the dividends its resident multinational corporations receive from their foreign affiliates, while most other countries have territorial systems that exempt these dividends. This report examines the experience of four countries – two with long-standing territorial systems and two that have recently eliminated taxation of repatriated dividends. We find that the reasons for maintaining or introducing dividend exemption systems varied greatly among them and do not necessarily apply to the United States. Moreover, classification of tax systems as worldwide or territorial does not adequately capture differences in how countries tax foreign-source income.

Perhaps surprisingly, this Article has shown that the debate over formulary apportionment is little more than an alternative path to the larger debate over worldwide taxation versus territorial taxation. The present U.S. international income tax regime for U.S. MNEs is an implicit, overly-generous, and incoherent quasi-territorial system that relies on residence rules, source rules, and the arm’s-length approach to apportion international business profits between domestic income that is currently taxable by the United States and foreign income that is effectively exempt, or nearly so, from U.S. taxation because of deferral and cross-crediting. This version of territoriality is quite ugly because it is highly complex and it imposes only modest restraints on the ability of U.S. MNEs to shift income out of the U.S. tax base to low-tax foreign countries.

Four forms of explicit territoriality have been proposed as alternatives to the current U.S. system. The first is traditional territoriality, which relies on source rules and the arm’s-length approach to apportion international business profits between taxable domestic income and exempt foreign income. This is a simpler regime than the current U.S. system because it confers exemption directly rather than implicitly through deferral and cross-crediting. It does, however, preserve the capacity of taxpayers to shift income to low-tax foreign countries subject only to the modest restraint imposed by the arm’s-length approach. Most importantly, it is inconsistent with the principle of ability-to-pay and it provides a powerful incentive to locate business activity in low-tax foreign countries.

The other three forms of territoriality that are currently part of the debate are three-factor, two-factor, and single-factor global formulary apportionment. Each of them is simpler than either the current U.S. system or traditional territoriality, but each of them leaves U.S. MNEs with considerable capacity to accomplish erosion of the U.S. tax base through income shifting and each of them shares the defects of traditional territoriality regarding inconsistency with the ability-to-pay principle and distortion of business activity. Thus, U.S. policy makers are left with a choice between a normatively flawed and distortive territoriality that imposes modest restraints on income shifting through the arm’s-length approach (i.e., both the current U.S. system of de facto territoriality and traditional territoriality) and a simpler but normatively flawed and distortive territoriality that still allows a substantial amount of income shifting (i.e., three-factor, two-factor, and single-factor global formulary apportionment). This unhappy dilemma can be avoided by adopting real worldwide taxation or, alternatively, by keeping the current regime while creating a Subpart F income category for low-taxed foreign income and insulating that category from cross-crediting with a separate foreign tax credit limitation basket. A more limited form of formulary apportionment then should be used for, and tailored to, particular forms of income, such as intangible income and global trading income, that present discrete taxation problems. Nevertheless, when such income is earned by a U.S. MNE, allocation of income to a foreign jurisdiction under this more limited form of formulary apportionment should not ipso facto result in the income being exempted from U.S. taxation.

This amicus curiae brief in Altera Corporation v. Commissioner supports the government's position and the view of the majority in a 9th Circuit opinion issued on July 24, 2018 and later withdrawn. Amici are tax law professors who conclude that the stock-based compensation cost sharing regulations at issue in this case are not arbitrary and capricious, but rather are consistent with the arm's length standard and are valid and reasonable under Section 482 of the Internal Revenue Code.

In this article, we discuss how various defects in the current U.S. international tax system - deferral, defective income-sourcing and cost allocation rules, lenient transfer-pricing rules, generous cross-crediting, the export sales source rule, the effectively tax-exempt treatment of many types of foreign-source royalties, and the deduction of foreign losses against U.S.-source income - can be combined to make the present U.S. system as generous as, and in some important respects more generous than, a properly designed exemption or territorial system for taxing foreign-source income of U.S. resident corporations. In other words, when judged from a public policy standpoint, the current U.S. system can produce worse-than-exemption results. Because of this, the U.S. multinational corporate community largely has shifted its lobbying efforts away from support for an exemption or territorial system and toward support for changes in the current incoherent international tax system that would further reduce the effective U.S. income tax rate on U.S. corporations’ foreign-source income by magnifying the worse-than-exemption results. In our view, reform efforts in the international tax area should be directed toward comparing the strengths and weaknesses of a properly designed worldwide system with the strengths and weaknesses of a properly designed exemption system, and then proceeding to enact one of those two coherent systems for taxing the international income of U.S. persons. Based on our prior work in the international tax area we believe that such an analysis will lead to a conclusion that a strengthened and properly designed worldwide system is superior to a properly designed territorial system and is definitely superior to our defective and incoherent current U.S. international tax system.

The G20/OECD’s multi-year campaign to combat base erosion and profit shifting (BEPS) marks a critical step in the evolution of the international tax regime and the roles of institutions that guide it. This General Report for Subject 1, IFA Congress 2017, provides a snapshot of the outcomes of the BEPS project by comparing national responses to key mandates, recommendations and best practices through the end of October, 2016 based on National Reports representing the perspectives of 48 countries. These National Reports reveal that the impact of the BEPS initiative on a particular country corresponds to at least three key factors, namely: (1) the extent to which domestic law is already in substantial compliance with BEPS outcomes; (2) the degree to which implementation of BEPS outcomes appears capable of delivering positive revenue or economic results, or both, relative to a country’s experiences and perceptions prior to BEPS; and (3) the type and degree of involvement of a country in the formative stages of the initiative preceding the release of the final BEPS action plans. As BEPS continues to unfold, it is difficult to gauge the full extent to which countries in fact will adhere or defect from the rules. However, the BEPS project has witnessed the transition of global tax governance from the OECD countries exclusively to global fora. This leaves open questions regarding agenda-setting for international tax policy going forward. As we conclude this interim snapshot of the origins, standards, and responses to BEPS to date, we look to future IFA congresses for answers to these questions and a final assessment of the BEPS project.

If there is fundamental U.S. international income tax reform, regardless of the reform option chosen, the United States must decide how to handle the $2.4 trillion to $2.6 trillion of previously untaxed foreign income accumulated by U.S. multinational corporations. In this report, Fleming, Peroni, and Shay argue that the proper approach is to treat the income as a subpart F inclusion in the year before the effective date of fundamental reform and to tax it at regular rates with an option to make the payments in installments that bear market-rate interest. The authors explain why the case for a low or deferred tax on this income is inferior to the case for full immediate taxation.

Although the ability-to-pay fairness principle is a foundational element of American income tax policy, it has played a surprisingly small role in evaluating the U.S. international income tax regime. Perhaps this is because the application of the ability-to-pay concept to international income taxation is complicated by the presence of foreign taxpayers, by income earned through C corporations and by the claims of other governments to tax cross-border income. Nevertheless, it is possible, and indeed essential, to analyze international tax policy in terms of fairness. In this article, we extensively explore the international dimension of the ability-to-pay norm. We argue that this fairness criterion supports the conclusion that taxing worldwide income and ending the deferral privilege provides a tax regime that is superior to either the current U.S. international income tax system or the adoption of an exemption system.

This article is slightly edited from a public comment letter originally submitted to Treasury and the IRS. The article argues that the proposed elective expansion of a high-tax exclusion from the reach of GILTI is inconsistent with the statute, loses revenue, and exacerbates the TCJA’s failure to allocate and disallow expenses incurred to earn foreign income exempted from U.S. taxation. The article explains that allowing a deduction for expenses incurred to earn exempt foreign income is a subsidy for the foreign investment. Taxation of the income to which the expense would be allocated by another country does not alter the character of the expense allowance, against other taxable income, as an unjustified subsidy by U.S. taxpayers of U.S. multinationals’ foreign investments.

In "Reconsidering the Taxation of Foreign Income," Jim Hines analyzes the consequences of taxing, as opposed to exempting, active foreign business income by comparing the expected effects on capital ownership of a "pure" worldwide income taxation system with the effects on capital ownership of a "pure" territorial taxation regime. Consistent with his earlier work, Hines asserts that a capital ownership neutrality analysis supports exempting foreign active business income from home country residence taxation and points to global welfare losses from taxing income on a worldwide basis with a credit for foreign taxes.

As he has previously, Hines sets up his discussion of capital ownership neutrality by criticizing the "older wisdom" of international tax policy that established a "tension between policies that maximize national welfare - NN - and policies that maximize global welfare - CEN." According to Hines, perhaps the most critical of the assumptions underlying the traditional investment location neutrality framework is that "home country taxation does not directly or indirectly affect foreign firms." Hines argues that if greater investment abroad triggers greater investment by foreign firms in the residence country, "[t]he NN implication that home countries maximize their own welfare by subjecting foreign income to taxation with only deductions for foreign income tax payments then no longer follows." If the productivity of an investment depends on its ownership (without regard to the location of the investment) and home and foreign firms compete for ownership of capital around the world, then taxation of foreign income (with a credit for foreign tax) does not necessarily contribute to production efficiency. Instead, Hines argues, different home country taxation resulting from worldwide taxation distorts optimal asset ownership and results in a global welfare loss. In the absence of a global adoption of worldwide taxation, Hines concludes that under an ownership neutrality analysis, exemption of foreign income advances national welfare.

In considering the problem of allocation of expenses, Hines argues that, to assure ownership neutrality, it is not enough to exempt foreign net income. In addition, "general expenses," such as interest and general administrative overhead, should "not be allocated at all [between domestic and foreign income], but instead traced to their uses."

Hines briefly considers the implications of certain practical complications, including transfer pricing and the difficulty of sourcing income, for his analysis. Hines suggests that allowing transfer pricing enforcement concerns to affect the policy prescription would have "a strong element of the transfer pricing tail wagging the tax system dog." In response to fairness questions raised by favorable treatment for foreign income, Hines argues that equity considerations in fact support a special regime for foreign income.

This Commentary first considers the significance of ownership neutrality for economic efficiency based on observations of ownership arrangements in today's marketplace. It next probes certain premises of Hines' argument, including whether substituting foreign-owned for domestic-owned investment results in equal tax revenue from the investment and whether asset ownership is meaningfully linked to the method of double taxation relief employed by a residence country. I argue that the uncertainty of the explanatory power of ownership efficiency, and the limits of current empirical understanding of the effects of alternative international tax policies, makes ownership neutrality an unreliable guide for policy prescription.

This Commentary next considers the effect of tracing indirect expenses, such as interest and general and administrative expense, and suggests this will result in an over-allocation of such expense to domestic income. I question whether it is desirable to further advantage foreign investment in light of the extent of questions regarding ownership neutrality as a policy guide. I then consider some of the "practical complications" briefly addressed by Hines, focusing on transfer pricing difficulties that make Hines' proposed exemption of foreign income (and the current system of deferral) problematic. This discussion supports evaluating policy changes at least in part on the basis of their expected effects on the business income tax base. The Commentary concludes with a brief consideration of Hines' comments on fairness.