Person:

Shay, Stephen

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.

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.

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.

Arguably, the largest problem in international income taxation is the proper treatment of income that is subject to the legitimate taxing claims of two or more countries. A source country's jurisdiction to tax foreign persons is limited to income earned within the source country's borders. Under current international norms, however, the taxpayer's residence country is required to accommodate the source country's taxing right by employing a foreign tax credit or by exempting foreign source income. Thus, source taxation is at once geographically constrained, but also jurisdictionally superior to residence taxation.

These principles require that international income be divided and accounted for between countries according to criteria that relate income and deductions to geographic locations. To be specific, the consequence of geographically limited source taxation and overlapping, but secondary, residence taxation is that the source of income must be determined so that the right to tax can be assigned. In this sense, the concept of "source" is at the heart of international taxation.

We argue in Section II that the right of source countries to tax foreign persons on their source country income has a robust normative foundation. By contrast, we find that source rules that serve as instruments for implementing source taxing jurisdiction and effecting residence country accommodation of source country taxation are surprisingly lacking in normative content. Thus, if timing of income and expense recognition is the Achilles heel of a purely domestic income tax system, the source of income and expense is an equally weak link in the international tax rules. Because no clear economic or equitable principles guide the formulation of rules to divide income and expense by geographic origin, the construction of these rules has been a significantly arbitrary exercise.

Why is it important to get source and source taxation rules right? One reason is to protect the U.S. income tax base. Today, sophisticated taxpayer planning exploits weaknesses in the income tax regimes of the United States, as well as other developed countries, by taking advantage of (1) the evolution of economic activity in the developed world toward value-added services and intangible assets, (2)increased flexibility in locating tangible economic functions and intangible assets, (3) technological and communications advances that challenge the ability of countries to impose tax at source, (4) substantial innovations in the structuring of financial assets, and (5) the continued availability of low-tax countries that sometimes erect enforcement obstacles in the form of confidentiality restrictions.

Although source taxation plays a vital role in the U.S. international income tax regime by protecting the U.S. income tax base, there has not been a systematic reexamination of U.S. source taxation rules since 1966. In that year, the Foreign Investors Tax Act of 19669 reduced the "force of attraction," net-basis taxation of. foreign investors' U.S. investment income in order to encourage investment of foreign capital in the United States to relieve a chronic balance of payments deficit in the early 1960's. Since that time, however, the balance of payments has ceased to be a concern and the United States has become a net importer of foreign direct as well as portfolio investment." A reexamination of U.S. source taxation rules is long overdue.

A fresh consideration of source rules and source taxation also is timely because international income is an increasingly important element of the U.S. economy. The 2002 Economic Report of the President identifies two directly relevant trends: (1) increased globalization and location of economic activity according to advantageous terms of trade, and (2) a related evolution of U.S. economic activity toward highly mobile value-added services and intangible products (and tangible products with embedded intangible value). Indeed, total trade (measured as imports plus exports) increased from 16% of gross domestic product in 1975 to 26% in 2000.

In our reconsideration of source taxation and the related rules that assign geographic source to items of income and expense, we assume that source taxation will continue to have primacy over residence taxation, except to the extent that treaties provide otherwise, and that international double taxation issues will continue to be addressed through unilateral and bilateral measures. Moreover, we assume that nations will not forgo self-interest in any significant way when they undertake such unilateral and bilateral measures. In short, we believe that reconsideration of source taxation and source rules must be constrained by the premise that nations will continue to approach international taxation issues within a structure that does not depart radically from current international norms. In particular, we see nothing to suggest any reasonable prospect for nations, including particularly the United States, joining in multilateral approaches that deal with sourcing and double taxation of income.

In Section II we set out the theoretical justification for taxing foreign persons who earn both active and passive income by making use of the U.S. physical, legal, and/or economic infrastructure. We evaluate alternative approaches to imposing tax at source on U.S. business activity and conclude that taxation of net business income at the same progressive rates applicable to residents is the best alternative. We also evaluate the role of fairness considerations in source taxation and conclude that they do not bear significantly, except that fairness would not necessarily be enhanced by eliminating taxation at source.

In Section III we summarize the U.S. tax policy objectives regarding international income and develop criteria for U.S. source taxation of foreign persons on income from their U.S. businesses and portfolio investments. U.S. source taxation of nonresidents is important to preserve the perceived legitimacy of residence-based taxation with respect to similar activities carried on by U.S. persons. Specifically, we suggest that a need for "perceived parity" requires a level of effective source taxation comparable to that imposed on residents engaged in the same activity. Moreover, source taxation is important to prevent residents from having an incentive to become nonresidents and earn U.S. income.

As a country whose residents invest abroad, the United States also has strong reasons to resist excessive or discriminatory taxation of nonresidents. We suggest in Section III, however, that the existing treaty concept of nondiscrimination does not adequately recognize the ways in which differential taxation of owners of U.S. business entities should be taken into account in evaluating whether a tax rule results in discrimination in fact.

Finally, in Section III we undertake an extended review of the impact of source taxation's geographical limitations on the administration and enforcement of source tax rules. We observe that withholding at source helps overcome limitations on jurisdiction to enforce. Adoption of the qualified intermediary rules extends the reach of this regime outside the United States to the financial institution dealing directly with the nonresident taxpayer. Notwithstanding these improvements in enforcement mechanisms, we conclude that administration of source taxation would be less burdensome and enforcement less problematic if exceptions from source taxation were adopted only by treaty. We also conclude that enforcement of netbasis taxation at source on a remote seller (of goods, intangibles, or services) without a direct physical presence is extremely difficult in the absence of a treaty.

In Section IV we consider the implications for certain selected U.S. source rules of the criteria developed in Section III. We disclaim, however, any attempt at a comprehensive critique of U.S. source rules. Instead, we provide illustrative examples of our analytical approach by considering the consequences of applying the Section III criteria to the U.S. sourcing rules for services and royalties. We also discuss the implications of residence-based source rules. While we do not evaluate the policy wisdom of exempting income from foreign owned capital, in the light of changes in the U.S. mechanisms for enforcing source taxation of investment income, we argue that now is an appropriate time to consider whether reciprocal treaty exemptions should replace the current U.S. unilateral exemption of portfolio interest and gains on the sale of large stock holdings. We also suggest consideration of developing mechanisms to tax at source income from U.S. sales of goods and services by remote sellers, subject to relief by treaty.

In Section V, we contrast the source rules used for source taxation with the source rules used for the foreign tax credit limitation. We conclude that the two sets of source rules need not be symmetrical if the differences reflect different objectives.

We conclude that there is a need to reevaluate the current scope of U.S. taxation at source. In the absence of a treaty, the objective of the U.S. source taxation regime should be parity in taxation of U.S.-owned and foreign-owned businesses carried on in the U.S. marketplace and a desired level of taxation on income earned by foreign owned capital employed in the U.S. marketplace. The structure of U.S. rules for taxing international income should not expose the U.S. tax base (all income of U.S. residents and U.S. income, appropriately defined, of nonresidents) to erosion. Relief from source taxation should be extended by treaty, not unilaterally, so that the United States can receive reciprocal benefits and can obtain the treaty partner's assistance to assure that the relief does not go to inappropriate persons. We also urge a comprehensive reexamination of U.S. source rules to take account of the purpose for each rule.