International Taxation on the Road to Economic Recovery Clemens Fuest

University of Oxford IFA Trilateral Meeting London, November 3 rd , 2010 1

Summary: • • • • In international taxation, there is a danger that unilateral tax reforms increasingly undermine the consistency and efficiency of the international tax system. It is necessary to

rethink the principles

underlying the taxation of border crossing economic activity. Agreement on these principles can then be a basis for more tax coordination.

Example: Reform of UK Controlled Foreign Companies (CFC) legislation 2

1. Unilateral tax reforms increasingly undermine the consistency and efficiency of the international tax system

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• • Main objectives driving tax reforms: Increasing competitiveness of the corporate income tax system Protection of the national tax base. • • • Policies: Increasingly countries unilaterally restrict the deductibility of interest payments. Unilateral transfer pricing policies. Unilateral policies on exit taxation.

Result: Double taxation or ‘white income’, distortions of international investment flows, uncertainty 2

2. Rethinking the principles underlying the taxation of border crossing economic activity. The example of UK Controlled Foreign Companies (CFC) legislation

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Why do we tax corporations at all?

• • Corporate tax as a proxy for income tax of domestic residents:

ownership principle

(but: firm ownership increasingly internationally diversified) Corporate tax is a tax on economic activity which takes place in the country and benefits from public services:

territorial principle

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Implications for corporate taxation in the UK • •

Ownership principle

requires taxation of foreign source income of UK residents

Territorial principle

requires exemption of foreign source income of UK residents 3

Principles guiding UK corporate taxation of foreign source income: HM Treasury and HMRC, Reform of Controlled Foreign Companies (CFC) Policy Principles Document (July 2009): ‘A move towards a more territorial approach, whilst retaining ownership as an underlying principle seems to be the optimal solution’(29) How can this work?

‘This can be achieved by refocusing CFC rules on

artificial diversion of profits

from the UK,…’(ibid.) 3

Implications: • Main objective: Implement taxation based on

territorial principle

• Role of CFC Legislation: National tax base has to be protected against artificial profit diversion • CFC rules will not tax ‘

profits that are genuinely earned

in overseas subsidiaries’ 3

How can this be implemented?

It is helpful to consider some examples, taken from Devereux (2010):

Example 1

: A UK company uses retained earnings to finance a CFC which produces goods in a country with a lower tax rate than the UK, for example Poland. The profits are distributed to the UK as dividends.

UK CFC principles suggest exemption.

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Example 2

: The same UK company uses retained earnings to equity finance a finance company located in a tax haven. The finance company lends to the same Polish CFC in the first example. The Polish company pays interest to the finance company, which in turn pays dividends to the UK company.

UK CFC principles seem to suggest taxation of the financing company although there is no substantial difference to the first example.

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How can this be implemented?

Example 3

: As example 1, except that the UK company borrows in the UK to finance the equity injection into the Polish company. Here deductibility of interest payments in the UK would imply that the UK subsidises investment in Poland. This is incompatible with territorial taxation (denying deductibility would raise EC law issues, though).

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Example 4

: The same UK company uses retained earnings to equity finance a finance company located in a tax haven. The finance company now lends to a UK subsidiary. The interest paid to the finance company reduces UK profits. Here it seems that profits are artificially diverted from the UK. However, the financing structure of the UK subsidiary could be identical to that of any other UK subsidiary of a foreign company. 3

Key Issue

: To a large extent, the difficulties of dealing with these cases arise because debt and equity financing are treated differently. This can be overcome by either granting deductions for equity costs (ACE) or by introducing source taxes on interest payments (or other limitations to interest deductibility. 3

3. Conclusions

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• • • • • There are good reasons to place more emphasis on taxing corporations on the basis of the

territorial principle

Many issues of tax base protection are caused by the deductibility of interest on debt (and royalties as well as other financing costs) It is helpful that the policy debate about UK CFC legislation is conducted with reference to tax principles, although sometimes the implications of territorial taxation are not fully taken into account One way of implementing territorial taxation would be to extend the use of source taxes on financing costs, royalties and so on Implementing the territorial principle would also mean that foreign losses cannot be set against domestic taxable income (HM treasury discussion document on Foreign Branch Taxation does suggest that loss relief should be granted) 3

Thank you very much.

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