The growth of international trade and the spectacular proliferation of multinational business ventures is major business news in the world press. This expansion can be attributed to increased political and financial stability in the countries involved, to the establishment of common markets and free trade areas, and to similar developments that arouse considerable interest in the general public.
One important factor rarely stressed is international tax relations. In this field the specialists are frequently left to themselves, largely because of the complexity of the subject and the technical terminology associated with it. This article makes no attempt to offer new solutions or in-depth analysis, but seeks to put forth the main issues in a clear light.
Border Tax Adjustments1
There is fairly general agreement, codified to some extent under the General Agreement on Tariffs and Trade (GATT), that indirect taxes should basically be levied in the country of destination rather than in the country of origin. In other words, if excises, sales taxes, or similar levies are collected in a country, goods exported may be—and generally are—exempted; this is not constituted as dumping. Likewise, when a country combines an excise or tax on domestic production with a corresponding tax on imported goods, it is not regarded as a protective measure. This principle differs from that of origin applied in respect of direct taxes. Under GATT, specific income or profits tax reliefs in respect of exports are labeled as subsidies, and duties on imported goods imposed to compensate for the direct domestic tax burden are basically not acceptable.
The practical application of the destination principle sometimes meets with difficulties. Indirect taxes entering as a cost of production—e.g., on machinery and transport equipment—are often not easy to allocate between the domestic production and the export production of a manufacturer, and reliefs provided for exportation as well as compensating import duties may sometimes be insufficient, or sometimes go too far. One of the motives for introducing a value-added tax is to achieve a more exact method for computation. Sales taxes levied at a late distribution stage, such as retail taxes, with adequate exemptions for production goods, may also reduce this difficulty, since with them, no refund is needed in connection with exportation, and tax on imported goods will generally be collected at the same stage—retail—as the tax on domestic goods.
However, the destination principle has been under attack, particularly by representatives of countries with comparatively low indirect taxation and high direct taxes. The main argument is that a country may achieve an effect comparable to that of a devaluation by changing the relative tax burden from direct to. indirect taxes. In fact, there have been examples of such measures, e.g., France, which in 1968 reduced its payroll tax (which follows the principle of origin) and compensated for the consequent fiscal loss by an increase in the value-added tax (which follows the principle of destination). Before the appreciation of the deutsche mark in 1969, Germany undertook a measure in the opposite direction, reducing the border tax adjustments connected to the value-added tax, and so, in effect, pre-empting the subsequent appreciation.
It is safe to say that the destination principle as currently applied has firm and almost universal support. It is still an open issue whether modifications of the border tax adjustments and/or the tax structure by reason of the similarity of effects between them and changes in the exchange rates should be scrutinized under rules similiar to those governing exchange rate adjustments under the Fund Agreement. This is a large issue, with substantial political implications.
Export duties, as they exist in many developing countries, are in fact a negation of the destination principle. However, export duties are in most cases levjed on primary products such as cocoa and coffee and as a substitute for income or excess profits tax on the producers. They seem appropriate mainly where the supply of the product of the exporting country is sufficiently inelastic, or the demand for it is sufficiently elastic, to make it likely that the incidence of the duties will fall on the domestic producers. The situation where the country is limited to an export quota or would other-wise lose through overproduction is particularly conducive to export duties.
Source vs. Domicile
The principle of destination is not applied on direct taxes such as income and profits taxes. However, two other conflicting principles are generally applied and give rise to intricate problems of double taxation. According to one principle, income should be taxed in the country in which it has its source (e.g., income from real property in the country where the property is situated, business income in the country where the business has been carried on, salaries and wages where the work was performed, and dividends and interest in the country in which they were paid). Another rule is to tax income in the country in which the taxpayer has his domicile.
There is double taxation if the same income is taxed in full both in the source country, because it has emanated from that country, and in another country, because the taxpayer earning the income has his domicile there. It is obvious that if the tax in both countries is significant and one country does not offer any tax relief in respect of the other country’s tax, such double taxation may easily wipe out the income altogether, or reduce it to a point at which the activity is not worth-while.
What is called “economic double taxation” can exist when, e.g., the source country has a very high income tax and low indirect taxes and the country of domicile a high indirect tax to make up for the low income taxes. Similarly, if the income is earned by a corporation in the source country and distributed as a dividend to the taxpayer in the other country, there may be no double taxation in the narrow sense of the word, one country taxing the corporate profits, the other the dividend. But again, the economic double taxation may be significant. This is particularly true if the former country has a high corporate tax and a low tax on dividends, and the latter country a low corporate tax and a high tax on dividends. However, such solely economic double taxation is not the topic here.
Relief from Double Taxation
To give relief from double taxation, three main ways are possible. One is to introduce a general rule that all countries should apply only one principle, either the source principle or the domicile principle (or, perhaps, the principle of citizenship).2 With adequate agreements as to what constitutes the right source or country of domicile (citizenship), this would help. Another way is to introduce unilateral tax relief, either by way of the domicile country exempting foreign-source income (which basically implies the adoption of the source principle, although perhaps with the modification that a person’s total world-wide income is computed for purposes of tax progression), or by offering a credit against the tax computed on the world-wide income in the country of domicile in respect of the tax paid in the source country. A deduction from income, though helpful, is not adequate. With the credit method a reduction is made in the tax on foreign income by the amount paid to the foreign country on the same income. The third method is to make agreements, double tax treaties, between the countries involved, in which the countries agree upon the extent to which each country may extend its charge to tax, and to offer relief from double taxation either through exemption of certain types of income from tax in one of the countries, or through one country offering its taxpayers a credit in respect of tax paid to the other country.
A general application of the principle of domicile is absolutely out of the question, since it would deprive the capital-importing countries, including virtually all the developing countries, of what they regard as their fair share of the tax base. A general acceptance of the source principle is an equally farfetched objective, since many countries, particularly among the capital-exporting countries, apply equity standards attached to the concept of world-wide income and would feel that such a change would jeopardize not only their revenue but, what may be more important, the compliance by their taxpayers, since this may depend on the recognition of the system as fair and equitable.
Unilateral tax relief is offered by a growing number of capital-exporting countries. The technicalities are complicated. Basically, they have to do with the limitation of the credit to foreign taxes actually paid, and paid in respect of what is recognized as foreign-source income. A further complication is the limitation to an amount not exceeding the domestic tax computed in respect of the foreign income, either this is measured country wise or for all foreign income as a whole. Discrepancies between source country and country of domicile in the rules for the computation of income may cause other troubles.
There is a general impression that the tax treaty system is a burdensome complication of the tax law, which it would be good to have simplified, perhaps by way of multilateral tax treaties bringing in as many countries as possible. Efforts in this direction, however, have so far failed. What has been more successful is the international work on draft treaties, serving as a pattern for treaties concluded in bilateral negotiations. The efforts started by the League of Nations have been brought forward by the Fiscal Committee of the Organization for Economic Cooperation and Development (OECD) in the form of a draft treaty of 1963. The OECD draft has not been adhered to unanimously by the OECD countries and leaves alternatives open on some issues. It is generally admitted to be insufficient for use in relations between capital-importing countries such as the developing countries, and industrialized, capital-exporting countries.
The reason for this is mainly that the OECD draft treaty allocates the revenue between the source country and the country of domicile under the theory that advantages and sacrifices will even out. If one treaty country is purely capital-importing, however, it will get no benefit from those provisions of the OECD draft, which allocate the right to tax foreign income to the domicile country. Thus the capital-importing country will not feel that it is getting a quid pro quo, for accepting any treaty limitations on its right to tax as a source country. The Economic and Social Council of the United Nations has set up an Ad Hoc Group to study these issues with the aim of producing a draft treaty that will adequately cover the tax relations between developing and industrialized countries. Some of the issues studied by this Group will be dealt with below.
One crucial concept in international taxation is that of permanent establishment. The term is used in tax treaties to restrict the right to tax of the source country in respect of business profits: only business carried on from a permanent establishment in a country constitutes a source of business income taxable in that country. Among the examples of permanent establishment in the OECD treaty (Art. 5) is a place of management, a branch, an office, a factory, a workshop, a mine or the like, and a building site or construction or assembly project which exists for more than twelve months. Among the exceptions are the use of facilities solely for storage, display or delivery, the maintenance of a stock of goods for such purposes, the maintenance of a fixed place of business solely for purchasing goods or merchandise, etc. An independent agent is not a permanent establishment, but a dependent agent may be one, if he has and habitually exercises an authority to conclude contracts in the name of the enterprise. A subsidiary company is not in itself a permanent establishment of the parent company, nor the parent company of the subsidiary.
For revenue purposes, the source country will be interested in an extension of the permanent establishment concept, and thus the scope of income-earning activities it may tax under the treaty. Therefore, there is steady pressure from developing countries to extend it, for example to construction projects of shorter duration than a year, to storage for delivery, to exclusive agents even though they may be independent, and to purchasing activities. On the other hand, the host country may be as interested as the entrepreneur in having his road paved. One consequence of this is the inclusion of particular exempting provisions for preparatory and purchasing activities. Another is the desire of some countries to acquire the exclusive right to tax in order to be able effectively to exempt the profits of foreign investors from tax. (One issue in this context is the so-called “tax sparing” issue, the provision in a treaty whereby a capital-exporting country extends the tax credit benefit to include tax payments waived by the source country under its incentive program.)
As far as the foreign investor is concerned, he may be perfectly ready to pay the tax, but feel unhappy about being obliged to undertake the resulting paper work and risk a possibly disagreeable confrontation with the tax administrations in each of the countries with which he has some slight business connection. Therefore, such limitations of the concept of permanent establishment as restrict the taxable permanent establishments to the more significant activities might help to promote international trade.
The tax treatment of corporate profits and dividends is particularly complicated in the context of double tax treaties. Traditionally, dividend income is treated as taxable in the country of the shareholder. However, there is a strong argument in favor of taxing dividends in the country from which they are paid, and even in the OECD treaty a limited right to tax dividends at source has been recognized. If a country applies a split corporate income tax rate, with lower tax on profits distributed, it will regard a relatively high tax on the dividends as a natural correlative to the corporate tax rate, perhaps even a necessary one to prevent dividends to foreign shareholders and reinvestment of them in the corporation from being a cheaper way of expanding the corporate capital than the retention of profits.
Just as in the case of business profits, there is a mixture of motives in the case of dividends both in the source country and the investor’s country. The source country may be interested in high taxes for revenue purposes, in exclusive rights to tax combined with low rates for incentive purposes. The investor’s country may be interested in low rates or exemption in the source country in order to get more income to tax itself. Paradoxically, it may also be interested in high rates in the source country, in order to prevent an unwanted outflow of capital. In treaty relations between industrialized and less developed countries, it has happened that the former have been requested not to reduce their withholding taxes on dividends, in order to prevent taxpayers in the latter from being tempted to invest abroad.
If there is a withholding tax on dividends, in combination with a tax on corporate profits, the source country will have a strong case for a tax on interest as well. Once again, the traditional attitude is to give the investor’s country the principal right to tax. The OECD treaty (Art. 11) acknowledges a right to tax in the source country, but limits it to 10 per cent. The idea behind such a restriction is not only to preserve the prerogative of the investor’s country, but also to ensure that the withholding tax, if applied on the gross interest received from the source country, will not exceed the domestic tax, which will be applied on the net interest after the lender has taken the appropriate deduction for interest paid on borrowed capital. There is another argument for limiting the tax in the source country: the lenders will often be interested in the net interest only, leaving it to the borrower in the source country to pay whatever additional interest is necessary to make up for the withholding tax. If the incidence of the tax on interest is of this kind, there might be arguments against such a tax. However, a growing number of capital-importing countries feel the need for revenue from taxing foreign interest payments at the source. They may also question the concept of taxing interest on a net basis, particularly if the use of financial intermediaries reduces the net interest to a small fraction of the gross interest they feel has its source in their country. To these reasons for taxing interest may be added the desire to prevent the undercapitalization of corporations through debt financing.
Perhaps still more than the exchange of goods, the exchange of patents and know-how is of growing importance. Once again, there is a conflict between the source country’s claim to tax royalties and payments for know-how, as income derived from activities in that country, and the fiscal interest of the receiving country. The particular difficulty lies in the allocation of the income. As long as royalties from abroad constitute merely a minor part of the total income derived from the patent-holder’s activities, it may seem quite acceptable to regard them as marginal income, to which no part of the cost of producing the patent should be allocated. However, if the use abroad of a patent represents the main part of royalties and other income derived from it, it may seem strange to the country of domicile of the patent-holder that all the costs are deductible in that country, and that the source countries should be entitled to levy taxes on the gross. It has recently been noted that this is the situation for many of the large film-producing corporations. Limits on the withholding taxes on gross payments or fairness in the allocation of cost deductions may be the alternatives at hand.
Just as in the domestic context, favorable tax treatment offered to capital gains serves as an inducement to remodel current income into capital gain, income taxable in one country, e.g., dividends, may be held down in favor of a corresponding accumulation of profits in a foreign-owned corporation, realized as a capital gain. The problem involved, from the point of view of the capital-importing country, is that while dividends may be subject to withholding taxes, capital gains on corporate stock realized by foreign stockholders are not only exempt in the capital-importing country under the provisions of virtually all double tax treaties—they are technically very difficult, or quite impossible, to reach with a claim to tax, even if there is no treaty exempting them. The source country may, however, take some comfort from the fact that most schemes for turning current income into capital gain will have the beneficial side effect of preventing an early repatriation of profits made in the country.
Settlement of Conflicts
The confrontation of one taxpayer with two different tax administrations does sometimes produce a need for the settlement of conflicts, not only between the taxpayer and one or the other of the administrations, but between the administrations themselves. One of the functions of double tax treaties is to codify the willingness of the signatory countries to avoid such overlapping tax measures as would lead to double taxation. Although the treaty clauses in general, either by giving exclusive right to tax certain incomes to one country or the other, or by providing for credit against tax, ensure that no double taxation shall take place, issues of conflict may still arise. Conflicts of this kind are regularly settled in negotiations between the administrators concerned. Discussions have been going on for a long time on whether it would be an improvement to introduce some instrument of international arbitration or court procedure to deal with them, or whether such a procedure would merely complicate matters.
Treaties between countries with extensive tax systems lose some of their importance, if financial operations are channeled through countries with low taxes or no taxes at all. It is a matter of common interest to capital-exporting and capital-importing countries to prevent operations aimed at avoiding or evading their taxes through the use of intermediaries in such “tax havens.” Concerted action against such abuses is not in sight, however. Unilateral actions, aiming at a fair allocation of profits for tax purposes, may be necessary steps to fight the abuse of tax havens, but may easily cause difficulties in relations with countries that are not tax havens.
A Pragmatic Approach
These then are some of the relevant issues in international taxation. It is easy to identify diverging principles. However, it is important that the practical differences involved are not necessarily as large as the theoretical ones. A pragmatic approach to the issues is desirable to safeguard the interests at stake, both as concerns revenue, equity, and economic progress.
Since this term may be confusing, the GATT Working Party on Border Tax Adjustments has proposed the expression “tax adjustments applied to goods entering into international trade,” or, more briefly, “tax adjustments.”
The territoriality principle is also a common term for the principle of taxation in the source country only. The principle of citizenship is applied only by very few countries, among them the United States.