Article

International Aspects of the Taxation of Corporations and Shareholders

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1975
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MITSUO SATO and RICHARD M. BIRD *

The growth of direct investment abroad, with the rising concern about its implications for national economies and international monetary stability, has led in recent years to much discussion of the international aspects of taxation. The emergence of multinational corporations has also given rise to considerable interest in their effects on growth, efficiency, and national and world redistribution—to all of which the taxation of international profits is relevant. Furthermore, international tax questions have become significant because of efforts in the European Economic Community (EEC) to integrate European goods and capital markets.

With these developments as background, this paper concentrates on the international aspects of the taxation of corporate-source income, an issue that falls somewhere between a full-fledged general equilibrium analysis of the effects of tax changes on international capital flows and a detailed study of the international implications of a specific tax measure in one country. Although it systematically examines the interactions of recent attempts to integrate the corporate and individual income taxes within countries and the continuing effort to avert international double taxation (or tax avoidance), this paper does not treat the system in a particular country nor attempt to deal with the important domestic effects of alternative systems. The paper is thus general and expository; it is not an empirical study of tax-induced corporate investment and other responses to taxation nor an analysis of the impacts of tax changes on international capital flows. Furthermore, attention is focused on the industrial countries, with only passing reference to the taxation of international investment between developed and developing countries, where the issues tend to be different largely because of the traditional one-way direction of investment flows.1 Despite these rather stringent limitations and the fact that many more narrowly relevant issues are not discussed, the complexity of the subject matter is such that the paper is relatively long and involved.

Section I describes the principal alternative systems of taxing corporations and shareholders, and Section II outlines briefly the institutional framework of international tax relations. Section III, the core of the paper, then systematically reviews the international aspects of alternative corporate tax systems in the light of key analytical criteria. Section IV examines major issues that have been raised concerning this subject in several industrial countries. The final section of the paper summarizes the results of the analysis and considers possible standards or codes of conduct for the international taxation of corporate-source income among developed countries.

I. Alternative Systems of Corporate and Shareholder Taxation

This section outlines the major alternative systems of corporate and shareholder taxation with particular reference to the systems in selected industrial countries, as summarized in the Appendix, Tables 56.2 This analysis should clarify the structural differences among the systems and thus provide a basis for the discussion of international aspects of corporate taxation. The more detailed outline of the various systems in the Appendix, Tables 56, supplies much of the illustrative material used later in the paper.

Methods of taxing corporate and shareholder income may be classified into three major types depending on whether and how much the corporation income tax and personal income taxes on shareholders are integrated.3 At one extreme, a corporation is recognized as a separate entity distinct from its shareholders and is therefore taxed in its own capacity (separate entity system).4 The corporation tax and the personal income tax are imposed independently of each other, and there is no recognition of the fact that distributed corporate-source income is taxed twice: when received by the corporation and when received by the shareholder.

At the other extreme, a corporation is considered to amount to no more than the aggregate of its shareholders. The corporation tax, including that portion levied on undistributed profits, is therefore treated as a withholding tax to be fully credited by shareholders against the personal income tax due on their imputed share of corporate profits. Alternatively, the separate corporation tax is eliminated completely, and shareholders are taxed on their imputed shares of corporate profits (whether distributed as dividends or not).5 Under this approach, the corporation tax and the personal income tax on shareholders may be said to be fully “integrated” (full integration system). In other words, there is no separate tax on corporate profits as such.

Between these two extremes, there are two intermediate systems commonly used in industrial countries; these partially integrate the corporation and personal income taxes by providing relief for corporate distributions at either the corporation or the shareholder level (partial integration system). Relief at the corporation level usually takes the form of a lower tax rate on corporate distributions than on retained profits (split rate system).6 A system of allowing the deduction of dividends in computing corporate taxable income, which amounts to a tax on undistributed profits alone, may be considered an extreme form of this system, with a zero rate on corporate distributions.7 Relief at the shareholder level is normally provided by a credit for part of the corporation tax against personal taxes due on dividends received by shareholders (imputation, or dividend credit system).8 If all the corporate tax allocated to dividends is creditable, this system amounts to full imputation (to be distinguished from full integration, in which all corporate income (whether distributed or not) and corporate income tax are imputed to shareholders).

The remainder of Section 1 outlines these alternative systems in greater detail, with special reference to the features that largely determine their effects on international investment patterns.

the separate entity system

Structurally, the separate entity system is the simplest form of corporate taxation. Normally, a flat rate is applied to the entire amount of corporate profits, whether retained or distributed, and distributed profits are then taxed at the shareholder level in the same way as any other personal income. Intercorporate dividends, however, are usually exempted, completely or in large part, in the hands of receiving corporations, presumably to avoid multiple taxation of dividends.

As shown in the Appendix, Tables 56, the United States and the Netherlands have a separate entity system, and many other countries adopt similar approaches.9 In the United States, for example, a corporation is recognized as a separate entity for income tax purposes, and virtually no relief is provided to shareholders for further personal income taxes levied on distributed corporate earnings.10 The United States corporate tax rate is (in 1974) 22 per cent of the first $25,000 of profits and 48 per cent of income in excess of this amount. Intercorporate dividends are exempt from taxation to the extent of 85 percent of the amount received; in a corporate group that may elect to be taxed on a consolidated basis—which requires at least 80 per cent common ownership—complete exemption is allowed. No withholding tax is levied on dividends paid to domestic shareholders.

The Netherlands system is “purer” than that of the United States in providing no relief at all at the shareholder level. Corporations are taxed at 46 per cent,11 and shareholders are subject to progressive personal tax on all dividends received.12 Intercorporate dividends are generally exempt from corporation tax, however, since a “participation exemption” is granted to a receiving corporation with more than 5 per cent ownership in a paying corporation. Unlike the United States, the Netherlands imposes a withholding tax of 25 per cent on domestic dividends. Under the separate entity system, the imposition of a withholding tax on dividends is not an essential part of the system; whether one exists or not depends largely on administrative considerations.

partial integration systems

Systems aimed at achieving partial integration of corporation and personal income taxes are more complex. The split rate system, for example, reduces the corporation tax levied on distributed profits. Since there is no adjustment at the shareholder level, dividends can be taxed in the same manner as other income. The operation of the system is usually complicated, however, by the levying of an additional tax on certain intercorporate dividends and by a time limitation on defining qualifying distributions in order to avoid administrative burdens from retroactive adjustments.

The split rate system may be illustrated by the Federal Republic of Germany’s present system, which replaced a separate entity system in 1953.13 Corporations are taxed at 51 per cent on retained earnings and at 15 per cent on distributed profits, with a rate differenial of 36 per cent.14 As the tax on distributed profits must itself be paid from retained earnings bearing the 51 per cent tax, the effective rate on distributions is actually 23.4 per cent, instead of the nominal 15 per cent.15 An individual shareholder is also subject to personal income tax on dividends received. An additional tax (Nachsteuer), equivalent to the rate differential, is levied at 36 per cent on intercorporate dividends that are not subsequently paid out in dividends by receiving corporations enjoying a participation exemption (Schachtelprivileg).16 Distribution relief is thus confined to cases where recipients are actually subject to personal income tax.17 Furthermore, the lower rate is applied only to distributions from current earnings, so that no relief is provided for distributions from profits earned in previous years (and taxed at the higher rate in those years). This time limitation is designed to avoid administrative complications arising from retroactive adjustments of corporate tax liabilities. Because of the lower corporation tax on distributions, the need for a withholding tax on dividends is stronger than under the dividend credit system, which requires the reporting of dividends to obtain the credit. The Federal Republic of Germany therefore imposes a withholding tax on distributions, currently at a rate of 25.75 per cent.18

In contrast to the split rate system, a dividend credit or imputation system gives distribution relief at the shareholder level only. Corporations are taxed at a flat rate on all profits, whether distributed or not, but shareholders are entitled to credit a part (or all) of the corporation tax attributed to their dividends against their personal income tax on those dividends. Normally, dividends are “grossed up” by the amount of credit before being included in taxable income; they are then taxed at the applicable personal rate, and the credit is deducted from the total personal income tax owed by the dividend recipient. Any excess of credit over the personal tax is refunded. The amount of the credit, like the rate differential under the split rate system, depends on the desired extent of relief.

Since no relief is provided at the corporation level, the imputation method is free from the problems of the Nachsteuer and the time limitation on the qualifying distributions; intercorporate dividends are simply exempted, and the dividend credit is given without tracing the source of the dividends. Also, since in effect the corporation tax itself functions like a withholding tax under this system, no separate withholding tax is usually required. On the other hand, a question arises as to whether the dividend credit should be given on dividends paid out of profits not fully taxed at the corporation level; to the extent that the credit is considered to be solely an alleviation of the “double taxation” of dividends, presumably no such credit should be extended.19

The systems now used in France and the United Kingdom are examples of this approach. France changed to the imputation system from a separate entity system in 1965. In the same year, the United Kingdom moved to a separate entity system from a form of partial integration. In 1973, however, the United Kingdom moved back to a partial integration system, adopting an imputation method very similar to that used in France, after initially considering a split rate system along the lines of the Federal Republic of Germany.

In France corporations are taxed at a flat 50 per cent, and shareholders are allowed to credit 50 per cent of the corporation tax against personal tax. Dividends are grossed up by the amount of dividend credit (avoir fiscal), and the credit is then deducted from the personal tax computed on the grossed-up amount. Similarly, the United Kingdom taxes corporations at 50 per cent and provides a dividend credit equivalent to three sevenths of the corporation tax imposed on dividends.20 Intercorporate dividends are exempt from corporation tax in the United Kingdom and qualify for the dividend credit when redistributed to ultimate individual shareholders; France provides a similar treatment for dividends received and redistributed by a parent company, although a more complicated mechanism is used.21

In principle, little limitation needs to be placed in these systems on the time between the earning and the distribution of profits, although policy considerations in fact limit the relief to recent or “proportionate” distributions in both countries.22 A difference between the French and U.K. systems relates to the problem of distributions from profits not fully taxed at the corporation level. The French solution is to levy an advance tax (précompte mobilier) at 50 per cent (equivalent to the avoir fiscal) on distributions made out of corporate earnings not fully taxed, while the United Kingdom imposes an “advance corporation tax” (ACT) at three-sevenths—again equivalent to the dividend credit—on all distributions but allows a corporation to deduct the ACT from the corporation tax proper. The ACT is therefore always collected, whether or not a corporation has sufficient regular (“mainstream”) corporation tax to offset it. Both devices are designed to limit the relief to distributions that are taxed at least at a rate corresponding to the dividend credit, and at the same time to permit a uniform treatment of dividends at the shareholder level.

Despite structural and technical differences, there is an essential identity between the two basic methods of partial integration.23 A credit on grossed-up dividends equivalent to the differential between the corporate rates on retentions and distributions provides exactly the same relief for corporate distribution, provided equal revenue is raised from the corporate sector and the two methods do not have different effects on the dividend payout ratio. This point may be illustrated by a simplified comparison, shown in Table 1, of the systems existing in France, the United Kingdom, and the Federal Republic of Germany, with their hypothetical alternatives.

Table 1.Equivalence of Partial Integration Methods in France, the Federal Republic of Germany, and the United Kingdom1(In per cent)
MethodFranceUnited KingdomGermany
Dividend credit
Corporate rate5050(51)
Dividend credit233⅓30(36)
Effective rate2528.6(23.4)
Split rate
Rate on retentions(50)(50)51
Rate on distributions(16⅔)(20)15
Effective rate(25)(28.6)23.4

All profits are assumed to be distributed, except those needed to pay corporate tax. Hypothetical alternatives are shown in parentheses. The derivation of these figures is shown in the paper cited in footnote 23 of the text.

As per cent of grossed-up dividends.

All profits are assumed to be distributed, except those needed to pay corporate tax. Hypothetical alternatives are shown in parentheses. The derivation of these figures is shown in the paper cited in footnote 23 of the text.

As per cent of grossed-up dividends.

A split rate system with the rate combination of 50 and 16% per cent thus provides the same distribution relief as a dividend credit system with a 50 per cent credit (33⅓ per cent for grossed-up dividends). Similarly, a dividend credit rate of three sevenths is essentially identical to a split rate system combining a 50 and 20 per cent rate.

Since either method may serve to achieve any desired level of distribution relief, other policy and technical considerations may control the choice of method of partial integration. In particular, it is important to note that the dividend credit system must extend the same credit to nonresident shareholders if the identity of methods of partial integration is to be maintained. In fact, the crucial policy difference between the two systems hinges on this question of the treatment of nonresident shareholders, as discussed below.

full integration approach

Full integration of corporation and personal income tax has never been implemented in practice, although it has been proposed in some countries, notably in Canada by the Royal Commission on Taxation in 1967.24 Under this proposal, corporations were to be taxed at a uniform 50 per cent, while shareholders were to be subject to personal income tax on both dividends received and the share of undistributed profits allocated to them. That is, both dividends received and the share of allocated retained earnings, grossed up by the amount of corporation tax, were to be included in the personal income tax base of shareholders. To offset this, however, shareholders were to be entitled to a full credit of corporation tax against personal income tax due on dividends and the allocated share of grossed-up retentions. The amount of this credit exceeding the personal income tax (and it would often have exceeded it with the proposed top marginal personal rate of 50 per cent) was to be refunded to the shareholder.25 As a result, under this system all corporate profits would be subjected to tax at progressive personal rates, and the corporation tax would be no more than a means of withholding personal income tax.

Complete integration of corporation and personal income taxes along these lines requires considerable sophistication in the income tax structure. For example, this system in effect taxes at full personal income tax rates that portion of capital gains attributable to corporate retentions. Equity then requires that all capital gains arising from the transfer of shares be taxed, including both those attributable to corporate retentions and those from other sources. But if all capital gains are subject to tax, the cost basis of corporate shares must be adjusted by the amount of retentions previously allocated to shareholders in order to provide proper credit to them for the reinvested profits already allocated and taxed to them on a current basis. Furthermore, as in the dividend credit method, an additional tax must be levied on distributions from corporate earnings not taxed at the full corporate rate, if “excessive” relief is to be averted.26 On the other hand, with full integration intercorporate dividends may simply be exempted at the receiving corporation, and the credit attaching to the original dividends may be passed through to the eventual shareholders by treating redistributions like ordinary dividends. A withholding tax on dividends is unnecessary, as the corporation tax itself is a withholding tax.

mixed systems

Finally, some countries have a mixed system, combining the features of the split rate and dividend credit systems, and thus providing some distribution relief at both corporation and shareholder levels. Japan and Belgium have mixed systems, and the Federal Republic of Germany intends to adopt such a system in the near future. Under the present Japanese system, for example, a corporation is taxed at 40 per cent on its undistributed earnings and at 30 per cent on distributions. Intercorporate dividends are normally exempt from corporation tax in the hands of a receiving corporation but are subject to an additional tax (similar to the Nachsteuer), corresponding to the rate differential, to the extent that they are not redistributed.27 The lower rate on distribution applies only to that part of dividends paid from taxable profits of the current year; payouts from previous years’ profits are not granted the lower rate. In addition, individual shareholders are entitled to a dividend credit of 10 per cent which can be set off against personal income tax due on dividends received.28 Grossing up of dividends is not required, however, and the credit is simply deducted from the personal income tax calculated on cash dividends. On the other hand, no refund is allowed even if the credit exceeds the personal income tax. All dividends are eligible for the credit regardless of whether the profits from which they are paid have been fully taxed at the corporation level or not; no device similar to the French précompte is utilized. A withholding tax of 15 per cent (20 per cent after 1975) is levied on dividends.

II. Institutional Framework of International Income Taxation

Before turning to the international implications of the alternative systems of taxing corporations and shareholders, a brief description of the institutional framework of international income taxation is necessary since the issues at stake are closely related to the principles and practices of international income taxation. Because of the complexity of international tax rules, an analysis of the economic implications of alternative systems requires some knowledge of this background. This section outlines three major aspects: basic jurisdictional rules, methods of providing relief from international double taxation, and the role of tax treaties. Appendix, Tables 56 summarize the relevant international aspects of corporate-source taxation in selected countries.

basic jurisdictional rules: residence versus source

Because there are no international laws limiting the tax jurisdiction of a country, each country may theoretically adopt whatever jurisdictional tax rules it wishes. In practice, however, two basic jurisdictional rules have developed: the source principle and the residence principle. The rules adopted by most countries fall under one of these principles or some combination of the two.

The source principle, which originally evolved in several European countries with schedular income taxes (where the rates vary with the type or source of income), basically asserts tax jurisdiction over income that has its source within a country. Under this principle it is immaterial who the recipients of income are, since taxation is based on income flow. Residents and nonresidents alike are thus taxed only on income that arises from sources within the country. If this principle were to be adopted by all countries, it would appear to provide an easy means of avoiding the possibility of two countries taxing the same income flow (often referred to as “international double taxation”), provided each country adopted basically the same rules for determining the source of income.

In reality, however, despite the apparent clarity of the concept of “source,” its definition involves considerable technical difficulties.29 Conflicting source rules between countries may thus negate the apparent simplicity of this way of avoiding international double taxation.30 In addition, the source principle is inconsistent with the basic concept of a global income tax as a way of reaching the ability to pay of resident individuals because of the exclusion from taxable income of income received by residents from outside the country. Partly for this reason, countries where investment abroad by residents is substantial have tended to adopt some sort of residence principle, particularly with respect to personal income taxation.31

In contrast to the source principle, the residence principle is thus closely connected with the concept of a unitary (or global) income tax which considers primarily the income recipient’s ability to pay. Such an income tax is not in principle a tax on income itself but on the recipient of income, taking into account his income from all sources, including that received from abroad. Under this principle, taxation is not based on the geographic source of the income but on the residence of the taxpayer. As with the source principle, however, simplicity disappears when it comes to applying the principle in practice, because various technical problems arise and different countries may resolve them differently.

Worldwide taxation of a particular group of persons (for example, residents), despite the lack of a geographical connection between their income and the country of residence, requires the definition of “residence.” Citizenship, domicile, physical presence for a fixed period of time, or some combination of these factors are used as criteria for individuals in many countries. For corporations, two major rules are used to determine residence: the place of incorporation test and the seat of management test.32 Under the first rule, a corporation is regarded as a resident of the country in which it is incorporated, while under the second it is deemed to be a resident of the country from which its policy is actually controlled.33 An important implication of these two rules concerns taxation of a domestic corporation’s subsidiary organized abroad. Under the place of incorporation test, such a subsidiary is not regarded as a resident corporation, so taxation is normally postponed until profits are repatriated to the parent company. This practice is known as “deferral.” Under the seat of management rule, however, the income of subsidiaries may sometimes be taxed currently, if desired, though few countries in fact do so, presumably to reduce the possibility of double taxation. Some countries using the place of incorporation rule may also in practice deny deferral to the income of a subsidiary and consequently impose tax currently on resident shareholders, in order to prevent tax avoidance through the deferral for subsidiary income arising in countries with low tax rates.34 The more countries take such measures to reduce tax avoidance, the more conflict is likely to arise between the interests of different countries in the field of international taxation.

Up to this point, the source and residence principles have been discussed as if they constituted a symmetrical set of jurisdictional rules. In practice, however, complete symmetry does not exist between the two principles, because most countries using the residence principle do not confine their tax jurisdiction to their residents; they also impose a tax on income derived by nonresidents from sources within their territories, thus asserting their tax jurisdiction over this income. As far as nonresidents are concerned, most countries, regardless of the treatment of their own residents, in effect rely on the source principle and look to the geographical connection between the income and the country.

The real contrast is therefore not between the “source only” and “residence only” principles but between the “source only” and “residence (resident taxpayers) plus source (nonresident taxpayers)” principles. This extension of tax jurisdiction to nonresidents gives rise to two important issues. One concerns the manner in which the income of nonresidents is taxed by the country of source (taxation of source country), while the other concerns the treatment by the country of residence of the income that has already been taxed in the country of source.

With respect to the first issue, in the absence of a tax treaty the taxation of the source country is governed unilaterally by its own laws. Each country is free to choose whatever rule it wants to use in determining the source of income, calculating the taxable income, and applying the tax rate. In practice, a degree of uniformity appears to have emerged, at least among developed countries, with respect to the taxation of corporate-source income. Generally, a subsidiary of a foreign corporation is taxed in the same way as a purely domestic corporation.35 Countries using a split rate system (like the Federal Republic of Germany) have usually applied the differential rates to foreign-owned subsidiaries as well as to domestic corporations. Countries adopting a dividend credit system (like France) have not, however, normally given the dividend credit to the foreign parents (or to foreign individuals), although they generally apply the same corporate tax rate to both subsidiaries and domestic corporations. Almost all countries levy a special tax on dividends paid by a subsidiary to its foreign parent, with statutory rates ranging from 20 to 30 per cent. This rate is often reduced by tax treaty, normally to 5 per cent between developed countries.36 Although usually called a “withholding tax,” this tax is quite different from most withholding taxes in that it generally constitutes the final determination of tax liability by the levying country; it is thus not a prepayment of the domestic income tax but a substitute for it.

Profits of branches of foreign corporations are treated quite differently. While the tax rate applied to such profits is usually the same as the domestic corporation rate in countries with a separate entity system, the lower rate on distributed profits has not generally been applied to branch profits in the split rate system,37 nor has a dividend credit been granted to distributions from branch profits by countries using a dividend credit system. On the other hand, no withholding (or similar) tax is usually levied on branch profits, although there are a few exceptions.38

methods of alleviating international double taxation

If one country taxes profits on the residence principle and the same profits are also taxed in the source country, the result is often referred to as “international double taxation.”39 The application of an unmodified residence principle would, for example, normally permit taxes paid in the source country to be deducted from the tax base as a cost of earning taxable income, but the full amount of the tax paid in the source country could not be recouped in the country of residence through this procedure.40 Since international double taxation is considered in many countries inequitable or undesirable on other grounds, devices have been developed to eliminate or alleviate it. The most common methods are the exemption of foreign-source income from tax in the country of residence or the provision of credits for taxes paid in the source country.41

The exemption method, which is utilized, for example, by France and the Netherlands for subsidiary-parent dividends and branch profits, attempts to avoid international double taxation simply by exempting from domestic tax the income derived by residents from abroad, usually on condition that the income has been taxed by foreign countries.42 Thus, a resident corporation is subject only to the foreign corporation tax regardless of whether the foreign tax rate is higher or lower than the domestic rate.

Table 2 illustrates how exemption works. The tax burden on subsidiary income is determined solely by the foreign tax rate, since the income is simply exempted from the domestic corporation tax. In effect, this treatment is equivalent to the application of the source principle for those forms of income for which relief is provided. It also provides a means of achieving capital-import neutrality, a concept explained in Section III below.

Table 2.Example of Methods of Alleviating International Double Taxation1
MethodSubsidiary

in

Country B
Subsidiary

in

Country C
Total
Gross profits100.0100.0200.0
Foreign tax
Corporation tax40.030.070.0
Withholding tax3.03.56.5
Domestic tax
Exemption method
Credit method2
Domestic tax before credit40.040.080.0
Foreign tax credit40.0333.5(76.5)473.5
Net domestic tax0.06.5(3.5)46.53
Deduction method
Gross income100.0100.0200.0
Deduction43.033.576.5
Taxable income57.066.5123.5
Domestic tax22.826.649.4
Total tax (domestic plus foreign)
Exemption method43.033.576.5
Credit method43.040.0(80.0)483.0
Deduction method65.860.1125.9

In this example, it is assumed that a country A corporation has subsidiaries in countries B and C, each of which earns profits of 100. The corporation tax rate in B is 40 per cent and in C is 30 per cent; all after-tax income is transferred to the parent corporation as dividends, with a 5 per cent withholding tax being imposed on the dividends in both countries. The corporation tax rate in country A is 40 per cent.

This example assumes that indirect credit is granted (see text for explanation).

With the per-country limitation some of the taxes levied by country B are not credited, because the combined rate in country B exceeds the domestic tax rate.

Figures in parentheses show results with overall limitation.

In this example, it is assumed that a country A corporation has subsidiaries in countries B and C, each of which earns profits of 100. The corporation tax rate in B is 40 per cent and in C is 30 per cent; all after-tax income is transferred to the parent corporation as dividends, with a 5 per cent withholding tax being imposed on the dividends in both countries. The corporation tax rate in country A is 40 per cent.

This example assumes that indirect credit is granted (see text for explanation).

With the per-country limitation some of the taxes levied by country B are not credited, because the combined rate in country B exceeds the domestic tax rate.

Figures in parentheses show results with overall limitation.

Unlike the exemption method, the credit method involves the imposition of domestic tax on income derived from abroad, but provides a credit of foreign taxes against domestic tax (foreign tax credit). This approach is used, for example, by the United States, the United Kingdom, and Japan. The foreign tax credit is usually limited to the amount of domestic tax due, before the credit, on the income derived from abroad.43

Two methods are commonly used to calculate the maximum amount of the credit: a per-country limitation and an overall limitation. While the first calculates the credit ceiling on a country-by-country basis, the second permits the calculation on an aggregate basis, as shown in Table 2. If foreign taxes exceed the calculated ceiling, they may normally be carried backward or forward for a specified period of time and offset against credits not fully utilized in other years. The foreign tax credit may be limited to foreign taxes paid directly by the resident taxpayer (direct foreign tax credit) or—as is the case in the United States, the United Kingdom, and Japan—it may be extended to foreign corporation tax levied on the subsidiary income from which dividends are paid (indirect foreign tax credit).44 Assuming that an indirect credit is also granted, the mechanism of the credit method may be shown as in Table 2.

As Table 2 illustrates, with the credit method the overall tax burden on income derived from a foreign subsidiary is the same as that on a purely domestic corporation as long as the foreign tax rate (including withholding tax) is equal to or lower than the domestic tax rate. Even when the foreign tax rate is higher, the overall limitation may yield the same total tax burden by averaging the higher foreign tax with the lower foreign tax in another country.45 Despite its technical complexities, the credit approach thus provides a means of achieving what is known as capital-export neutrality, a concept discussed in Section III.

Since the deduction of foreign taxes from taxable income in computing domestic tax due on income derived from abroad is, as noted above, insufficient to provide full relief from international double taxation, this method is less frequently utilized by countries applying the residence principle, although it exists, for example, in the United States and Japan as an alternative to the credit method. Unless the foreign tax rate is zero, the combined foreign and domestic tax burden is always higher with the deduction approach on subsidiary income than on income from domestic operations. This can be seen clearly in Table 2.

As noted in passing above—and further developed in Section III—the credit and exemption methods may be used to achieve different types of neutrality. Similarly, the credit and deduction methods may be justified by different concepts of equity. The credit approach, for example, can achieve equity in the sense that the same total tax (foreign and domestic) will be imposed on the same amount of income regardless of its source. If, however, equity is defined in terms of imposing an equal domestic tax on a given amount of net income received in the country, regardless of its source, this can be achieved by using the deduction method.46 An unmodified application of the residence principle might appear to follow the latter concept of equity, since the taxable income of residents would be determined after deduction of all costs of earning this income, including foreign taxes. On the other hand, if the residence principle is viewed as an aspect of a global income tax, its prime objective might be considered to be the equalization of total taxes (domestic and foreign) on residents with the same income, regardless of the source of that income. The inclusion of worldwide income in the tax base can thus be argued to require the crediting of foreign taxes against domestic taxes, rather than their deduction from the tax base.

functions of tax treaties between developed countries47

The operation of the basic jurisdictional rules described above has in practice been considerably affected by the fact that most developed countries have negotiated treaties with their more important trading and investment partners—a process facilitated by the model treaty published by the Fiscal Committee of the Organization for Economic Cooperation and Development (OECD) in 1963.48 The willingness of countries to restrict their tax jurisdiction by treaty depends essentially on the reciprocal nature of the agreement and on their desire to encourage the free flow of international investment. When the investment flows between countries are approximately equal or when there is a strong desire to encourage the free movement of capital, there is a strong incentive to negotiate tax treaties.

Aside from provisions for administrative cooperation, tax treaties generally have two major objectives: (1) to facilitate the international flow of goods and capital by eliminating or alleviating international double taxation (world efficiency aspect), and (2) to set forth rules governing the allocation of the tax base between the contracting countries (inter-country equity aspect). These two roles of tax treaties are discussed briefly in this section, while Section III develops some implications of these objectives at more length.

Most tax treaties attempt to restrict withholding taxes levied by country of source, normally on a reciprocal basis, while at the same time defining the source of particular items of income for the corporate income tax. To the extent that high foreign taxes may result, even with a foreign tax credit, in a higher total tax on foreign-source income than on domestic-source income, the reduction by treaty arrangement of tax levied in the source country can help to reduce international double taxation. The adoption of common source rules may contribute to the same objective by improving the functioning of the crediting device. Otherwise, different definitions of the source of income may lead to the denial of foreign tax credit and hence to international double taxation in certain cases.49

The most important treaty restrictions are limitations on withholding taxes. In the OECD model treaty, for example, the withholding tax on subsidiary-parent dividends is limited to 5 per cent while the withholding tax on other kinds of dividends is restricted to 15 per cent (Article 10).50 The source of dividend income is defined as being in the paying corporation’s country of residence. Similarly, interest income is subjected to a withholding tax of 10 per cent by the source country, defined on the basis of the payer’s residence (Article 11). In contrast, the model treaty provides for no withholding tax on royalty incomes by the source country (Article 12). Capital gains on transfers of stocks and other securities (Article 13) and shipping and air transport profits (Article 8) are also exempt from tax in the country of source and are taxed only in the country where the taxpayer recipient is resident. On the whole, these recommendations have been followed in most actual treaties.

With respect to branch and similar operations, most tax treaties adopt the rule of “permanent establishment” under which branch and similar profits are taxable in the source country if such business facilities constitute a “permanent establishment” to the extent that such profits are “attributable” to the permanent establishment. Rules of attribution (usually an “arm’s length” rule) and for allocating overhead expenses are also provided (Articles 5 and 7). No additional tax is usually imposed by the country of source on subsequent distributions of the branch profits to shareholders (Article 10).51

In addition to such reciprocal restrictions on tax jurisdiction, the mere conclusion of a tax treaty may itself have a favorable effect on the international flow of goods and capital by reducing somewhat the risks involved in foreign trade and investment. By stabilizing tax rules applicable to foreign investments, a treaty provides some predictability of the tax consequences of investing abroad. It also offers an opportunity to solve international tax disputes by mutual consultation between the government authorities concerned (Article 25).

Treaty rules such as those described above also govern to some extent the allocation of gains arising from foreign investments between capital-importing (source) and capital-exporting (residence) countries. To the extent that treaties provide rules for taxing profits accruing to foreign capital (for example, withholding tax on dividends), they help to determine the relative share in capital income of the capital-importing country and the capital-exporting country. Since this distribution of the total tax burden is also a subject of treaty negotiations, tax treaties may thus bring about a distribution that the negotiating parties consider equitable.

In fact, however, apart from the withholding tax rates on dividends and other capital income and the “permanent establishment” rule for branch profits, tax treaties do not usually specify rules for the taxation of the income from capital. The income of subsidiaries, for instance, is generally taxed at the normal corporation tax rate of the source country. Similarly, the rates applied to branch profits are not specified in most treaties, although, as noted above, some rules for the calculation of taxable profits are usually provided. While foreign portfolio investors are taxed on dividends at the treaty withholding rate, treaties do not attempt to govern the taxation of corporate profits from which such dividends are paid.

Nevertheless, there is one important treaty rule—the so-called non-discrimination clause—which prohibits discriminatory treatment of residents and nonresidents in treaty countries (Article 24). By virtue of this clause, a capital-importing country must provide the same tax treatment to foreign corporations operating through a branch or subsidairy as to purely domestic corporations; discriminatory treatment, such as a higher tax rate or unfavorable rules for computing taxable profits, is prohibited. Although the concept of “discrimination” is not as clear as it may appear, the nondiscrimination rule at least ensures that the taxation laws of treaty countries do not discriminate capriciously between residents and nonresidents.52 The significance of this rule for international tax relations is discussed in more detail in the next section.

III. Analysis of International Implications of Alternative Systems of Taxing Corporate-Source Income

Obviously, international tax policy in any country is not guided by economic principles alone. Only its economic aspects can be considered here, however. The most important economic objective in this field appears to be the achievement of the desired degree of tax neutrality (or nonneutrality) between investment at home and abroad. Parenthetically, the apparent widespread acceptance of some sort of “neutrality” or “efficiency” objective with respect to international taxation is really quite curious in view of the equally widespread acceptance of very different (that is, certainly nonneutral and probably inefficient) domestic tax regimes for corporate and noncorporate business. The present paper simply accepts as legitimate the conventional standard of neutrality with respect to individual investment in the corporate sector.

Tax policy can be intended to promote “world efficiency” in resource allocation by removing all tax differentials between investment in different locations. Equally, it may be employed to discourage private individuals and firms from investing abroad rather than at home. One analytical criterion for international income taxation is thus its effect on allocative efficiency from a worldwide perspective (world efficiency). Another possible efficiency criterion concerns the efficient allocation of resources from a purely national viewpoint (national efficiency). In addition to these efficiency criteria, equity considerations are relevant, as always in tax discussions. In particular, the equitable distribution of tax revenue between capital-exporting and capital-importing countries, or what may be called “inter-country equity,” is a major issue.53 This section explores the international implications of alternative systems of taxing corporate-source income under these three main headings.

world efficiency

In an imperfectly competitive world, where national governments can establish artificial barriers or provide subsidies to influence the flow of resources to achieve national objectives, it is not possible to prescribe general criteria to achieve world efficiency in the allocation of resources. Nevertheless, in discussions of international tax policy, considerable emphasis is placed on international tax neutrality, defined as a tax regime that does not interfere with the taxpayer’s choice between investing at home and in foreign countries.54 This concept has, for instance, served as an important standard of reference in formulating policy. Under a neutral policy in this sense, net rates of return and hence investment decisions would not be affected by tax factors because there would not be any tax burden differential between domestic and foreign investment. Depending on their evaluations of the benefits and costs of foreign investment (social, political, and economic), creditor and debtor countries may desire to pursue policies that are not neutral in this sense.55 Equally, they may wish, for some reason, to achieve the objective of international tax neutrality, as is assumed in the following discussion.

Two concepts of international tax neutrality are relevant here: capital-export neutrality and capital-import neutrality. Capital-export neutrality may be defined as tax neutrality in the capital-exporting country in the treatment of income from domestic and foreign sources, while capital-import neutrality requires that capital funds originating in different creditor countries compete on equal tax terms in the capital-importing country.56 Capital-export neutrality may therefore be achieved through policy action by the capital-exporting country alone, because its rates of taxation are the controlling variable, whereas capital-import neutrality requires policy action by the capital-importing country to offset tax differentials among capital-exporting countries. Either concept can be achieved by negotiated agreements between governments to share the losses (in terms of revenue). In practice, however, apart from some agreements limiting the scope of taxation in source countries, capital-exporting countries have been more willing to provide credits for taxes paid in source countries (or otherwise to offset tax differentials) than capital-importing countries have been to provide credits for taxes paid in capital-exporting countries. Both for this reason and, more importantly, because only capital-export neutrality accords with the objective of world efficiency, the present discussion emphasizes capital-export neutrality rather than capital-import neutrality.

Credits versus exemptions

If the modified residence principle discussed in the preceding section is the basic jurisdictional rule in both countries, capital-export neutrality may be achieved by full crediting of foreign taxes offered by the country of residence (that is, the country in which the taxpayer is subject to taxation on worldwide income).57 The effective tax burden on returns from domestic and foreign investments is equalized through the full crediting mechanism, because the benefit of lower foreign taxes is removed by added domestic taxation while any additional tax burden arising from higher foreign taxes is removed by the refund of excess foreign taxes. Since domestic profits are subject to taxation on a current basis, taxation of foreign income must also be on a current basis to achieve this result (that is, “as earned”), with no tax deferral for reinvested income of subsidiaries, though of course with full indirect credit for taxes on the income of subsidiaries.

The other methods of relieving international double taxation discussed earlier cannot achieve the same neutrality. The exemption method, for example, results in tax differentials depending on the location of investment because the effective tax rate is determined solely by the tax rates in the country in which the investment is made and these rates differ from one country to another. The deduction method, on the other hand, always discriminates against foreign investment vis-à-vis domestic investment because the effective tax burden is always higher on foreign than domestic investment income.58

From another point of view, however, it can be argued that global taxation with full credit of foreign taxes will not achieve an efficient allocation of resources—assuming, as always in this discussion, that the only distortions are those introduced by government policy—and that only complete exemption of foreign income from domestic taxes will suffice. If, for example, net returns on investment are affected not only by taxes but also by government expenditures, equalizing tax burdens alone clearly will not ensure the most efficient allocation of resources on a world-wide basis. If all taxes on corporations are benefit taxes designed to match exactly the cost-reducing services provided by government to the corporations, and foreign investment receives such services only from the host country, then taxation by the source country alone—that is, exemption by the country of residence—is more appropriate for the achievement of world efficiency, since the net fiscal burden (tax minus benefit) on the corporation is in fact zero. Any additional tax (or refund) in the country of residence would result in an unwarranted penalty on (or subsidy to) foreign investment.

In practice, however, the assumptions needed to lead to this conclusion are rather farfetched. Corporation taxes are not levied as benefit taxes in the above sense, even though corporations may directly and indirectly benefit from some types of government expenditures. In addition, direct investment abroad will probably enjoy some benefits from expenditures in the capital-exporting country. To take only one example, education expenditures may have aided the development of the technical and managerial expertise used abroad. While it might still be theoretically ideal to equalize the net fiscal burden by tax and/or expenditure measures—imposing a tax on foreign investment if the net fiscal burden is lower abroad than at home and granting a subsidy if the net burden is higher abroad—such a system would hardly be practicable, if only because of the great difficulties in measuring the benefits that corporations receive from government expenditures. In any case, if a uniform level of government services is provided to business in different countries, differences in net fiscal burden would be reflected in tax differentials under a benefit system of taxation.59 This means that if expenditure benefits to business are roughly similar among industrialized countries, global taxation with full crediting by the capital-exporting country may still be more consistent with world efficiency than taxation by the source country only.60

A quite different argument sometimes made for exempting foreign income is that capital-import neutrality, despite what was said earlier, is really a more, relevant concept for international income tax policy than capital-export neutrality. In essence, the argument, which emphasizes the tax differential beween firms from different countries operating in the same country, is that any additional tax by the country of residence may place its firms that invest abroad at a competitive disadvantage because they will face higher effective tax rates than will local investors or investors from third countries.61 As noted above, capital-import neutrality defined in this way implies that the tax rate in the country of investment must be the controlling rate. In practice, therefore, exemption of foreign-source income from tax in the capital-exporting country is required. The exemption method would, however, still fail to achieve an efficient allocation between domestic and foreign investment in the capital-exporting country and would not, under competitive conditions, achieve world efficiency.62 In other words, while capital-import neutrality may be neutral in its effects on the expansion of enterprises investing in the same country with capital from different countries, it is highly nonneutral with respect to international flows of capital in the circumstances assumed here, unless tax rates are equal in all countries. If the tax rate is lower in the capital-importing than the capital-exporting country, capital will flow beyond the point warranted by the capital-export neutrality (or world efficiency) criterion; if it is higher, capital flow will be less than this criterion requires.

Finally, the use of the exemption method as a means of achieving capital-export neutrality might also be justified if there is universal shifting of corporation tax in the short run. In this situation, it can be argued that profit taxes in effect become equivalent to product taxes for which a border tax adjustment (that is, export rebates and compensating import duties) is often thought to be required to achieve tax neutrality.63 Unless profits taxes were imposed by the source country alone, foreign investment would be either unduly discouraged or encouraged by any additional tax or refund in the capital-exporting country. The assumptions required to support this case for the exemption method also appear to be rather unrealistic, however.64 The remainder of this section concentrates on ways to achieve capital-export neutrality through a credit approach, given different systems of taxing corporate-source incomes in the countries concerned.

Tax arrangements to achieve capital-export neutrality

Basically, the tax arrangements necessary to secure capital-export neutrality are simplest if all countries use a separate entity system for taxation of corporate-source income, and they are more complex and difficult to implement if one or more countries introduces any form of integration of corporate and personal income taxes. For purposes of the present discussion, it is assumed that corporation taxes are not shifted in the short run and that, as a rule, all investment takes place through corporate subsidiaries, the most important form of international investment in pratice. The tax arrangements needed to achieve capital-export neutrality for other types of foreign investment (in branch form, and corporate and individual portfolio investment) are touched on only briefly in the text and in more detail in the Appendix, Tables 79.65 The interested reader really has to work through Table 3 and Appendix Tables 79 very carefully in order to understand fully all the argument in this section.

Table 3.Tax Arrangements Needed in the Capital-Exporting Country to Achieve Capital-Export Neutrality1
System in Capital-

Exporting Country
System in Capital-Importing Country
Separate

entity
Split

rate
Dividend

credit
Full

integration
Separate entityCase 1Case 2Case 1Case 1
Split rateCase 1Case 2Case 1Case 1
Dividend creditCase 3Case 5Case 3Case 3
Full integrationCase 4Case 6Case 4Case 4

For corporate investment in subsidiary form. Corporate taxes are assumed to be unshifted.

For corporate investment in subsidiary form. Corporate taxes are assumed to be unshifted.

There are several possible combinations of the four basic systems of corporate-source taxation discussed in this paper. As shown in Table 3, at least six different arrangements are required to achieve capital-export neutrality in the tax treatment of foreign subsidiary income in the capital-exporting country, depending upon its system and that in the source country. The simplest occurs when both countries tax corporations as completely separate entities. In this case, current taxation with full credit for foreign corporation and withholding taxes will suffice. With the exception that the excess of foreign taxes over domestic corporation taxes is not generally refunded, this may appear to be the usual treatment in countries using the credit approach. In reality, however, the divergence between the theoretical prescription and actual practice is greater than this, as subsidiary income is normally subject to tax in the capital-exporting country only when it is remitted, whereas international tax neutrality as defined here requires current taxation of foreign-source income also, because domestic-source income is subject to domestic corporation tax as earned.66 The appropriate treatment of branch profits, which are taxed currently (and not usually subject to foreign withholding taxes), is similarly full crediting of the foreign corporation tax (see the Appendix, Tables 79).

Explanation of Cases:

Case 1Current taxation with full credit (including refunds, if necessary) for foreign corporation tax (including foreign withholding tax).
Case 2=Same as Case 1, but with subsequent adjustment in relation to foreign taxes actually paid.
Case 3=Same as Case 1, with no additional tax imposed on subsequent distribution and shareholders given full domestic dividend credit.
Case 4=Same as Case 3, with no additional tax imposed at distribution or allocation and shareholder given full benefit of integration.
Case 5=Same as Case 3, but with subsequent adjustment in relation to foreign taxes actually paid.
Case 6=Same as Case 4, but with subsequent adjustment in relation to foreign taxes actually paid.

Portfolio investment, both corporate and individual, raises more complicated questions, as shown in the Appendix, Tables 79. To achieve neutrality, foreign corporation and withholding taxes would have to be grossed up and credited to corporate portfolio investors, with any excess credit being refunded. Alternatively, there could be a “pass-through” to shareholders of the credit for foreign withholding tax. However, if the corporation is considered to be the decision-making unit, a full credit for both taxes at the corporation level would be more consistent with international tax neutrality.

For individual portfolio investment, a corporation tax adjustment is needed to eliminate the tax differential between domestic and foreign investments. That is, the domestic corporation tax has to be applied on a current basis to the investor’s pro rata share of corporate profits, and the foreign corporation tax must be fully credited. Further, the withholding tax on dividends should be fully credited against domestic personal income tax. In practice, individual portfolio investors normally can claim credit only for foreign withholding tax against domestic personal income tax liability.

Returning to the case of subsidiaries, with one exception, the appropriate tax arrangements for subsidiary profits are always as outlined above in a country which has a separate entity system (Table 3). The exception occurs when the source country has a split rate system, because the exact amount of the foreign corporation tax cannot be ascertained until profits are actually distributed, and therefore current taxation of subsidiary income with full credit of foreign taxes can only be approximated. A subsequent adjustment based on the foreign taxes actually paid would be required to achieve neutrality.67 Similar adjustments would be required for portfolio investment by corporations and individuals but not for branch profits, which do not generally receive the benefit of the lower rate on distributions.

When the source country has a dividend credit or full integration system, neutral tax arrangements for the capital-exporting country are basically the same in the subsidiary case as when both countries have separate entity systems. In the case of portfolio investment, however, a special tax may have to be levied to absorb the benefits of any dividend credit extended by the source country to nonresident investors.68 If this is not done, foreign investment will be encouraged to the extent that net yields on foreign shares are increased by the dividend credit unless the increase is fully capitalized into higher stock prices—a possibly significant qualification (in this and other respects) which cannot be discussed further here.

The difficulties in achieving capital-export neutrality are greater when the capital-exporting country employs any other system of taxing corporate-source income, even when the source country has a separate entity system. As implied by Table 3, the arrangements needed in the subsidiary case are similar to those in the separate entity example when the capital-exporting country has a split rate system. However, this system raises a serious question in the case of individual portfolio investors as to what the effective tax rate on domestic investment is for credit purposes, since that rate depends on the payout ratio of each corporation.69 A much more important problem, however, is that if the average effective rate of corporation tax is lower than it is in countries which do not provide tax relief for distributions, as may well be the case, the full crediting of foreign taxes required for international tax neutrality might involve massive refunds. Governments concerned, as most are, with the scope of potential revenue losses and considerations of national advantage are thus unlikely to be willing to provide for full crediting of foreign taxes in practice.

Similarly, if the capital-exporting country has a dividend credit system, it will have some difficulty in achieving capital-export neutrality (Table 3). Basically, what is required amounts to integration of the foreign corporation tax with domestic personal income tax. A corporation investing in a foreign country which has high taxes, for example, would have to be granted a full foreign tax credit with a refund in order to equalize the tax burden on foreign and domestic investment. In addition, a full domestic dividend credit would have to be extended to shareholders in such a corporation in order to place them in the same tax position as shareholders in corporations which only operate domestically.70 Furthermore, no additional tax—such as the French précompte or the U.K. advance corporation tax—should be imposed to compensate for a dividend credit granted to dividends paid out of foreign profits. The potential revenue loss from this system if the source country levies a high corporate tax appears to constitute an effective bar to its implementation in practice.

The required tax arrangements for neutrality are similar if the capital-exporting country has a full integration system, and they are therefore even less likely to be considered practical. Not only is a greater revenue loss involved in extending the full benefits of integration to all shareholders (including those in corporations investing abroad) but also foreign countries would be able, by raising their tax rates, to reduce even further the revenue accruing to the capital-exporting country. In addition, since full integration in effect amounts to the abolition of the absolute corporation tax, corporate investment policy might come to depend upon the tax burdens of shareholders rather than of corporations—and there is no practical way to equate these personal tax burdens as between foreign and domestic investment, unless all corporate investors distribute or allocate all foreign profits to their shareholders.71 In other words, as long as foreign profits are retained by the corporation (either the subsidiary or the parent corporation), the tax burden would be higher on foreign investment than on domestic investment, when, as in the system proposed by the Canadian Royal Commission (see Section I), the corporation tax rate equals the top marginal rate of personal income tax. The use of average personal tax rates or other proxy measures to approximate personal tax burdens would obviously leave some nonneutralities. Finally, individual portfolio investors in foreign corporations would also have to be taxed on a current basis with full credit for foreign taxes, because if they invested in a domestic corporation they would in effect be taxed on a current basis at personal income tax rates, since the corporation tax amounts to no more than a withholding of personal tax under a full integration system. This requirement, too, does not seem likely to be welcomed by most countries.

As shown in Table 3 and the Appendix, Tables 79, these difficulties in achieving international tax neutrality recur and in some instances are exacerbated when the source country also has some sort of integration system. If the capital-exporting country has a split rate system and the source country a dividend credit system, for example, full crediting of foreign taxes might involve massive refunds and hence result in practical difficulties. If the dividend credit is extended to portfolio investors, an additional arrangement would also be required to neutralize its effect along the lines suggested above. If both countries have comparable levels of corporation tax and if distribution relief is extended to foreign portfolio investors, this problem could be avoided, however.72 The problem of integrating foreign corporation tax with domestic personal income tax would be raised for the dividend credit country (as the capital-exporting country), although it might be less serious if the effective rate of foreign corporation tax is lower (unless a compensating withholding tax is imposed by the split rate country). A country with a full integration system would generally have the same problems. The earlier discussions can also be extended to cover the other cases in Table 3.

In summary, any form of integration between corporation and personal income taxes introduces some difficulties and complexities into the tax arrangements required to achieve capital-export neutrality. Distribution relief at the corporation level (split rate system) may create a serious refund problem. Relief at the shareholder level (dividend credit system) raises the question of the integration of the foreign corporation tax with the domestic personal income tax. This problem is more difficult when the partner country does not provide similar relief than when it does. On the other hand, the extension of the dividend credit to foreign investors, rather than helping to achieve capital-export neutrality as one might think at first, actually requires that offsetting measures be adopted by the partner country if neutrality is to be achieved. Full integration of corporate and personal taxes along the lines proposed by the Carter Commission leads to similar but more serious problems because of the greater degree of integration. In addition, equalization of personal tax burdens between domestic and foreign investment, which might be required by integration, involves considerable practical difficulties.

The conclusion up to this point is that integration, whether partial or full, makes the achievement of capital-export neutrality more difficult than it is when countries tax corporations separately from the personal income tax.73 The weight to be attached to this finding largely depends, of course, on the importance attached to what has been called here “world efficiency” in the design of national tax policy.

national efficiency

As noted at the beginning of Section III, tax policy may be guided by a quite different criterion of efficiency concerned with the allocation of resources from a purely national viewpoint in contrast to the world viewpoint underlying the objective of capital-export neutrality. Capital-export neutrality, as noted above, requires that net (after-tax) returns be equalized between domestic and foreign investments from the investor’s viewpoint. However, from the point of view of the capital-exporting country as a whole (investors and taxpayers as a group), receipts from investment abroad are reduced by taxes paid in the capital-importing country. If a policymaker wants to ensure the efficient allocation of resources from a strictly national viewpoint, the gross return on domestic investment must therefore be compared with the net (after-foreign-tax) return on foreign investment.74 If there were no other costs or benefits of foreign investment, national advantage would be increased, assuming no effects on investment, by equating the gross return on domestic investment with the net (after-tax) return from foreign investment, a result which could be achieved by applying the deduction approach to foreign taxes.75

An example may illustrate the point. Assume that the gross profits from a domestic and a foreign investment are equal to 100 and that the tax rate in both countries is 50 per cent. Under the full credit approach, investors would continue to invest abroad until the gross profits from foreign investment are equal to those on domestic investment. National gains from the investment, however, are reduced by the foreign tax to 50. Under the deduction approach, foreign investment would become less profitable than domestic investment, since the investor will now have to pay 50 in foreign tax and 25 in domestic tax. The gross profit on foreign investment would have to rise to 200 to yield the same net profit to the investor as 100 in gross domestic profits. National gains on foreign investment (that is, profits net of foreign tax) would then be equal to total gains on domestic investment.

If the deduction method is applied, the foreign tax rate becomes crucial to location decisions because the net profits on foreign investment, or Yf (1—tf), where Yf is gross foreign profit and tf is the foreign tax rate, have to be equated with the gross profits on domestic investment (Yd). The required profit differential to equate foreign and domestic investment may then be expressed as Yf/Yd = 1/(1—tf), which is a positive function of the foreign tax rate (tf).76 If, in an extreme case, the foreign tax rate is zero, Yf can be equal to Yd; if it is 20 per cent, Yf must be higher by one fourth, if it is 25 per cent by one third, and if it is 50 per cent, Yf must be twice Yd. Given a rate of return on alternative foreign investments, say, 50 per cent higher than the domestic rate of return (Yf/Yd = 1.5), a foreign country with a tax rate lower than 33.3 per cent will be attractive to investors, one with a higher tax rate will be unattractive, and a country with a 33.3 per cent tax rate will be just on the border line.77 Encouragement of investment in countries having low taxes and discouragement of that in countries having high taxes will thus result from the deduction method—which is, of course, one of the intended results of the national efficiency criterion.

The difficulties and complexities arising from the integration of corporate and personal taxes are less serious in this case than in the world efficiency case. The refund problem, for example, no longer exists, because under the national efficiency criterion there is no need to equalize corporate tax burdens between domestic and foreign investments. Foreign taxes can simply be deducted, rather than being credited against domestic tax. A split rate system thus causes fewer problems. Nor does the problem of integrating foreign corporation tax with domestic personal income tax exist, because under this criterion foreign investment will bear at least the same domestic corporation tax as domestic investment. A dividend credit would, however, still have to be given by the capital-exporting country to distributions of foreign income if corporate investment policy is assumed to be influenced by the cumulated tax burdens of shareholders, because otherwise foreign investment would be unduly penalized and national gains would not be maximized. Similarly, full integration, under which corporate investment decisions might be affected to a greater extent by the tax burden on shareholders, would have to be granted, regardless of the origin of profits.

Some difficulties with integration would thus still remain, even if one is concerned only with national efficiency. In particular, current taxation of subsidiary income would still be required, because deferral of taxation on reinvested foreign income would otherwise unduly encourage foreign investment from the standpoint of national efficiency. The failure to tax such income currently (with deduction of foreign corporation tax) would encourage capital outflows beyond the point where the net (after-foreign-tax) profits equal the gross domestic profits and would therefore result in national losses.78 But current taxation involves difficulties if the capital-importing country adopts some form of integration.79

Another, and perhaps more important, implication of integration in terms of national efficiency is that the benefit of integration may be exploited by foreign direct investors in ways not available to residents. As discussed above, the national efficiency criterion provides an incentive to invest in low-tax countries, given the same rate of return among alternative investments abroad. If the capital-importing country adopts a split rate system, where the rate differential is not fully offset by the withholding tax, the effective corporation tax may be lowered by increasing distribution, so that transactions by foreign investors involving the payment and then immediate full reinvestment of dividends would be encouraged.80 Similar exploitation of distribution relief could take place if a dividend credit were to be extended to foreign direct investors.

Since capital-export neutrality is, as noted above, not optimal from the standpoint of national economic efficiency as defined here, the prevalence of measures intended to approximate to this concept of neutrality in many countries—for example, foreign tax credits and the exemption of foreign-source income—may seem to reflect some degree of altruism, which is not a common quality in international relations. It may be more realistic, however, to interpret these devices as evidence that some capital-exporting countries must feel that they benefit in a roundabout way from the resulting greater freedom of international capital movements and the closer approach to world efficiency. Alternatively, the importance attached to capital-export neutrality may reflect a combination of inertia from an earlier period when tax rates were generally low and the efforts of business interests that gain from this approach—efforts that have been effective because most legislators do not understand these complex issues and there is no discernible effect on their constituents anyway.

inter-country equity81

In addition to the considerations of allocative efficiency discussed above, a crucial issue in international tax policy concerns the sharing of the gains from foreign investment between capital-exporting and capital-importing countries. As with most equity concepts, this “inter-country equity,” as it may be called, is analytically more difficult, but perhaps practically more significant, than the efficiency concepts discussed above.82

To begin with, investors are assumed to be indifferent as to the country to which they pay tax, provided that the total tax is equal between domestic and foreign investments; this equalization can be accomplished by full crediting of foreign taxes either in the capital-exporting or the capital-importing country. As mentioned previously, in practice credits are usually provided only by capital-exporting countries.83 As a result, capital-exporting countries are generally concerned with the taxes levied in the capital-importing country and with the resulting allocation to each country based on taxation of the gains from foreign investment. The capital-importing country receives, in addition to other possible net benefits from foreign investment, its tax collections from the profits of the foreign-owned corporation. These receipts, however, are at the expense of the capital-exporting country, as compared to a situation where the investment is made in the latter. The heavier the taxation levied in the capital-importing country, the greater is the revenue loss at a given level of investment to a capital-exporting country that provides credits for foreign taxes. In fact, one would expect the volume of foreign investment to adjust to restore equality between the net return received by investors abroad and at home, but this very important consideration is, for expositional convenience, not discussed further here.

Inter-country equity is concerned with the allocation of tax revenues between capital-importing and capital-exporting countries and not with the distribution of the gains (or losses) between the taxpayers and treasury of a particular country. The gains in the capital-importing country, for instance, take the form of an increase in government revenues (treasury gains) in the first place, although they may be passed on to taxpayers through tax reductions. Similarly, national losses in the capital-exporting country may, or may not, be accompanied by equivalent treasury losses. For example, if the country provides a full credit for foreign tax, the national loss would equal the treasury loss; but if the foreign tax is treated as a deduction, the national loss is shared by the treasury and the taxpayers; and if the country disregards the foreign tax completely (if there is double taxation) the taxpayers bear the entire national loss. The treasury loss in the capital-exporting country thus depends on such “intra-nation” transactions between a treasury and its taxpayers, while the loss to the nation as a whole is determined solely by the tax in the capital-importing country.

In view of the reality of conflicting national interests, the issue of inter-country equity is an important one in practice. It is very difficult, however, to determine what criteria should govern inter-country equity. The difficulties arise in part because of the nature of corporation tax and the inadequacy of knowledge about the nontax gains or losses associated with foreign investment. If corporate taxation were based on a pure benefit principle—that is, the tax rate were set so as to defray the cost of intermediate goods provided to corporations by government—the solution would be quite easy. Indeed, inter-country equity would in effect be self-implementing under the benefit principle, because the right to tax profits would be allocated among countries according to the cost-reducing services rendered by each. In the real world, however, although the benefit that foreign investors may receive from government expenditures is one element to consider in devising inter-country equity criteria, other equity criteria must be found for nonbenefit taxation.

National rental and redistribution criteria

Two possible criteria for defining inter-country equity have recently been proposed by the Musgraves:84 national rental and redistribution. The national rental criterion looks to economic rents accruing to foreign capital invested in a country which is poor in capital but rich in other resources. In such a situation, the capital-importing country might justifiably claim a rental or royalty share in the foreign investor’s gains that might be higher than the taxes on alternative investments at home. Such a policy has, for example, been followed by some countries with scarce mineral resources. While this criterion is economically meaningful, it is in practice hard to establish an appropriate level for such differential taxation (or rentals) mainly because of the difficulties in evaluating the many other factors relating to foreign investment, such as the intangible gains to the capital-importing country associated with an inflow of technical and managerial know-how and the intangible loss associated with foreign control.

The redistribution criterion is quite different in concept; it is intended primarily to achieve income redistribution on a world basis in view of “a highly unequal distribution of resource endowments and per capita income among countries….85 It is therefore less relevant for the relationships among developed countries which are the principal concern of this paper than for relationships between developed and developing countries. In any case, under this criterion the rates of taxation levied in the capital-importing country would be inversely related to the size of its per capita income compared to that in the capital-exporting country. Poorer countries would thus be permitted to levy higher rates of tax than richer countries. Obviously, such an arrangement could only be secured by a multilateral convention prescribing the tax rates to be levied by capital-importing countries.

Both of these criteria seem less relevant to developed countries than to relations between developed and developing countries. As with per capita incomes, disparities in factor endowment are less significant among developed countries than between developed and developing countries, and the economic rent on foreign-owned capital, if any, might be marginal, except perhaps in the case of extractive industries. Furthermore, the national rental criterion may be difficult to implement through corporate taxation because most corporate taxes probably impinge to some extent upon the costs of production. While the return on many investments no doubt includes some economic rent, the profits from corporate taxes are affected by many other factors, such as management capability, financing structure, chance, and cyclical fluctuations.

The nondiscrimination criterion

The problems with these new criteria do not by any means imply that there are easier answers to the problem of inter-country equity in the traditional legal rules of “nondiscrimination” and an equal reciprocal withholding tax rate, as embodied in the OECD model treaty, for example (see Section II above). While in practice these conventional rules provide a useful guideline for inter-country equity when all countries use a separate entity system for corporate taxation, their limitations become clear if countries introduce any form of integration of corporate and personal income taxes. Here the argument of van den Tempel in his pioneering analysis of alternative tax systems in the context of the EEC holds in substance, although the direction of his argument is quite opposite to that presented here. He emphasized the limitations of integration systems because they make the implementation of nondiscrimination difficult; the authors of the present paper would rather stress that the limitations of the nondiscrimination rule as a policy guide have been accentuated by the emergence of integration systems. This difference is not merely verbal. Our approach assumes, as is surely the case in practice, that the design of tax structures is governed in most countries primarily by considerations of domestic policy and not by concepts such as “international nondiscrimination.”

As van den Tempel argued (in the context of the EEC), the achievement of “equal fiscal treatment” between domestic and foreign investors in the capital-importing country is made difficult if the country adopts an integration system.86 A split rate system, for example, cannot readily achieve equality between individual portfolio investment in domestic and foreign parent companies, because of the lack of sufficient information in the capital-importing country on the redistribution of subsidiary-parent dividends to ultimate individual shareholders. Similarly, a dividend credit system discriminates against portfolio investors in foreign corporations vis-à-vis portfolio investors in domestic corporations, unless the same dividend credit is extended to both. The problems are basically the same for a full integration system (although van den Tempel did not consider the international implications of this system) but may be more serious because of the greater potential loss of revenue from a strict adherence to the nondiscrimination principle.

These factors suggest that the nondiscrimination rule is most appropriate when all countries employ a separate entity system.87 This rule may therefore require some modification in view of the growing tendency (presumably mainly for reasons of domestic policy) toward some integration of personal and corporate income taxes in industrial countries. The attempt to discourage integration because it fails to achieve nondiscriminatory treatment of resident and nonresident investors does not appear to be a realistic alternative.88 Strict adherence to the nondiscrimination rule could result in serious inequities between two countries whose residents invest in each other, if one country adopts an integration system and the other does not. In effect, this rule requires that the country adopting integration extend the same distribution relief to foreign investors simply because domestic investors are entitled to such benefits. But unless one motive for the adoption of integration in the first place was to reduce the effective burden of taxation on nonresidents in order to encourage foreign investment,89 there may not be much justification for reducing taxation on nonresidents. The other benefits and costs of foreign investment would not change, and the tax reduction would result in a loss of revenue to the capital-importing country. A corresponding windfall gain would accrue to the capital-exporting country that employs a separate entity system (or does not provide reciprocal distribution relief) from the combination of integration and the application of the nondiscrimination rule by the capital-importing country.

The effective reciprocity criterion

The need for a criterion of inter-country equity to deal with problems arising from the adoption of integration systems may thus be acute. A possible criterion might be effective reciprocity, to equalize the effective tax burdens on foreign-owned investment between two given countries rather than to adhere to the nondiscrimination rule and the formal reciprocity of withholding tax rates. Under this criterion, what matters is equality in the effective level of taxes on foreign investment income in the two countries. For this purpose, a variable or flexible withholding tax may be utilized.90

To illustrate how this system might work, a country with a relatively low corporation tax might employ a relatively high withholding tax on dividends, so that the total tax burden on foreign investment income may be approximated to that in the partner country. A country with a relatively high corporation tax, on the other hand, would be expected to apply a low or zero withholding tax, depending on the effective tax rate in the partner country. If the corporation tax is comparable in the two countries, a similar withholding tax (or none) may be used.

A compensating withholding tax would, for example, be justified for a split rate system under this criterion to the extent that the corporation tax is effectively reduced by the rate differential.91 The case for such a compensating withholding tax is grounded not on equality between domestic and foreign parent corporations (as might be the case under the “equal fiscal treatment” or nondiscrimination principle), but on equality in effective tax burdens on incomes flowing between the partner countries. A compensating tax would therefore not be justified if the partner country has an appreciably lower corporation tax or has a split rate or similar system but does not itself impose a compensating withholding tax. There is no reason for limiting the compensating tax to subsidiary-parent dividends. It could also justifiably be levied on portfolio dividends, if the effective corporation tax is sufficiently lower than that in the partner country.92

Along similar lines, a dividend credit may or may not be properly extended across the border in accordance with this criterion, depending on the effective tax burden in the country claiming the extension. If the claimant country has a similar system of partial integration and extends a comparable credit or has a split rate system and does not impose a compensating withholding tax, such a claim may be justified. But if the credit is claimed by a country with a high effective rate, it need not be extended under the effective reciprocity criterion.

Assuming a comparable corporation tax rate (or rate on undistributed profits in the case of the split rate system), the requirements for effective reciprocity between countries with the various systems of taxing corporate-source income may be summarized as in Table 4. Between two countries with the same system, reciprocal treatment would be justified. In the case of two separate entity systems, effective reciprocity thus in effect yields the same results as the nondiscrimination rule. Unlike the latter, however, the effective reciprocity principle can be extended to systems of partial or full integration by providing distribution relief (or integration benefit) on a reciprocal basis. Once this is done, withholding taxes could then be differentiated as to corporation tax differentials in the two countries, in order to yield the same effective taxes on each other’s foreign investments. With different systems in the two countries, additional equalizing measures in the form of a compensating withholding tax or nonextension of distribution relief (or integration benefit) would be needed, as shown in Table 4. In addition, a differential withholding tax could again be utilized if corporation tax rates differed appreciably in the two countries.

Table 4.Requirements for Effective Reciprocity
System in Capital-

Exporting Country
System in Capital-Importing Country
Separate

entity
Partial integrationFull integration
Separate entityReciprocityCompensating withholding tax by split rate country. No dividend credit extended by dividend credit countryNo integration benefit extended by full integration country
Partial integrationReciprocityCompensating withholding tax by split rate country. No dividend credit or integration benefit extended by dividend credit country or full integration country
Full integrationReciprocity

Although it does not by any means offer an entirely satisfactory solution to the many problems in this area, the effective reciprocity criterion may also have some economic justification by reducing tax burden differentials among countries. If government services are provided on a more or less uniform basis in developed countries, the criterion may both serve the presumed objective of world efficiency and provide an equitable means of financing government services.93 Since full crediting of foreign taxes would be facilitated, the so-called “overspill” or excess (uncreditable) foreign tax problem would be less serious than when the corporation tax and withholding tax are viewed separately, as is the case under the present regime of the nondiscrimination rule plus reciprocal uniform withholding taxes.

Finally, this criterion would have the significant advantage of freeing national choice among the various systems, especially that between a split rate system and a dividend credit system, from undue attention to international considerations. The prevailing interpretation of the nondiscrimination rule, for example, favors the adoption of systems of integration at the shareholder level, as shown in detail in Section IV. In contrast, under the effective reciprocity criterion, each country would be free to choose the most suitable system in the light of domestic policy, a result that might facilitate both administration and the anticyclical use of corporate tax changes.

On the other hand, the effective reciprocity criterion does not seem very relevant to tax relations between countries when capital flows are one-sided. In particular, reciprocal equalization of effective tax burdens may have little appeal to the developing countries which, as a group, are net recipients of substantial inflows of foreign capital. Concepts of inter-country equity along the lines discussed above—the national rental and redistribution criteria—seem more relevant in this context as a possible basis for allocating tax revenue between capital-importing and capital-exporting countries.

Another limitation of the effective reciprocity criterion is that it is inherently bilateral, requiring direct negotiation between the two countries concerned, in contrast to the nondiscrimination rule, which can be adopted unilaterally or multilaterally, if desired. Since international tax relations continue in practice to depend largely on the results of bilateral treaty negotiations, however, this limitation does not appear particularly severe. The more explicit recognition of the bargaining nature of all solutions to the inter-country equity issue inherent in this criterion may, indeed, be considered a virtue. In any event, a standard rate schedule, inversely related to the corporation tax rate of the capital-importing country, could, if desired, be developed and applied multi-laterally if the effective reciprocity criterion were to be adopted in international tax relations.

IV. International Income Taxation: Some Recent Issues and Arguments

In recent years many of the issues treated in the preceding section have been discussed at length in connection with both national tax reforms in several countries and tax harmonization in the EEC. This section reviews briefly some of the more important arguments in these contexts and appraises them in terms of the criteria set forth in Section III. First, however, it should be noted again that neither the domestic effects of alternative systems of taxing corporate-source income, nor such noneconomic influences on international tax policy as the desire for harmonious international relationships, are taken into account here, even though these factors may in practice often be more significant determinants of policy than the efficiency and equity criteria on which this discussion focuses.94 These limitations reinforce the caution expressed earlier to the effect that the treatment of different national tax systems in this paper is by no means definitive.

the EEC discussion

Since its inception in 1958, the EEC has recognized the need, in principle, to align at least the basic structure of the corporation tax systems in its member countries in order to achieve its ultimate goal of the free flow of capital within the Community (Treaty of Rome, Article 67). In 1962, the Fiscal and Financial Committee (the Neumark Committee) proposed to harmonize the corporation tax in the EEC by having all countries adopt a split rate system, although the international implications of the proposal appear to have been given little attention.95 Seven years later, another report (the van den Tempel report) published by the Commission of the European Communities focused on the international implications of the alternative systems and concluded that the separate entity system provided the most suitable basis for a harmonized system in the EEC.96 In view of the importance of this report, which provides a suggestive and pioneering analysis of the international aspects of alternative systems, the arguments leading to this conclusion deserve special attention, even though the Commission has in fact decided to adopt the dividend credit system.

As noted earlier, the basic reasons why van den Tempel preferred the separate entity system are the difficulties with either a split rate or dividend credit system in achieving the “equal fiscal treatment” required to remove fiscal distortions of capital flows. Although van den Tempel mentions two aspects of “equal fiscal treatment,” tax neutrality between investment at home and abroad by residents (capital-export neutrality), and tax neutrality between investment at home by residents and nonresidents (capital-import neutrality), he appears to have stressed the latter—arguing, for example, that both methods of partial integration distort the equality of treatment between resident and nonresident investors.

Both systems may in fact achieve some degree of equal treatment by extending distribution relief to nonresident portfolio investors—either automatically as under the split rate system or through the extension of the dividend credit system. But no such ready solution is available in the case of the more important direct investment by foreign corporations, because the lack of information on redistribution abroad of subsidiary-parent dividends or branch profits to the ultimate shareholders precludes the exact implementation of distribution relief across national borders.

In contrast, a separate entity system is free from such difficulties simply because it does not attempt to integrate corporation tax and personal income tax and therefore need not extend any relief across borders. A separate entity system thus complies with the test of equal fiscal treatment. It may also be neutral between domestic and foreign investments undertaken by residents if relief from international double taxation is provided.

This argument suggests that the primary criterion for the harmonization of corporation tax in the EEC member countries is capital-import neutrality, which may be impaired by the necessarily arbitrary application of distribution relief across the border and can be achieved only by the removal of such relief (that is, the adoption of the separate entity approach). Examining the problem in a somewhat broader context, Cardyn reached the similar conclusion that “the absolute separation of the two taxes is capable of providing a minimum of neutrality which is to be recommended in bilateral relationships and which is essential in community relationships.”97

As argued earlier, a case could indeed be made that capital-import neutrality is a relevant criterion for ensuring the efficient allocation of resources if there were universal shifting of corporation tax in the short run, or if the tax structure (including the tax base) were exactly the same in the different countries, although neither assumption is made by van den Tempel. It may also be argued, on the contrary, that capital-export neutrality is a more appropriate criterion, which is also more consistent with the Treaty of Rome.98 The argument of the previous section, which stresses the problems that integration gives rise to in achieving capital-export neutrality, is also relevant. In this connection, it will be recalled that the separate entity system does not in itself secure capital-export neutrality, although on the whole it provides a better basis for such neutrality than the other alternatives do. Strictly speaking, for capital-export neutrality to be achieved by a separate entity system, it must be accompanied by current taxation of corporate direct and portfolio investment abroad, a corporation tax adjustment for individual portfolio investment abroad, and the full crediting (including refund) of foreign taxes.”99

To sum up, it appears that van den Tempel was in fact more concerned with problems of inter-country equity than with international tax neutrality. In these terms, his argument that integration gives rise to many difficulties is quite persuasive if the nondiscrimination rule, as laid down for example in the OECD model treaty (Article 24), is considered to be the supreme criterion for inter-country equity. It is quite true that the nondiscrimination rule, combined with reciprocal withholding taxes, is simplest to implement when separate entity systems are used in both countries. But the question is whether this rule carries enough weight to offset the domestic policy benefits that different countries might obtain by adopting some form of integration. There would seem to be no economic basis for assuming that it does, so this argument may lead logically, not to separate entity systems in order to maintain the nondiscrimination rule, but to modifying this rule in order to accommodate different systems of taxing corporate-source income. Devising new treaty rules in response to a changing world situation may be a preferable alternative to adhering to the old rules and trying to reverse national movements away from tax systems that satisfied the old criteria. Such a modification of treaty rules in the direction of the effective reciprocity criterion discussed earlier, for example, need not be inconsistent with retaining the principal advantage of the nondiscrimination rule to countries—namely, preventing capricious discrimination in the taxation of nonresident investors in the treaty countries.

the United Kingdom

The discussions in the United Kingdom on the 1972 corporation tax reform provide a good example of the international implications of the alternative systems. Because the basic direction of the reform from the former separate entity system to a partial integration system had been predetermined by the U. K. Government’s Green Paper published in 1971, the discussions of the parliamentary Select Committee on Corporation Tax for the most part dealt with the international aspects of alternative approaches to partial integration. The Government finally chose the dividend credit system, as proposed by the Select Committee, rather than the split rate system which it had favored earlier.

The major international issues in this discussion were two: one relating to tax neutrality between investments at home and abroad by U. K. corporations, the other relating to the taxation of foreign corporations investing in the United Kingdom. The former issue centered on the possible discrimination against investment abroad which would be introduced by the proposed integration approaches, while the latter concerned the possible loss of revenues and foreign exchange, or more fundamentally national income, which would result from the adoption of a split rate system rather than a dividend credit system.

Under either system of partial integration, a corporation earning income abroad may in fact be discriminated against, because the foreign tax credit is limited to the corporation tax, which is reduced either by the lower rate on distribution (split rate system) or, in the United Kingdom’s proposals, by the advance corporation tax at three sevenths of dividends (dividend credit system). If the foreign tax cannot be fully credited, there is clearly an extra tax burden on corporations investing in countries with high taxes. This discrimination could be removed in most cases by adopting a dividend credit system without an advance corporation tax—in other words, the system used in the United Kingdom before 1965.100 The same result may be obtained by allowing the crediting of foreign tax against the advance corporation tax.

In their testimony to the Select Committee, many business groups urged the adoption of something like the pre-1965 system on grounds of equity, competitiveness abroad of U.K. enterprise, and possible inefficiencies arising from tax-induced corporate mergers.101 The Inland Revenue, however, objected to a pre-1965 system on a number of grounds: administrative complexities, undue subsidies to businesses operating abroad, possible loss of national gains,102 and, perhaps most significant, an aversion to giving relief for corporation tax not actually paid to the U.K. Treasury.103 The revenue loss arising from the adoption of the pre-1965 system was estimated to be about £100 million, which would have required a 2.5 percentage point increase above the proposed 50–20 per cent rates (split rate system) to yield the same revenue. An underlying policy judgment seems to have been that there was no need to further encourage investment abroad.104 These same considerations led the Inland Revenue to prefer a split rate system to a dividend credit system, because the former maintains “a firm line of demarcation” between corporation tax and the personal income tax, while the latter is vulnerable to “erosion” of the advance corporation tax, by which was meant the crediting of foreign taxes against it.105

The second major international issue concerned the taxation of foreign corporations investing in the United Kingdom. A common premise on this point was that the split rate system would automatically extend the distribution relief to foreign shareholders and would therefore involve more revenue losses than the dividend credit system, which permitted full taxation of subsidiaries owned by foreign parent companies. Another feature of the debate was the apparent belief of many that the United States would be unwilling to agree to the imposition of a compensating withholding tax to offset the automatic distribution relief of a split rate system on dividends paid by U.K. subsidiaries to U.S. parent corporations.106

The Inland Revenue, however, did not appear to be concerned about these disadvantages of the split rate system, largely because of the relatively small revenue loss involved and the growing tendency in treaty discussions to consider substantive equity between countries rather than formal reciprocity, as well as possible changes in the attitude of the United States. They also emphasized the possible adverse effects which the higher effective corporation tax rate, said to be implicit in the dividend credit approach, might have on capital inflow from the United States.

The Select Committee, after hearing these arguments and examining related evidence, precluded a return to a pre-1965 system on the grounds that their mandate was limited to the choice between the split rate and dividend credit systems. They then found two factors to be decisive in making the choice between these two systems: the extent to which the fear of “erosion” of the tax revenue, if the dividend credit approach were adopted, was well founded and the advantages of the dividend credit approach in the international context. On balance, the Inland Revenue’s preference for the split rate system was overruled by the Committee in view of the allegedly more favorable impact of the dividend credit system on the balance of payments and on the United Kingdom’s treaty negotiating position. An additional consideration was the harmonization of corporation tax systems in the EEC, which the Committee felt would be facilitated by the United Kingdom’s adoption of a dividend credit system.

The ensuing reform of the U.K. corporation tax system restricted the effective size of the foreign tax credit by limiting the integration of foreign corporation tax with domestic personal income tax through the device of the advance corporation tax (ACT). In fact, however, as noted above, a pre-1965 system would have been required to achieve capital-export neutrality; the limitation of the foreign tax credit through the ACT tends to discourage investment in countries with high taxes relative to countries with low taxes and hence to introduce a further distortion into international capital flows. While a larger foreign tax credit would admittedly provide some freedom to foreign countries to increase their revenues at the expense of the U.K. Treasury without fear of discouraging capital inflows, there appears to be no evidence that the pre-1965 system encouraged the raising of foreign tax rates. The new system thus cannot attain capital-export neutrality or world efficiency in the sense used in this paper. Nor does it attain national efficiency in the sense discussed earlier, because it extends larger foreign tax credits than the deduction method.

It may thus be suggested that the U.K. choice of a dividend credit system rather than a split rate system in part reflects the limitations in the present treaty rules governing inter-country equity. Had the nondiscrimination and reciprocal withholding tax rules not been deemed to be controlling in present international taxation negotiations, it might have been possible to adopt the split rate system, which the U.K. Inland Revenue strongly preferred. In the absence of a flexible withholding tax or compensating withholding tax principle, however, it is true that the dividend credit system is clearly superior to a split rate system from the national gains standpoint.

France

In 1965 France introduced a dividend credit system in place of a separate entity system. Developments since 1965 in France again illustrate the international issues involved in the integration of corporation tax and personal income tax. Initially, neither foreign shareholders investing in French corporations nor French investors in foreign corporations were granted the avoir fiscal. In 1967, however, France began to extend the dividend credit to foreign portfolio investors through bilateral treaty arrangements—first to the Federal Republic of Germany and then to Switzerland and the United States. By 1973, the avoir fiscal had been extended to nine countries and more extensions were under discussion.107

Several factors may account for this reversal in policy. In the first place, it has been argued that French policy toward capital inflow has changed since 1965.108 In addition, the new system was considered for various reasons to have failed in achieving one of its major policy objectives—namely, to increase stock prices by making equity investment more attractive. This failure appears to have been partly attributed by the authorities to the fact that the downward adjustment of corporate dividend policy in response to the dividend credit newly granted to resident shareholders was not compensated for by that credit in the case of nonresident shareholders. Moreover, there were international pressures to restore nondiscriminatory treatment between French and foreign shareholders. The position of the Federal Republic of Germany on this point was particularly strong because it was already giving automatic relief to French investors through the split rate and because the Treaty of Rome obligates EEC member countries to remove obstacles to free movements of capital within the EEC.

The method of extending the dividend credit to foreign shareholders differs from treaty to treaty, but the essence is the same. Only portfolio investors are granted the credit, and neither subsidiary-parent dividends nor the branch profits of foreign corporations qualify for the relief. Portfolio investors receive, in addition to cash dividends, the avoir fiscal (50 per cent of cash dividends) from the French Government, but a withholding tax of 15 per cent is then imposed on the sum of these two amounts. They are then subject to personal income tax (or corporation tax in the case of corporate investors) in their home countries on this total amount, with a credit for the French withholding tax. Foreign portfolio investors are thus put in the same position as French investors, as illustrated:

Foreign

Investor
French

Investor
Cash dividends100.0100.0
Avoir fiscal50.050.0
French withholding tax22.5
Taxable dividends150.0150.0
Personal tax (30 per cent)
Tax before credit45.045.0
Credit22.550.0
Net tax22.5-5.0
Net dividends105.0105.0

National gains accruing to foreign countries as a result of the extension of the credit (42.5) are divided into treasury gains (7.5) and shareholder gains (35).109

In view of the heated discussion in the United Kingdom on the possible impact of integration on U.K. investment abroad, it is surprising that the effect of the French integration system on capital outflow appears to have attracted little attention. A major reason for this disparity may be that France, unlike the United Kingdom, maintains a territorial (or source) principle for corporation tax purposes, under which corporate profits earned abroad are normally exempted from French corporation tax.110 Fundamentally, arguments of tax neutrality between domestic and foreign investment presume the notion of global taxation which intends, at least theoretically, to achieve equity and neutrality by subjecting worldwide income of resident taxpayers to tax, and granting relief from international double taxation in the form of a foreign tax credit. If foreign source income is simply exempted from domestic tax, considerations of neutrality or equity, such as those raised in the U.K. debate, do not arise in the discussions of integration.111

The exemption from French corporation tax of direct investment income from abroad is also really the main issue in France from a world efficiency viewpoint. Capital-export neutrality cannot be secured by exemption, unless universal forward shifting of corporation tax is assumed. The movement toward global taxation with a foreign tax credit, initiated by the 1965 tax reform, is more consistent with the achievement of tax neutrality in this sense, because tax differentials between domestic and foreign investments are reduced. Capital-export neutrality also requires integration of foreign corporation tax with domestic personal income tax, instead of the present regime of applying the précompte to distributions from foreign income. As in the United Kingdom, the heavier the foreign tax and the greater the distribution, the less are the net private profits from investment abroad. Full crediting of foreign tax combined with the dividend credit (without the précompte) is the only way to achieve capital-export neutrality in this system. Thus, like the new U.K. system, the present French system differentiates tax burden not only between domestic and foreign investments, but also between alternative investments abroad, depending on the foreign tax rate and the payout ratio. The national interest may perhaps be served by thus encouraging investment in low-tax countries relative to that in high-tax countries, but the system is not free from distortion resulting from payout differentials. Again, a deduction method may be a better alternative, if national efficiency is the only policy objective.

The extension of the avoir fiscal to nonresidents since 1967 appears to have been motivated by both domestic and international factors. The extension to a country such as the Federal Republic of Germany, which extends a comparable relief to French investors, can readily be justified under the effective reciprocity criterion. But the extension to other countries requires some other rationale, such as the encouragement of domestic capital markets, because capital-export neutrality is made more difficult to achieve in the partner country by France’s extension of the avoir fiscal, especially if the partner country uses a separate entity system and does not grant a similar relief to the domestic investors.

Canada

Finally, a few other points may be illustrated by reference to the recent extensive Canadian discussion on the international aspects of corporate and shareholder taxation. Throughout the lengthy reform process—the Carter Royal Commission recommendations (1967), the White Paper proposals (1969), and the 1971 legislation—Canada’s position has been consistent with regard to taxation of foreign investment in Canada, although in the course of the reform official policy changed considerably concerning taxation of Canadian investment abroad. Despite the alleged lack of theoretical grounds for a separate corporation tax, the Royal Commission reluctantly reached the conclusion that “there are good and sufficient reasons for continuing to collect a tax from” corporations, including the “loss in economic benefit to Canada” that would result from failure to tax nonresident shareholders on their share of corporate income earned in Canada.112 The alternative of a dividend deduction method, an extreme form of a split rate system, “would result in unwarranted revenue costs and would serve to increase the amount collected by foreign treasuries.”113 Further, the solution of a compensating withholding tax “would obviously be unacceptable to some of the countries with which it would be necessary to renegotiate tax treaties.”114 Moreover, it was assumed that the restriction of the benefit of the proposed full integration to domestic shareholders would have no adverse effect on foreign confidence in Canada and would bring about no retaliation because there would be no substantial changes in the tax position of most foreign shareholders.115 The Commission also proposed maintaining the existing general 15 per cent withholding tax on dividends paid to foreign shareholders, mainly on the grounds that the combined tax burden on corporate source income was close to, or exceeded, the ceiling of foreign tax credit in major investor countries (the United States and United Kingdom) and that therefore any increase in the rate would deter capital inflow to Canada. A special tax on branch profits was also to be continued at the same rate as the withholding tax in order to preserve neutrality in the rates of tax on investments in subsidiary and branch forms.116

In general, the Carter Commission approached the problem of international tax neutrality in an analytical way, proposing a unique (and complex) set of rule& to govern the, taxation of Canadian investment abroad. While it is not necessary to go through the proposed system in detail, the Commission offered two major reasons for not providing complete tax neutrality between domestic and foreign investment. First, the Commission argued that international tax neutrality “may not even be desirable” in view of the existence of nontax barriers such as tariffs, foreign exchange controls, and immigration laws.117 Because of the market imperfections brought about by such barriers, the Commission maintained, it is doubtful whether the before-tax yields in different countries reflect the “true” return from capital.118 International tax neutrality offered by Canada alone on the assumption of international market perfection may therefore not achieve world efficiency.

Second, and more pragmatically, a full gross-up and credit of foreign taxes would involve massive refunds of tax which had never been paid to the Canadian Treasury. In an argument similar to that of the Inland Revenue in the U.K. discussion, full integration of foreign corporation taxes with the Canadian personal income tax was said to leave the Canadian Treasury “at the mercy of foreign treasuries.”119 The crediting of foreign tax up to the Canadian rate was also rejected on the grounds that Canadian residents investing abroad would enjoy benefits from Canadian public expenditures and therefore should bear some of the costs of providing such benefits. Furthermore, a full gross-up and credit of foreign taxes was found objectionable in the proposed system of current taxation of subsidiary income because it involved greater technical complexity than the proposed maximum 30 per cent credit (mainly because of the recalculation of subsidiary income which would be required to permit exact crediting). This restriction on the foreign tax credit was aimed at deriving some net revenue for the Canadian Treasury.120 A minimum 30 per cent tax on subsidiary income was also designed to close the loophole created by the exemption of subsidiary income earned in countries which were tax havens.

The Commission’s analytical approach to international tax neutrality might appear to make its arguments easier to reconcile with this paper than some of the other discussions in this section. However, the stress it placed on capital market imperfections led the Commission to a quite different conclusion. This issue aroused a great deal of academic comment. Musgrave, for one, argued that international market imperfections might not support the proposed deviation from neutrality because such imperfections exist even in the domestic setting. He suggested that the real criterion for international taxation adopted in the report was a narrow concept of national interest. He also suggested that the proposal would do little to remove tax differentials according to country of investment. Deferral of branch profit taxation until the time of distribution would favor investment in a low-tax country,121 and the minimum tax would discourage subsidiary operation in a country where the tax rate is low. The only means to achieve tax neutrality as to country of investment would be to adopt a full gross-up and credit approach. Mieszkowski, on the other hand, emphasized that the Carter report’s deviation from international neutrality would not greatly serve Canada’s national interest because the Canadian rate of return on equity would in fact continue to be determined by American rates that would not be affected by the Carter proposals.122

In practice, the Commission’s idea of integrating foreign corporation tax with domestic personal income tax to the extent of 30 per cent was soon dropped. The 1971 legislation provided a uniform credit of one third of cash dividends (or one fourth of grossed-up dividends)123 to domestic shareholders, regardless of whether Canadian corporation tax had been paid or not. This procedure is in sharp contrast to the French and U.K. systems discussed earlier. The theory is that the credit is intended to encourage individual investment in equities and not to alleviate “double taxation” of corporate profits, so that it is not relevant whether any corporate tax has been paid or not.124 In the 1971 reform, however, taxation at the corporation level was still differentiated according to the type of investment, country of investment, and foreign tax rate. The current taxation of foreign branch profits was continued, with a credit for foreign corporation tax. Foreign subsidiary income is to be exempted from Canadian corporation tax, when derived from countries with which Canada has a tax treaty. If earned in countries where Canada has no tax treaty, however, such income is to be taxed after 1975 to the extent that dividends received (grossed-up by the foreign withholding tax) exceed the total of the underlying foreign corporation tax and twice the amount of the withholding tax.125 Current taxation is also to be applied to certain “passive income” earned abroad. Portfolio investors in foreign corporations receive a foreign tax credit for withholding tax only, which will be limited to 15 percentage points after 1975.

In addition to a greater emphasis on practical considerations, these changes reflect changing attitudes toward integration of corporate and personal income taxes. The Carter Commission’s limited integration of foreign corporation tax with domestic personal income tax was motivated by the potential losses in revenue which would have resulted if the far-reaching full integration proposed domestically had been extended to foreign-source income. In the White Paper proposals, which were issued in 1969, partial integration to the extent of half the corporation tax was coupled with the “flow-through” of withholding tax and a 50 per cent credit for Canadian corporation tax in order to offer a rough degree of tax equality between domestic and foreign investment.126 The more generous attitude of the 1971 legislation toward integration of foreign corporation tax with domestic personal income tax may perhaps be accounted for by the further reduction in integration to one third of corporation tax and the resulting smaller revenue loss from such integration.

The system in Canada prior to 1971 resulted in different after-tax profits for investments with the same before-tax rate of return, depending on the investment and the foreign tax rate. While branch profits were treated like domestic profits, being subjected to current taxation with a credit for foreign corporation tax, the net profits from subsidiary operations abroad in fact varied with the foreign tax rate because of the absence of equalizing tax measures in Canada. Corporate portfolio dividends were treated less favorably, since no credit was granted for the foreign corporation tax. As a result, the system tended to encourage subsidiary investment in low-tax countries and discourage portfolio investment, particularly in high-tax countries. The Carter proposal removed the tax differential that depended on form of investment by providing the same treatment to all types of investment, although it also tended to discourage investment in high-tax countries where the effective tax rate exceeded the proposed credit limitation of 30 per cent. The White Paper proposal mentioned above also resulted in tax differentials, depending on type of investment, country of investment, and the foreign tax rate. Subsidiary investment in countries which had a tax treaty with Canada and had low tax rates was favored because of the exemption they granted to subsidiary profits, while corporate portfolio investment was discouraged because no credit was extended to foreign corporation tax. The actual 1971 legislation also favors subsidiary investment in such countries, while discouraging portfolio investment, particularly in countries with high tax rates. The system is, however, free from the tax distortion on corporate payout behavior which is inherent in a system restricting integration of foreign corporation tax with domestic personal income tax through a device like the French précompte or the U.K. advance corporation tax.

As suggested earlier, if the maximization of national gain had been a prime objective of the Canadian tax reform, the deduction approach would have been attractive for the taxation of Canadian investment abroad. But Canada’s heavy dependence on foreign capital appears to have precluded the adoption of such a drastic measure for fear of retaliatory restrictions on capital flows into Canada on the part of the United States and other capital-exporting countries. Similar considerations might also have influenced the final choice of a more limited integration system which may more easily satisfy the requirements of international tax neutrality by integrating foreign corporation tax with domestic personal income tax. Finally, Canada’s apparent desire not to extend integration benefits or dividend credit to foreign investors finds some support from the criterion of inter-country equity since, as argued earlier, it is not appropriate to extend such distribution relief across the border unless capital-exporting countries extend a comparable relief to Canadian investors in their countries.

V. Summary and Conclusions

Whatever the domestic advantages and disadvantages of the alternative systems of taxing corporations and shareholders discussed in this paper, it is clear that the different systems vary widely in their international implications. Judged by the criterion of world-wide efficient resource allocation (in an undistorted market), which has been provisionally taken as a standard of reference here, any integration system involves difficulties and complexities.

The split rate system, for example, poses serious practical problems in that the full crediting needed to achieve neutrality may be complicated by the refund problem if a low effective corporation tax rate is applied under this system—that is, if there is a high ratio of dividends to total profits. There are also technical difficulties in achieving capital-export neutrality in the case of individual portfolio investment. Full equalization of tax burdens between domestic and foreign investments would thus be difficult to achieve.

The dividend credit system, while free of some of these problems, has to integrate foreign corporation tax with domestic personal income tax in order to achieve capital-export neutrality. As evidenced by the debates in the United Kingdom, France, and Canada, this requirement presents practical difficulties for the achievement of capital-export neutrality by the capital exporter. These problems are particularly acute when the capital-importing country imposes a high corporation tax on foreign-owned investments. Extension of the dividend credit to foreign investors may serve the purpose of capital-import neutrality, but it also complicates the tax arrangements necessary to achieve capital-export neutrality in the investor’s country. The problems are essentially the same, but more serious, for a full integration system. If corporate policy is assumed to be affected by the personal income tax under full integration, these difficulties are compounded by the need to equalize the personal tax burden between domestic and foreign investments. The problems to which any integration system gives rise are not significantly reduced when the corporation tax is assumed to be universally shifted.

The separate entity system, however, escapes these difficulties and is thus clearly a superior system in terms of capital-export neutrality. Although the system is not entirely free of problems, it appears to provide a better basis for the attainment of “world efficiency”—that is, the efficient allocation of capital among countries.127

If the policy objective is to achieve national rather than world efficiency, however, most of the difficulties inherent in integration disappear, basically because foreign taxes need not now be fully credited against domestic tax but instead may simply be deducted as costs of doing business abroad. If this criterion were adopted, there would then be no significant differences among the alternative systems. The adoption of this criterion by major industrialized countries would, however, lead to allocative inefficiencies, not only between domestic and foreign investment but also between alternative investments abroad. Investment at home would be encouraged relative to that abroad, and investment in low-tax foreign countries would be encouraged vis-à-vis that in high-tax foreign countries, at the possible cost of diminishing world gains because of the free flow of international investment.

In the context of inter-country equity, the introduction of various forms of integration in important countries may necessitate modifications in the conventional adherence to nondiscrimination and reciprocal withholding tax rates as key elements of the international tax structure. An equitable allocation of investment gains between capital-importing and capital-exporting countries may therefore require a new criterion. The difficulties in complying with the nondiscrimination rule arising from integration might, for example, be solved by an appropriate modification of the rule. Although not entirely satisfactory, an effective reciprocity criterion was suggested above as a possible approach toward such a modification. This criterion would look to the effective tax burden in countries with different systems and attempt to equate the tax burden as much as possible by applying different withholding tax rates. Agreed variations in rates of withholding tax along these lines might then result in a more equitable inter-country division of investment gains, particularly when the capital flows are more or less similar in both directions, without negating the basic principle underlying the nondiscrimination rule, namely, the desire to prevent capricious discrimination in the taxation of nonresidents. Where capital flows are one-sided, however, the criterion of effective reciprocity is less relevant to the formulation of policy because the benefits of tax treaties to partner countries will be unequal.

Recent legislative changes in some developed countries suggest that international tax policies that are nonneutral with respect to capital exports are becoming more important, largely because changes from a separate entity system to a dividend credit system have not been accompanied by full integration of foreign corporation taxes with the domestic personal income tax. The U.K. advance corporation tax, for example, works to restrict such integration by imposing an additional tax, equivalent to the dividend credit, on distributions of foreign direct investment income. The new tax in the Federal Republic of Germany will apparently be structured along similar lines. These devices provide an incentive to invest in low-tax countries and to retain foreign-source income as undistributed profits.

The spread of nonneutral tax policies is also evident with regard to the taxation of foreign-owned investment. The final U.K. choice of a dividend credit system, for example, was motivated in part by the revenue loss inherent in a split rate system. The French choice of a dividend credit system in 1965 was based in part on similar considerations, although the avoir fiscal has since been extended to certain foreign portfolio investors (as has the U.K. dividend credit). The Carter Commission in Canada retained the corporation tax largely on similar grounds. To put it another way, the emerging preference for a dividend credit system reflects, at least in part, considerations of inter-country equity, since adherence to the existing rules of nondiscrimination and reciprocal withholding tax rates may result in national gains and losses with other systems.

It may, however, be possible to establish alternative international standards or “codes of conduct” for taxation that would be more consistent with the achievement of international tax neutrality, assuming that countries are concerned with the free flow of international investment. The need for a change in present standards may be especially acute for the EEC and other economic communities attempting to remove fiscal barriers to free movements of capital among member countries. Despite the conclusion of the van den Tempel report in favor of a separate entity system, the EEC has, for instance, recently agreed to adopt a dividend credit system for taxing corporate-source income.128 Four of the nine member countries (France, Belgium, Ireland, and the United Kingdom) have already adopted such a system. While tax harmonization in economic communities is affected by many considerations, some standardized measures must be employed by all the member countries if international tax neutrality is to be achieved, unless and until the tax structure (including the tax base) is completely harmonized.

As demonstrated earlier, one such essential measure is to integrate foreign corporation tax fully with domestic personal income tax so that taxation of domestic and foreign investment may be made neutral. In practice, however, this measure faces considerable opposition because of the significant revenue losses and administrative difficulties involved. For example, the current practice in some countries of exempting direct investment abroad from domestic tax would have to be replaced by current taxation of such investment with full credit for foreign corporation and withholding taxes. In addition, a corporation tax adjustment would have to be applied to portfolio investments abroad, despite the technical difficulties entailed in its implementation. Mutual extension of dividend credits across the border, is not, however, required to achieve capital-export neutrality; the granting of full domestic dividend credit to portfolio investments abroad by the investor’s home country will better achieve this objective. In addition, corporate rate differentials among the member countries would have to be adjusted by using the technique of flexible withholding tax rates if the criterion of effective reciprocity were to be employed.

The adoption of such standards by all the members of an economic community would no doubt result in efficiency gains within the community, but this would not necessarily be true if the outside world is taken into consideration, because tax burden differentials would still exist between domestic investments or between the member countries and countries outside the community.129 Thus, the suggested standards must be applied to world-wide investment if complete international tax neutrality in the sense sought here is to be achieved.

Clearly, however, there are substantial practical difficulties in fully integrating foreign corporation tax with domestic personal income tax because of treasury and national gain considerations. Objections on this score would be particularly strong when the outside country uses a separate entity system under which no reciprocal distribution relief is provided to foreign or even to domestic income. Mutual extension of a dividend credit by the member countries may aggravate the problem in this context, because the extension of comparable relief cannot be expected from the country outside the community which uses a separate entity system.

Broader application of these standards will also encounter more difficulties than when they are limited to an economic community, if only because the choice between the alternative systems and policy toward foreign investment are matters of national sovereignty. A logical step, however, may be re-examination of the current standards embodied in the OECD model treaty. There appear to be two areas requiring revision, one relating to world economic efficiency and the other to inter-country equity.

In the first place, the OECD model treaty provides for two alternative methods of double taxation relief—exemption and credit.130 The exemption method, however, cannot be justified on the criterion of world efficiency unless universal shifting of corporation taxes is assumed. The credit method, while better serving the objective of world efficiency, is limited because it is not a “full” credit in the sense used in this paper (that is, no refund is required of the excess foreign tax) and because an “indirect” credit is not required for subsidiary investment abroad. In addition, as already pointed out, it would be necessary to tax foreign-source income currently rather than only when it is repatriated. Further, there are no rules at all in the OECD model treaty governing the international integration of corporate and personal income taxes. In the interests of world efficiency, the standards set forth in this model treaty ought therefore to be re-examined with particular emphasis on the possibility of (1) fuller crediting of foreign tax, (2) extension of the credit to the “underlying” foreign tax (indirect credit) combined with current taxation of subsidiary income, and (3) full integration of foreign corporation tax with domestic personal income tax when a country has an integration system.

The present rule of nondiscrimination, coupled with reciprocal withholding tax rates, also has to be re-examined if inter-country equity is to be achieved when countries have integrated systems. While the nondiscrimination rule is a familiar one and is related in the minds of many to the general framework of international economics and politics, it is now so interpreted, it has been argued, as to constrain domestic tax reform unnecessarily. It may prove desirable, for example, to end the present separation of corporation tax and withholding tax on dividends paid abroad and instead to consider the two taxes jointly. Flexibility could be introduced in fixing the withholding tax rate so that effective tax burdens would be equalized. In order to avoid the very high withholding taxes that might result from such flexibility, however, some standard rate schedule, inversely related to the corporation tax rate of the taxing (capital-importing) country, might be applied multilaterally. The nondiscrimination rule could then be revised so that it is not interpreted to require a country with a dividend credit system to extend a credit to foreign investors.

This paper has concentrated on the taxation system as such, abstracting from problems of tax rates and the definition of the tax base, and has discussed the allocative and inter-country equity implications of alternative systems of taxing corporations and shareholders in the developed countries. Further work on this subject must take into account the differences in effective tax burden among different countries, particularly when a sectoral analysis is undertaken, since extractive industries, for example, are granted special tax treatments in many countries. More basically, the implications of the alternative systems for international capital flows and balance of payments really must be assessed in a fully articulated, general equilibrium framework in order to assess the effects of alternative systems.131 Another related subject meriting further study is the taxation of multinational corporations. Financial transfers between the affiliates of such corporations have an important bearing not only on international capital flows but on inter-country equity, since profit allocation through transfer pricing and other means might result in inequitable allocation of tax gains among the countries concerned. The problems of operations in countries that are tax havens are closely related. Finally, and perhaps most important, capital flows between the developed and developing countries demand special consideration and inquiry. Here, world efficiency and inter-country equity based on effective reciprocity may offer less appropriate criteria than in the case of developed countries alone. In the interests of world redistribution, some deliberate deviation from international tax neutrality and effective reciprocity may be justified, although the effects of taxation measures should always be compared with those of such alternatives as outright grants and concessionary loans.

APPENDIX
Table 5.General Taxation of Corporations and Shareholders in Selected Countries
United StatesNetherlandsFranceUnited KingdomFederal Republic

of Germany
Japan
Basic structureSeparate entitySeparate entityDividend creditDividend creditSplit rateMixed
Tax rates1
Corporation tax48 per cent46 per cent50 per cent50 per centRetained: 51 per cent Distributed: 15 per centRetained: 40 per cent Distributed: 30 per cent
Withholding of personal income tax on dividendsNone25 per centNoneNone25 per cent15 per cent
Dividend credit
On net dividends50 per cent42.8 per cent10 per cent (or 5 per cent)2
On grossed-up dividends33½ per cent30 per cent
Intercorporate dividends
General treatmentGenerally, 85 per cent exemptionParticipation exemption (5 per cent ownership)Participation exemption (10 per cent ownership)Generally, exemptionParticipation exemption (25 per cent ownership)Generally, exemption
Nachsteuer on retention36 per cent (51 per cent minus 15 per cent)One fourth of dividends retained taxed at 40 per cent
Measures for uniform dividend creditPrécompte, levied on certain dividends, not deducted from corporation taxAdvance corporation tax levied on all dividends, deducted from corporation taxNone

Basic or representative rates, not including local taxes or temporary surtaxes.

If the total taxable income of dividend recipients exceeds 10 million yen.

Basic or representative rates, not including local taxes or temporary surtaxes.

If the total taxable income of dividend recipients exceeds 10 million yen.

Table 6.International Taxation of Corporations and Shareholders in Selected Countries, 19731
Method of TaxationUnited StatesNetherlandsFranceUnited KingdomFederal Republic

of Germany
Japan
Basic rules
Jurisdictional principleGlobalMixedTerritorialGlobalMixedGlobal
Taxation of subsidiary abroadDeferral, with exceptional current taxationExemptionExemption2DeferralExemption3Deferral
Double taxation reliefCredit, direct and indirectExemption for business income; credit for investment incomeExemption for business income; credit for investment incomeCredit, direct and indirectExemption for business income; credit for investment incomeCredit, direct and indirect
Taxation of residents
Direct investment
Parent-subsidiary dividendsTaxed, direct and indirect creditExemptedExempted; Précompte levied on redistributions; may be reduced by foreign withholding tax credit under some treatiesTaxed, direct and indirect credit; advance corporation tax levied on redistribution; not reduced by foreign tax creditExempted; lower rate on distribution not appliedTaxed, direct and indirect credit; lower rate on distribution applied; dividend credit available to redistributions
Branch profitsTaxed, direct creditExemptedExempted; Précompte levied on distributionsTaxed, direct credit; advance corporation tax levied on distributions; not reduced by foreign tax creditExempted; lower rate on distribution not appliedTaxed, direct credit; lower rate on distribution applied; dividend credit available to distributions
Portfolio investment
Dividends received by corporationsTaxed, direct creditTaxed, direct creditTaxed, direct credit. Dividend credit available to redistributionsTaxed, direct credit; advance corporation tax levied on redistributions; not reduced by foreign withholding tax creditTaxed, direct credit; lower rate on distribution appliedTaxed, direct credit; lower rate on distribution applied; dividend credit available to redistributions
Dividends received by individualsTaxed, direct creditTaxed, direct creditTaxed, direct credit. No dividend credit appliedTaxed, direct creditTaxed, direct credit; no relief for foreign corporation taxTaxed, direct credit; no dividend credit applied; no relief for foreign corporation tax
Taxation of nonresidents
Direct investment
Parent-subsidiary dividendsCorporation tax plus withholding tax at 5 per cent (treaty)Corporation tax plus withholding tax at 5 per cent generally (treaty)Corporation tax plus withholding tax at 15 per cent or zero (treaty); no dividend credit extendedAdvance corporation tax (no withholding tax); no dividend credit extendedCorporation tax (lower rate on distribution) plus withholding tax at 25 per cent (treaty)Corporation tax (lower rate on distribution) plus withholding tax at 10 per cent (treaty); no dividend credit extended
Branch profitsCorporation tax onlyCorporation tax onlyCorporation tax plus tax on distribution at 25 per cent; no dividend credit extendedCorporation tax only; no dividend credit extendedCorporation tax only, at 49 per centCorporation tax only, at 35 per cent; no dividend credit extended
Portfolio investment
Dividends received by corporationsCorporation tax plus withholding tax at 15 per cent (treaty)Corporation tax plus withholding tax at 15 per cent (treaty)Corporation tax plus withholding tax at 15 per cent (treaty); dividend credit extended to some countries by treatyCorporation tax only (Dividend credit will be extended by treaty arrangement.)Corporation tax (lower rate on distribution) plus withholding tax at 15 per cent (treaty)Corporation tax (lower rate on distribution) plus withholding tax at 15 per cent (treaty). No dividend credit extended
Dividends received by individualsCorporation tax plus withholding tax at 15 per cent (treaty)Corporation tax plus withholding tax at 15 per cent (treaty)Corporation tax plus withholding tax at 15 per cent (treaty); dividend credit extended to some countries by treatyCorporation tax only (Dividend credit will be extended by treaty arrangement.)Corporation tax (lower rate on distribution) plus withholding tax at 15 per cent (treaty)Corporation tax (lower rate on distribution) plus withholding tax at 15 per cent (treaty). No dividend credit extended

In addition to those points where treaties are specifically mentioned, other provisions summarized here may also be altered by treaty arrangements in particular cases.

Whenever optional global taxation is provided for subsidiary income and branch profits, direct and indirect credits are available.

From 1972 on, subsidiary income may be taxed under certain conditions, with an indirect credit being granted. Most exemptions in the Federal Republic of Germany presuppose a treaty.

In addition to those points where treaties are specifically mentioned, other provisions summarized here may also be altered by treaty arrangements in particular cases.

Whenever optional global taxation is provided for subsidiary income and branch profits, direct and indirect credits are available.

From 1972 on, subsidiary income may be taxed under certain conditions, with an indirect credit being granted. Most exemptions in the Federal Republic of Germany presuppose a treaty.

Table 7.Tax Arrangements Needed in Capital-Exporting Country to Achieve Capital-Export Neutrality for Corporate Investment in Branch Form1
System in Capital-

Exporting Country
System in Capital-Importing Country
Separate

entity
Split

rate
Dividend

credit
Full

integration
Separate entityCase 1Case 1Case 1Case 1
Split rateCase 1Case 1Case 1Case 1
Dividend creditCase 2Case 2Case 2Case 2
Full integrationCase 3Case 3Case 3Case 3

Corporate taxes are assumed to be unshifted.

Corporate taxes are assumed to be unshifted.

Explanation of Cases:

Case 1:Current taxation with full credit (including refunds if necessary) for foreign corporation tax.
Case 2:Same as Case 1, with no additional tax imposed at subsequent distribution, and shareholders given full domestic dividend credit.
Case 3:Same as Case 1, with no additional tax imposed at distribution or allocation, and shareholders given full benefit of integration.
Table 8.Tax Arrangements Needed in Capital-Exporting Country to Achievi Capital-Export Neutrality for Corporate Portfolio Investment1
System in Capital-

Exporting Country
System in Capital-Importing Country
Separate

entity
Split

rate
Dividend

credit
Full

integration
Separate entityCase 1Case 2Case 3Case 3
Split rateCase 1Case 2Case 3Case 3
Dividend creditCase 4Case 6Case 8Case 8
Full integrationCase 5Case 7Case 9Case 9

Corporate taxes are assumed to be unshifted.

Corporate taxes are assumed to be unshifted.

Explanation of Cases:

Case 1:Current taxation with full credit (including refunds if necessary) for foreign corporation tax (including foreign withholding tax).
Case 2:Same as Case 1, but with subsequent adjustment in relation to foreign taxes actually paid.
Case 3:Same as Case 1. If a foreign dividend credit is extended, a special tax must be applied to recoup it.
Case 4:Same as Case 1, with no additional tax imposed at subsequent distribution, and shareholders given full domestic dividend credit.
Case 5:Same as Case 1, with no additional tax imposed at distribution or allocation, and shareholders given full benefit of integration.
Case 6:Same as Case 4, but with subsequent adjustment in relation to foreign taxes actually paid.
Case 7:Same as Case 5, but with subsequent adjustment in relation to foreign taxes actually paid.
Case 8:Same as Case 4. If a foreign dividend credit is extended, a special tax must be applied to recoup it.
Case 9:Same as Case 5. If a foreign dividend credit is extended, a special tax must be applied to recoup it.
Table 9.Tax Arrangements Needed in Capital-Exporting Country to Achieve Capital-Export Neutrality for Individual Portfolio Investments1
System in Capital-

Exporting Country
System in Capital-Importing Country
Separate

entity
Split

rate
Dividend

credit
Full

integration
Separate entityCase 1Case 2Case 3Case 3
Split rateCase 4Case 5Case 6Case 6
Dividend creditCase 7Case 8Case 9Case 9
Full integrationCase 10Case 11Case 12Case 12

Corporate taxes are assumed to be unshifted.

Corporate taxes are assumed to be unshifted.

Explanation of Cases:

Case 1:Current corporation tax applied to pro rata profits with full credit for foreign corporation tax; personal income tax applied to dividends with full gross-up and credit for foreign withholding tax.
Case 2:Same as Case 1, but with subsequent adjustment in relation to foreign corporation tax actually paid.
Case 3:Same as Case 1. If a foreign dividend credit is extended, the personal income tax must absorb it. (No special tax is needed because the actual amount of the credit is known at the time the personal income tax is levied.)
Case 4:Same as Case 1, but with the current corporation tax imposed at a proxy (average) domestic corporation tax rate.
Case 5:Same as Case 4, but with subsequent adjustment in relation to foreign corporation tax actually paid.
Case 6:Same as Case 4. If a foreign dividend credit is extended, the personal income tax must absorb it.
Case 7:Same as Case 1, with full domestic dividend credit.
Case 8:Same as Case 7, but with subsequent adjustment in relation to foreign corporation tax actually paid.
Case 9:Same as Case 7. If a foreign dividend credit is extended, the personal income tax must absorb it.
Case 10:Current personal tax applied to pro rata profits with full credit for foreign corporation tax and withholding tax.
Case 11:Same as Case 10, but with subsequent adjustment in relation to foreign taxes actually paid.
Case 12:Same as Case 10. If a foreign dividend credit is extended, a special tax must be applied to absorb it.

Mr. Sato was a senior economist in the Tax Policy Division of the Fiscal Affairs Department at the time this paper was written. A graduate of Tokyo University, he was formerly on the staff of the Tax Bureau, Ministry of Finance, Japan, and was in charge of tax treaty negotiation and planning of international taxation policies. He is now Director, Direct Tax Department, Regional Tax Office, Osaka, Japan.

Mr. Bird was Chief of the Tax Policy Division of the Fiscal Affairs Department at the time this paper was written. He is now Professor of Economics at the Institute for the Quantitative Analysis of Social and Economic Policy, University of Toronto, Ontario, Canada. A graduate of Dalhousie University (Halifax, Canada) and Columbia University, he has taught at Harvard University and the University of Toronto and has written several books and numerous articles.

In addition to colleagues in the Fund, the authors are grateful for helpful comments and assistance from Daryl Dixon, Charles E. McLure, Peggy B. Musgrave, Carl S. Shoup, and A. J. van den Tempel.

Other differences include the virtual absence of foreign individual investment, the greater importance of intermediate subsidiaries, and especially the clear violation in many cases of the assumption of basic market rationality underlying most of the analysis in this paper.

While every effort has been made to make these summaries as current and as accurate as possible, it is not possible to depict all relevant characteristics nor to allow for all possible situations in such a brief presentation. The material in the Appendix, Tables 56, like all references to specific country situations in this paper, should therefore be regarded as primarily illustrative and not as a definitive treatment.

For a similar classification of taxation methods in the member countries of the Organization for Economic Cooperation and Development (OECD), see Company Tax Systems in OECD Member Countries (Paris, 1973).

In a recent study for the European Economic Community, this approach is called the “classic system”; see A. J. van den Tempel, Corporation Tax and Individual Income Tax in the European Communities (Commission of the European Communities, Brussels, 1970), p. 7. The use of the term “separate entity” to describe this system should not be confused with the separate tax treatment of a foreign affiliate with a separate accounting system, a practice sometimes referred to by the same phrase. Much discussion in this field is unnecessarily confused by terminological ambiguity. Throughout the present paper, the authors have tried to define all terms used and to adhere to the definitions.

This approach is sometimes called the “partnership method,” although partnerships are not always taxed in this manner. See Mitsuo Sato, “The Tax Treatment of Partnerships” (unpublished, International Monetary Fund, May 1, 1973). Van den Tempel, ibid., pp. 33–34, calls this approach “fiscal transparency.”

Van den Tempel, ibid., p. 7, calls this approach the “system of the double rate.”

Musgrave, however, considers this approach (sometimes called the “dividend-paid credit”) to be a method of discriminating against corporate retentions. See Richard A. Musgrave, “Taxation of Corporations,” in Conference Report of the Canadian Tax Foundation, 1970 (Toronto, 1970), pp. 124–26. Alternatively, it may be considered a method of removing the present bias in favor of debt financing by allowing dividends to be treated like interest (that is, deducted).

Van den Tempel, op. cit., p. 7, calls this the “credit system.”

For example, the system is adopted in its pure form in Luxembourg and for the federal corporate tax in Switzerland, and in a slightly modified form in Denmark, Iceland, and Sweden.

There are a few exceptions to this basic rule, however. For example, an individual shareholder is permitted to exclude from taxable income $100 of dividends received from domestic corporations, and certain corporations may opt to be taxed like partnerships, with their profits being imputed and taxed directly to their shareholders. This exclusion was introduced in 1964 to replace a previous exclusion of $50 and a 4 per cent dividend credit (without gross-up) which had been introduced in 1959. In 1936 and 1937, on the other hand, the United States imposed an additional penalty on retained profits to encourage payout of dividends.

This rate applies to taxable income exceeding 50,000 guilders. The rate is 43 per cent for taxable income not exceeding 40,000 guilders and 43 per cent plus 15 per cent of the excess of taxable income over 40,000 guilders for taxable income between 40,000 and 50,000 guilders.

The Netherlands Government proposed in 1960 that this system be changed to a split rate system similar to that now used in Germany and proposed in 1965 that it be changed to a dividend credit system. Since 1968, however, there have been no official proposals to change the present system.

This split rate system also exists in such countries as Austria, Finland, and (in a slightly modified form) Norway. A number of developing countries use the extreme form of this system, with no tax at all being levied on dividends at the corporate level.

Because of a temporary surcharge of 3 per cent, the rates in 1974 were 52.53 per cent and 15.45 per cent respectively, the rate differential being 37.08 per cent.

Let t be the effective rate on distributions, td the tax rate on distributed profit, and fd the tax rate on retained earnings. Then

t = td/(1 – (trtd)).

This exemption requires 25 per cent ownership in the subsidiary. To determine whether and how dividends are redistributed, a tracing rule is necessary. The rule followed is that the receiving corporation is deemed to have paid dividends first from its own earnings and then from dividends received from other corporations (subsidiary companies).

For expositional simplicity, the complications for integration arising from tax-exempt organizations are not considered in this paper. This question does, however, raise serious problems in practice in all integration systems.

Recently, the Government agreed in principle to reform the present system in 1976, basically by allowing shareholders to credit the tax on distributed profits (to be raised to 36 per cent) against their personal tax liabilities. Since a higher rate (56 per cent) would still be maintained on undistributed profits, the country would have a mixed partial integration system, in contrast to the full imputation system proposed in 1971.

Alternatively, as in the Canadian system discussed below or the system used before 1965 in the United Kingdom,*the credit may be intended, in whole or in part, as an encouragement to investment by individuals in corporate shares. In this case it should not be relevant whether corporate taxes have been paid or not.

Thus, the dividend credit in France is equal to 33⅓ per cent of grossed-up dividends and that in the United Kingdom to 30 per cent. As the basic personal income tax rate in the United Kingdom is 30 per cent, a shareholder taxed at the basic rate pays no personal income tax on dividends received; if the personal tax rate is higher than 30 per cent, he pays the balance, and if it is lower, he gets a refund of the excess of credit over the tax. Excess credits are also refundable in the French system. (In April 1974 the U. K. corporate tax rate was increased to 52 per cent; personal tax rates were also increased slightly.)

In France, only “participation dividends” (normally, those received by a parent company having 10 per cent or more ownership in a paying company) are exempt from corporation tax, and the avoir fiscal (credit) attaching to those dividends is passed through to the shareholder of the parent company. More precisely, 95 per cent of the grossed-up dividends are exempt in the hands of the receiving corporation, and the précompte (advance tax) which becomes due on redistributions is discharged by using the avoir fiscal attaching to the original dividends. By virtue of the précompte, the ultimate shareholder is in turn entitled to the dividend credit. Dividends other than participation dividends are taxed in the hands of receiving corporations, with the avoir fiscal being set against the corporation tax. Redistributions are treated as ordinary dividends in the hands of individual shareholders. See also the Appendix, Tables 56, on the complex system in France (and the United Kingdom).

France limits the avoir fiscal to dividends paid out of corporate profits earned for the last five years. The tracing rule is that dividends are deemed to be paid from the profits most recently earned. The United Kingdom does not impose a time limitation, but instead limits the deduction of advance corporation tax (ACT) from “mainstream” corporation tax to an amount equal to 30 per cent of the current year’s taxable profits, that is, the amount of ACT which, with the distribution to which it relates, absorbs the whole of the current year’s taxable profits. The reason for this restriction is to keep the relief from going “beyond the Government’s aim of neutrality between distributed and undistributed profits.” (United Kingdom, Reform of Corporation Tax, Commandment Paper 4955, presented to Parliament by the Chancellor of the Exchequer (Her Majesty’s Stationery Office, London, April 1972), p. 6.) That part of the ACT not deducted from the corporation tax may be carried back or forward for two years.

For an algebraic demonstration of this identity, see Mitsuo Sato and Richard M. Bird, “International Aspects of the Taxation of Corporations and Shareholders” (unpublished, International Monetary Fund, May 29, 1974), Appendix II.

See Canada, Report of the Royal Commission on Taxation, Vol. 4: Taxation of Income (Queen’s Printer, Ottawa, 1966), pp. 3–98. For the fate of the Commission’s recommendations in the subsequent legislative process in Canada, see later discussion; also Meyer Bucovetsky and Richard M. Bird, “Tax Reform in Canada: A Progress Report,” National Tax Journal, Vol. 25 (March 1972), pp. 15–41. The 1971 proposal of the Federal Republic of Germany noted above amounted to full imputation, not full integration, since no attempt was made to integrate the taxation of undistributed profits.

Tax-exempt organizations, such as pension funds, were to be granted the same credit, with the result that they would be entitled to the full refund of corporation tax.

In Canada, for example, corporate profit not fully taxed at the corporate level because of the exemption of foreign-source income or some incentive legislation was, in principle, to be subject to an additional tax at the time of distribution so as to permit a uniform credit at the shareholder level. On policy grounds, however, the pass-through to shareholders of part of the tax benefits due to such incentive measures as an investment credit was to be permitted.

Unlike the tracing rule in the Federal Republic of Germany, corporate distributions are deemed to be made first from dividends received from other corporations and then from a paying corporation’s own profits for the purpose of levying the additional tax.

The rate is 5 per cent for a shareholder whose total taxable income exceeds 10 million yen. In recent years these credit rates have been lowered several times. Shareholders may also opt for separate taxation of dividends, in which case dividends are subject to a flat tax, currently 25 per cent, and are not subject to personal income tax.

A simple example may suffice to illustrate the point. A manufacturer in country A produces goods and exports them to a firm in country B which sells them there. What is the country of source of income arising from this activity? Is it country A because the manufacturing was done there, or is it country B because the sale was made there? Or should the source be apportioned between countries A and B by some formula? Are other factors (such as the place of sales contract, the place in which title passes, and the place of payment) relevant or not? While many rules can be devised, no single rule can be said to be definitely superior to the others. (These issues have long been discussed in some federal states also; for a recent discussion, see Charles E. McLure, Jr., State Income Taxation of Multi-State Corporations, a report prepared for the United Nations Conference on Multinational Corporations, February 1974.)

Using the same example as in the previous note, if both countries A and B assert the source principle but A deems the source to be the country of manufacture while B deems it to be the country of sale, complete double taxation may ensue. On the other hand, if both countries regard the source as being outside the country, international nontaxation will arise. It should be noted that there is no presumption in this discussion that either of these extremes is necessarily good or bad.

This is true even for developing countries. See Oliver Oldman, ‘Tax Policies of Less Developed Countries with Respect to Foreign Income and Income of Foreigners,” in Readings on Taxation in Developing Countries, edited by Richard M. Bird and Oliver Oldman, revised edition (the Johns Hopkins Press, 1967), pp. 200–207.

The place of incorporation test is utilized, for example, by the United States and Sweden. Japan uses virtually the same rule (the place of head office test). The United Kingdom and some other European countries employ the seat of management test.

Rules other than those for tax purposes may also be important. For example, countries may simply prohibit foreign management of companies operating locally.

Examples of such an arrangement are the provisions in the United States for current taxation of U. S. shareholders on their pro rata share of the undistributed profits of “controlled foreign corporations.” For an outline of the complex relevant rules, see Harvard Law School, International Program in Taxation, Taxation in the United States (Commerce Clearing House, Chicago, 1963), pp. 1042–80. Similar rules have been proposed for adoption in Canada.

In a country adopting the place of incorporation test, such a subsidiary is presumably a resident corporation and is therefore subject to the same treatment as domestic corporations.

Dividends paid to foreign portfolio investors are also usually subjected to a withholding tax, with the rate often reduced by tax treaty to 15 per cent.

For example, the Federal Republic of Germany applies a 49 per cent rate to all branch profits despite the ordinary rate differential of 51 and 15 per cent.

France, for example, imposes a “tax on distribution” on branch profits (after corporation tax) at 25 per cent. Canada levies a similar tax of 15 per cent.

Although commonly used in the literature, this term has unfortunate emotive connotations which are not necessarily valid since in fact the major economic concern is with the level of total taxation on profits and not with its distribution between taxing governments. In principle, there is no more problem in the fact that both country A and country B tax the same profits than there is in the fact that both tax the same product. Problems arise in both cases only when the total tax levied on a particular base by A plus B exceeds that levied on competing firms taxed only by A or B.

If one wished to restrict investment abroad substantially, one could, as some countries in fact do, go further and disallow even the deduction of foreign taxes.

There are other measures to alleviate international double taxation, such as preferential rates for foreign-source income and exemption with progression (which means that foreign-source income is exempt from domestic tax but is included in calculating the rate applicable to domestic-source incomes).

In the Netherlands, the exemption technically takes the form of a credit against tax on global income, but the creditable tax is computed in proportion to the ratio of foreign income to global income at the Netherlands tax rate regardless of whether the foreign tax rate is higher or lower. Owing to this and other rules, virtually no Netherlands corporation tax is imposed on business income derived from abroad. France, too, has a credit mechanism to cover cases in which international double taxation might otherwise arise.

If tax rates in the source country are higher than those in the country of residence, a limitation on the size of the available credit to the domestic tax rate may result in some double taxation of income from sources in such countries. This possibility will be less relevant if there is an overall and not a per-country limitation on the amount of the credit.

There is usually some minimum ownership requirement for a parent to be able to claim indirect credit (for example, 10 per cent in the United States). No country provides an indirect credit for portfolio investors. It has been argued that the indirect credit is not very consistent with the concept of separate identity presumably underlying the deferral of tax on foreign subsidiary income. See Peggy B. Musgrave, “Tax Preferences to Foreign Investment,” in The Economics of Federal Subsidy Programs, a compendium of papers submitted to the Joint Economic Committee, Congress of the United States (U.S. Government Printing Office, Washington, 1972), p. 184.

The overall limitation is not always favorable to taxpayers, however. If some foreign operations result in losses, the credit ceiling is reduced because the losses are offset against income from other foreign countries, a result which does not occur under the per-country limitation. (Taxpayers are generally not allowed to switch from one to the other at will.)

The former concept of equity is called “international equity” and the latter “national equity” by the Musgraves. See Peggy B. Musgrave, United States Taxation of Foreign Investment Income: Issues and Arguments (Harvard Law School, 1969), p. 122; and Richard A. Musgrave, Fiscal Systems (Yale University Press, 1969), p. 245.

The factors which influence tax treaties between developed and developing countries are essentially different from those considered here, both because the flow of investment is predominantly in one direction from creditor to debtor countries, and because there are significant differences in the wealth and capacity to raise revenue of the countries concerned. For extensive discussions of such treaties, see United Nations, Department of Economic and Social Affairs, Tax Treaties Between Developed and Developing Countries (New York, 1969), Second Report (New York, 1970), Third Report (New York, 1972), Fourth Report (New York, 1973), and Fifth Report (New York, 1975).

OECD, Fiscal Committee, Draft Double Taxation Convention on Income and Capital (Paris, 1963).

Almost all crediting countries unilaterally give a foreign tax credit, using their own source rules, to income which is deemed to have come from foreign sources. On the other hand, the foreign tax credit is denied to income that is deemed by unilateral source rules to have come from domestic sources, even if it is taxed abroad.

All references in this section to articles are to those in the model OECD treaty.

Shareholders who are deemed by the source country to be resident in that country may, however, be subjected to additional taxes.

All income tax systems in fact apply different treatments to residents and nonresidents, generally because it is not possible to determine the total income of the latter (or, in the case of individuals, their personal circumstances and ability to pay). Differences in the taxation of these two groups are thus not considered discriminatory unless they are motivated by considerations unrelated to the relevant characteristics of the groups. It is obviously very hard to draw this line. For example, does a flat corporation tax on the branch profit of foreign corporations by a country adopting a split rate system constitute “discrimination” or not? As noted earlier, the Federal Republic of Germany imposes a flat 49 per cent tax on such branch profits, although it has a split rate system for other corporate profits.

The traditional tax criterion of equitable treatment among individual taxpayers is not treated separately here in order to avoid substantial duplication of the discussion on efficiency. Basically “international equity” among individuals, which requires that taxpayers who are resident in the same country and who have equal global incomes pay the same total taxes (domestic and foreign), will be achieved when capital-export neutrality is achieved. “National equity,” on the other hand, which is concerned only with the domestic taxes paid by equally situated taxpayers, would presumably treat foreign taxes as costs deductible in arriving at net income and thus be in accord with the national efficiency criterion. See P. Mus-grave, United States Taxation of Foreign Investment Income (cited in footnote 46), p. 122.

For an elaboration of the requirements for neutrality, see ibid., pp. 109–13.

For discussions of some of the theoretical issues relevant to the pursuit of nonneutral policies, see, for example, Koichi Hamada, “Strategic Aspects of Taxation on Foreign Investment Income,” Quarterly Journal of Economics, Vol. 80 (August 1966), pp. 361–75; Robin Bade, “Optimal Foreign Investment and International Trade,” Economic Record, Vol. 49 (March 1973), pp. 62–75; and Murray C. Kemp, The Pure Theory of International Trade (Englewood Cliffs, New Jersey, 1964), Chapters 13 and 14, pp. 192–207.

If the systems of taxation in all capital-importing and capital-exporting countries are perfectly identical, the results of capital-export and capital-import neutrality become identical. Strictly speaking, as shown below, capital-import neutrality is not consistent with world efficiency; it is discussed at this point, however, because it is generally considered as an alternative to capital-export neutrality.

This argument assumes that there is no short-run shifting of corporate taxes, an assumption which is relaxed in Sato and Bird, “International Aspects of the Taxation of Corporations and Shareholders” (cited in footnote 23), Appendix V. The term “full crediting” or “full credit” is used to mean a foreign tax credit without limitation, that is, full refund (or credit against tax on domestic income) of any foreign tax which exceeds the credit ceiling.

It should be remembered, however, that the deduction method is compatible with the concept of individual taxpayer equity (“national equity”), which aims at equalizing the domestic taxes borne by taxpayers with the same net income (as defined here).

For example, if the cost-reducing expenditures are at the same level of 20 per cent of gross profits in both Countries A and B and the tax rates are 50 per cent in Country A and 40 per cent in Country B, the difference in net fiscal burden of 10 percentage points (30 – 20) is the same as the tax rate differential (50 – 40).

See P. Musgrave, United States Taxation of Foreign Investment Income (cited in footnote 46), p. 117.

See Dan Throop Smith, “Taxation of Foreign Business Income—The Changing Objectives,” Taxation of Foreign Income by United ‘States and Other Countries (Tax Institute of America, Princeton, 1966), pp. 241–55. This argument assumes that the tax rate in the capital-exporting country (for example, the United States) is higher than that in the capital-importing country (for example, developing countries) or in other capital-exporting countries.

It is assumed throughout that capital is mobile but capitalists are not. See the arguments presented in R. Musgrave, Fiscal Systems (cited in footnote 46) pp. 254–55; P. Musgrave, United States Taxation of Foreign Investment Income (cited in footnote 46), pp. 119–20; and Peggy Brewer Richman, Taxation of Foreign Investment Income: An Economic Analysis (the Johns Hopkins Press, 1963), p. 8.

While the present paper does not explore the tortuous issues involved in border tax adjustments, it should be noted that the case for such adjustments is invalid when exchange rates are free to vary, at least for taxes which cover a significant sector of the economy (as the corporate tax does in most industrial economies).

The shifting case is discussed further in Sato and Bird, “International Aspects of the Taxation of Corporations and Shareholders” (cited in footnote 23), Appendix V.

On the shifting case, see Sato and Bird, ibid.

One argument against the elimination of deferral is that it would involve liquidity problems, since taxpayers would, in effect, have to pay taxes on some income not yet received. This problem could be particularly serious for portfolio investors who may have no influence over the dividend policy of the foreign firm. In fact, however, there would appear to be no real liquidity problem as to direct corporate investment in subsidiaries in the adoption of current taxation and full crediting, unless the foreign tax rate was very much lower than the domestic rate, a situation which seems unlikely for industrial countries. More important difficulties would be likely to arise from such technical problems as imputing foreign corporate profits to investors.

This problem is not too difficult if the benefit of the lower rate on distributed profits is limited to distributions out of current profits, but it can become quite involved if distributions out of some past profits are also subject to the lower rate.

This assumes that the amount of dividend credit, which depends on the actual distribution, is unknown at the time the foreign tax credit is granted. This problem would presumably not arise in the case of a full integration system.

The difficulty arises because in practice relief is given only to distributions out of current profits and those within a limited past period. If it were not for this limitation, there would be no reason, in principle, why full relief could not be given to foreign-source as well as domestic-source profits when they are distributed; but if there were no such limitation, the effective corporate tax rate would eventually be equivalent to the rate on distributions (apart from the interest factor, which means that the effective tax burden will in any case vary with the time distribution of dividends).

If corporate investment decisions are assumed to be affected only by taxes at the corporation level, it might be argued that there is no need to grant such a credit to shareholders in corporations investing abroad. But if this policy is followed and the result is that the payout ratio of such corporations has to be increased to compensate for the failure to grant the dividend credit to their shareholders, the result is nonneutral treatment of investment at home and abroad.

Theoretically, this could be done—or all foreign-source profits could be imputed to individual shareholders—but the practical difficulties are obviously much greater than simply equating corporate tax burdens on foreign and domestic investment.

On the basic assumption that the Federal Republic of Germany’s rate differential is 50 and 16⅔ per cent instead of the actual 51 and 15 split, and that the effective dividend payout ratio is the same as for French corporations, the tax treaty between France and the Federal Republic of Germany achieves tax neutrality in this respect, as is shown in Sato and Bird, “International Aspects of the Taxation of Corporations and Shareholders” (cited in footnote 23), Appendix IV.

This conclusion is essentially similar to that in the van den Tempel report, although it has been derived using a different neutrality concept. See the discussion below. This conclusion is not altered if the corporation tax is assumed to be shifted forward in prices. (See Sato and Bird, ibid., Appendix V.)

See G. D. A. MacDougall, “The Benefits and Costs of Private Investment from Abroad: A Theoretical Approach,” Economic Record, Vol. 36 (March 1960), pp. 13–35.

See R. Musgrave, Fiscal Systems (cited in footnote 46), pp. 249–50. Note that this procedure would also achieve “national equity” as among individual taxpayers. As before, it is assumed the corporation tax is unshifted. If universal shifting of corporation tax is assumed, the exemption of foreign income may be justified on national efficiency grounds, as in the world efficiency case (see Sato and Bird, op. cit., Appendix V). To the extent that foreign investment is a complement to domestic investment, rather than a substitute for it, these results would have to be modified.

From the investor’s viewpoint, net foreign profit of Yf (1 – tf) (1 – td), where td is the domestic tax rate, should be equated with net domestic profits of Yd (1 – td). Therefore,

Yf (1 – tf) = Yd and Yf/Yd = 1/(1 – tf).

The general equation is derived as follows:

Since Yf (1 - tf) = Yd, 1tf=YdYf and tf=1YdYf=11/YfYd. If YfYd=1.5, tf = 0.333.

Assuming, for example, the same gross profits and tax rate on both foreign and domestic investments, the national efficiency criterion clearly does not justify any investment abroad. Under the deferral approach, however, taxation can be postponed until the time of profit repatriation so investors might still find it profitable to invest abroad.

Individual portfolio investment abroad would cause particular difficulties. National efficiency requires that net dividends be subjected to domestic corporation tax and the balance to personal income tax, because without such a corporation tax investment abroad would be encouraged beyond the optimal point. To put it another way, in order to achieve national efficiency, foreign portfolio investment has to be limited to the point where the net (after domestic corporation tax) dividends equal the domestic dividends. Under a dividend credit system, this will require the granting of dividend credit to foreign portfolio dividends. If, on the other hand, the capital-importing country provides a dividend credit, net cash receipts (original dividends plus dividend credit minus withholding tax) have to be subject to domestic corporation tax and the balance to personal income tax.

In the world efficiency case, the benefit of low foreign tax rates is absorbed by the full crediting mechanism, and investors do not gain from such transactions.

Considerations of individual tax equity are not separately considered here, although such concepts can and do influence attitudes toward international tax relations. As noted earlier, the two basic concepts of equity among individuals with regard to domestic taxpayers are neatly matched by the concepts of world and national efficiency, so that a separate discussion would result in substantial duplication.

For a fuller discussion of this matter, see Richard A. Musgrave and Peggy B. Musgrave. “Inter-Nation Equity,” in Modern Fiscal Issues: Essays in Honor of Carl S. Shoup, edited by Richard M. Bird and John G. Head (University of Toronto Press, 1972), pp. 63–85. This concept has been called “inter-country equity” here to avoid confusion with the concept of “international equity” (see footnote 53), which pertains to individuals rather than to countries.

Some capital-importing countries, especially developing countries, may, however, in effect remove all domestic taxes from foreign investors through tax holidays and similar measures.

Musgrave and Musgrave, “Inter-Nation Equity,” op. cit., pp. 72–75.

Ibid., p. 74.

Van den Tempers concept of “equal fiscal treatment” is rather broader than the treaty rule of nondiscrimination in that it covers equal treatment for portfolio investments and other such “privileged treatment of non-residents.” See van den Tempel, Corporation Tax and Individual Income Tax (cited in footnote 4), p. 37.

While this point is not explicitly mentioned in the model treaty, it may perhaps be inferred from the remark that a reciprocal withholding tax on dividends “would cause difficulties for Germany … owing to the peculiarities of their national tax laws.” See OECD, Draft Double Taxation Convention on Income and Capital (cited in footnote 48), pp. 104–106.

The important domestic arguments sometimes made for some form of integration are not discussed in this paper. See Canada, Report of the Royal Commission on Taxation, Vol. 4 (cited in footnote 24) for a full statement of the domestic case for full integration. The point here is that there is no case for concluding that the international tail (nondiscrimination) should wag the domestic dog (integration), although the distinction between the two is no doubt fuzzier within a common market like the EEC than among independent countries.

Of course, one motivation for integration may be precisely to encourage investment in the corporate sector by both residents and foreigners, in which case the credit should presumably be extended to nonresidents, not for reasons of equity or efficiency, but on incentive grounds.

For a similar brief suggestion, see P. Musgrave, “Harmonization of Direct Business Taxes: A Case Study,” in Fiscal Harmonization in Common Markets, Vol. 2, edited by Carl S. Shoup (Columbia University Press, 1967), p. 313.

If the lower rate is applied only to distributions from current year’s profits, no compensating withholding tax on distributions from profits earned in previous years would be justified.

It should perhaps be noted that the exemption of intercorporate dividends from tax is a privilege not normally extended to dividends received from abroad by a domestic company, but it should also be remembered that the present suggestion for a compensating tax is made in the context of full crediting for foreign taxes levied on corporate profits and dividends.

It should be remembered that any specific benefit tax element in corporate taxation has been ignored in this discussion. If corporations receive benefits from government expenditures, the tax differentials with which the world efficiency criterion is concerned are net of that portion of taxes which pays for these benefits.

For a brief discussion of the relevant domestic considerations, see OECD, Company Tax Systems (cited in footnote 3), pp. 13–22.

Commission of the European Communities, Report of the Fiscal and Financial Committee (Brussels, 1962).

Van den Tempel, Corporation Tax and Individual Income Tax (cited in footnote 4).

Charles Cardyn, “General Report—The Multiple Burden on Dividends and Shares by Taxation on Income and Capital of Both Corporations and Shareholders: Possibilities of Modification,” Cahiers de Droit Fiscal International/Studies on International Fiscal Law (International Fiscal Association, Rotterdam, 1970), p. 1/66 (also published in German and Italian).

Article 67 (1) of the Treaty of Rome provides: “Member States shall, in the course of the transitional period and to the extent necessary for the proper functioning of the Common Market, progressively abolish as between themselves restrictions on the movement of capital belonging to persons resident in Member States and also any discriminatory treatment based on the nationality or place of residence of the parties or on the place in which such capital is invested.”

Note that avoidance of international double taxation in accordance with the OECD convention is not necessarily sufficient to secure capital-export neutrality, because the OECD model treaty provides for both exemption and credit methods as alternative systems for double taxation relief. See OECD, Draft Double Taxation Convention on Income and Capital (cited in footnote 48), p. 54. The exemption method is, as noted earlier, much less likely to achieve capital-export neutrality than the credit method, even given the limitations of the latter in achieving neutrality. Finally, as always, it is well to remember that achieving capital-export neutrality may not necessarily result in the maximization of world efficiency in an imperfect world. (None of this discussion means much in practice unless effective tax rates on corporate-source income differ significantly among countries; in this connection, tax incentives limited to investment within national borders also need to be taken into account.)

Under the actual pre-1965 system, there was a “net U.K. rate restriction” which limited the refund of corporation tax to shareholders (subject to personal tax rates lower than the standard rate) by reference to the ratio of U. K. corporation tax actually paid to the corporation tax before foreign tax credit.

A corporation with foreign source profits, it was argued, may seek to acquire corporations with substantial domestic profits in order to preserve the U. K. corporation tax for the crediting of foreign tax, while satisfying the shareholders by making distributions from domestic profits. See U.K. Government, Report from the Select Committee on Corporation Tax, Session 1970–1971 (Her Majesty’s Stationery Office, London), pp. 75, 86, 146, and 183.

Full crediting of foreign taxes in the United Kingdom, it was argued, would give foreign countries a degree of freedom to raise tax rates without fear of discouraging capital inflow. Tax gains in foreign countries are losses of national income in the United Kingdom.

U. K. Government, Report from the Select Committee on Corporation Tax, pp. 4 and 20. Note that this last point is concerned with treasury rather than national gains.

Ibid., p. 171.

Ibid., pp. 28, 48,81.

The compensating withholding tax has been utilized by the Federal Republic of Germany in some tax treaties in the form of a 25 per cent withholding tax on subsidiary-parent dividends, which is much higher than the 5 per cent tax provided in the OECD model treaty (Article 10). The Federal Republic of Germany was not able, however, to negotiate a compensating withholding tax with the United States, which held firmly to the reciprocity of withholding rates. As a compromise, the two countries agreed in 1965 on a protocol under which an additional 10 per cent tax (over and above the treaty withholding rate of 15 per cent) may be imposed by the Federal Republic of Germany on dividends reinvested by U. S. parent companies in a German subsidiary, where “reinvestment” is defined as transfers in a calendar year by parent companies to a subsidiary which exceed 7.5 per cent of dividends received in that year (Germany-United States Treaty, Article VI). In the United Kingdom, investment from the United States accounts for nearly 80 per cent of all profits earned by foreign direct investors.

OECD, Company Tax Systems (cited in footnote 3), pp. 52–54.

See Robert W. Gillespie, “The Policies of England, France, and Germany as Recipients of Foreign Direct Investment,” in International Mobility and Movement of Capital, edited by Fritz Machlup, Walter S. Salant, and Lorie Tarshis (Columbia University Press, 1972), pp. 403–14.

National gains consist of an increase in net receipts from France (127.5 – 85 = 42.5, 85 being net receipts before the extension of the credit), which is equivalent to French national loss (27.5 + 15 = 42.5). The gains accrue to foreign governments by 7.5 (22.5 – 15) and to foreign shareholders by 35 (105 – 70), assuming of course a 30 per cent personal tax, as illustrated in the text.

The conventional territorial principle has, however, been somewhat modified by the provision since 1965 of optional global taxation to certain corporations deriving income from abroad, under which foreign taxes are credited against French corporation tax and the distributions are granted the avoir fiscal without the précompte. In practice, the application of this method appears to be limited, probably because of the stringent conditions which must be met for its application. For an outline of the system, see United Nations, Department of Economic and Social Affairs, Interaction Between the French Tax System and Those of Developing Countries (New York, 1971), pp. 12–18.

What is relevant instead is the rather technical problem of whether to give the avoir fiscal to distributions made out of profits derived from foreign sources which have not been subject to French taxation. In practice, relief was denied to such distributions, although they are granted the same credit at the shareholder level through the device of the précompte.

Canada, Report of the Royal Commission on Taxation, Vol. 4 (cited in footnote 24), pp. 4–5.

Ibid., p. 44.

Ibid.

Ibid., p. 483.

Ibid., pp. 539–40 and 546–47.

Ibid., p. 495.

Ibid., p. 506.

Ibid.

The Canadian tax yields are calculated as

where tf is the foreign tax rate including withholding tax, tc is the Canadian tax rate and m is the marginal tax rate of shareholders. If m is less than 30 per cent, there is a net refund; if it is equal to 30 per cent Canadian tax yields are zero; and if it is greater than 30 per cent, there is net Canadian tax. The Commissions appears to have considered that m would on average be higher than 30 per cent.

This must be the logical conclusion of Musgrave’s arguments, although he emphasized instead the possible discouragement of branch operations in high-tax countries because of the 30 per cent restriction of foreign tax credit. Under the Carter proposal, however, branch profits were to be exempt from Canadian corporation tax so that tax burden at the corporation level would be determined by foreign tax rates, disregarding the proposed 20 per cent withholding tax on distributions. The 30 per cent restriction would operate at the shareholder level but not at the corporation level. See Richard A. Musgrave, ‘The Carter Commission Report,” Canadian Journal of Economics. Vol. 1, Supplement No. 1 (February 1968), pp. 159–82.

Peter Mieszkowski, “Carter on the Taxation of International Income Flows,” National Tax Journal, Vol. 22 (March 1969), pp. 97–108.

The credit is not precisely one third, owing to different provincial income tax systems. See Bucovetsky and Bird, “Tax Reform in Canada” (cited in footnote 24), p. 31.

Similar systems exist in Belgium and Ireland. The latter is also one of the few countries to provide a credit to residents for foreign dividend income. See OECD, Company Tax Systems(cited in footnote 3), p. 27.

This means that as long as total foreign tax (including withholding tax) is equal to or higher than 50 per cent, no Canadian corporation tax is payable. Canadian tax is expressed as tc = 0.5 [(1 – tfc) – (tfc + 2tfw (1 – tfc))] = 0.5 [1 – 2(tfc + tfw(1 – tfc))], where tfc is foreign corporation tax and tfw foreign withholding tax. If total foreign tax—that is, tfc + tfw(1 – tfc)—is 0.5, tc is zero; if lower than 0.5, tc is positive. The total tax on corporations, foreign and Canadian, will always be 0.5, so long as the total foreign tax is equal to or less than 50 per cent. (The Canadian parent corporation may postpone tax payments by treating the taxable amount as a return of capital.)

See E. J. Benson, Proposals for Tax Reform (Queen’s Printer, Ottawa, 1969).

This conclusion is in interesting contrast to the strong arguments which have been put forward, notably by the Canadian Royal Commission, in the domestic context to the effect that full integration is the most efficient (or neutral) tax system. Although as noted in Section IV, the Commission does not appear to have thought through the full implications of its recommendations for international taxation, this does not mean that its conclusion on domestic policy was wrong; indeed, a principal purpose of the present paper is to suggest ways of altering present international tax rules to accommodate such innovative national tax policies more readily.

Financial Times Tax Newsletter, December 1973, pp. 1–3.

Let countries A and B be the members of an economic community requiring such standards and country C represent the rest of the world. Countries A, B, and C have unequal tax rates (tA > tB > tC), and A and B previously exempted income from foreign direct investment. Before such standards are set, international capital flows have adjusted to the tax differentials, and in equilibrium the net (after-tax) rates of return to investors in countries A and B are equal in all three countries:

rA (1 – tA) = rB (1 – tB) = rC (1 – tC)

where r is gross return to capital. Thus rA > rB > rC. After such standards are imposed, the net rate of return to an investor in country A will be: rA (1 – tA) = rC (1 – tC) > rB (1 – tA), and that to an investor in country B will be: rB (1 – tB) = rC (1 – tC) < rA (1 – tB). The investor in country B will thus redirect investment from countries B and C to country A, while the investor in country A will redirect investment from B to A and C. The resulting reallocation of capital from B and C to A is efficiency increasing, but that from B to C is efficiency decreasing.

If the standards are applied also to investment in C, the net rate of return to an investor in country A will be:

rA (1 – tA) > rB (1 – tA) > rC (1 – tA),

and that to an investor in country B will be:

rA (1 – tB) > rB (1 – tB) > rC (1 – tB).

Capital will then be reallocated from B and C to A, which are all efficiency increasing. For similar arguments, see P. Musgrave, “Harmonization of Direct Business Taxes” (cited in footnote 90), pp. 227–28; and R. Musgrave, Fiscal Systems (cited in footnote 46), pp. 250–51. This analysis is obviously analogous to the “trade-creating” and “trade-diverting” effects long associated with customs unions.

OECD, Draft Double Taxation Convention on Income and Capital, Articles 23A and 23B (cited in footnote 48), pp. 54 and 140–50.

For such a study of the Canadian Carter and White Paper proposals, see Alan R. Dobell and Thomas A. Wilson, “The Impact of Taxation on Capital Flows and the Balance of Payments in Canada,” in International Mobility and Movement of Capital, edited by Machlup, Salant, and Tarshis (cited in footnote 108), pp. 519–62.

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