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 5–6, 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)

¹All 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.

²As per cent of grossed-up dividends.

Table 1.

Equivalence of Partial Integration Methods in France, the Federal Republic of Germany, and the United Kingdom¹

(In per cent)

Method		France	United Kingdom	Germany
Dividend credit
	Corporate rate	50	50	(51)
	Dividend credit2	33⅓	30	(36)
	Effective rate	25	28.6	(23.4)
Split rate
	Rate on retentions	(50)	(50)	51
	Rate on distributions	(16⅔)	(20)	15
	Effective rate	(25)	(28.6)	23.4

¹All 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.

²As per cent of grossed-up dividends.

View Table

Table 1.

Equivalence of Partial Integration Methods in France, the Federal Republic of Germany, and the United Kingdom¹

(In per cent)

Method		France	United Kingdom	Germany
Dividend credit
	Corporate rate	50	50	(51)
	Dividend credit2	33⅓	30	(36)
	Effective rate	25	28.6	(23.4)
Split rate
	Rate on retentions	(50)	(50)	51
	Rate on distributions	(16⅔)	(20)	15
	Effective rate	(25)	(28.6)	23.4

¹All 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.

²As 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.

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

¹In 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.

²This example assumes that indirect credit is granted (see text for explanation).

³With 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.

⁴Figures in parentheses show results with overall limitation.

Table 2.

Example of Methods of Alleviating International Double Taxation¹

Method			Subsidiary in Country B	Subsidiary in Country C	Total
Gross profits			100.0	100.0	200.0
Foreign tax
	Corporation tax		40.0	30.0	70.0
	Withholding tax		3.0	3.5	6.5
Domestic tax
	Exemption method		—	—	—
	Credit method2
		Domestic tax before credit	40.0	40.0	80.0
		Foreign tax credit	40.03	33.5	(76.5)473.5
		Net domestic tax	0.0	6.5	(3.5)46.53
	Deduction method
		Gross income	100.0	100.0	200.0
		Deduction	43.0	33.5	76.5
		Taxable income	57.0	66.5	123.5
		Domestic tax	22.8	26.6	49.4
Total tax (domestic plus foreign)
	Exemption method		43.0	33.5	76.5
	Credit method		43.0	40.0	(80.0)483.0
	Deduction method		65.8	60.1	125.9

¹In 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.

²This example assumes that indirect credit is granted (see text for explanation).

³With 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.

⁴Figures in parentheses show results with overall limitation.

View Table

Table 2.

Example of Methods of Alleviating International Double Taxation¹

Method			Subsidiary in Country B	Subsidiary in Country C	Total
Gross profits			100.0	100.0	200.0
Foreign tax
	Corporation tax		40.0	30.0	70.0
	Withholding tax		3.0	3.5	6.5
Domestic tax
	Exemption method		—	—	—
	Credit method2
		Domestic tax before credit	40.0	40.0	80.0
		Foreign tax credit	40.03	33.5	(76.5)473.5
		Net domestic tax	0.0	6.5	(3.5)46.53
	Deduction method
		Gross income	100.0	100.0	200.0
		Deduction	43.0	33.5	76.5
		Taxable income	57.0	66.5	123.5
		Domestic tax	22.8	26.6	49.4
Total tax (domestic plus foreign)
	Exemption method		43.0	33.5	76.5
	Credit method		43.0	40.0	(80.0)483.0
	Deduction method		65.8	60.1	125.9

¹In 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.

²This example assumes that indirect credit is granted (see text for explanation).

³With 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.

⁴Figures 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 countries ⁴⁷

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.

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.

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 7–9.⁶⁵ The interested reader really has to work through Table 3 and Appendix Tables 7–9 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

¹For corporate investment in subsidiary form. Corporate taxes are assumed to be unshifted.

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 entity	Case 1	Case 2	Case 1	Case 1
Split rate	Case 1	Case 2	Case 1	Case 1
Dividend credit	Case 3	Case 5	Case 3	Case 3
Full integration	Case 4	Case 6	Case 4	Case 4

¹For corporate investment in subsidiary form. Corporate taxes are assumed to be unshifted.

View Table

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 entity	Case 1	Case 2	Case 1	Case 1
Split rate	Case 1	Case 2	Case 1	Case 1
Dividend credit	Case 3	Case 5	Case 3	Case 3
Full integration	Case 4	Case 6	Case 4	Case 4

¹For 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 7–9).

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, 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.

View Table

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, 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 7–9. 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 7–9, 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 Y_f (1—t_f), where Y_f is gross foreign profit and t_f is the foreign tax rate, have to be equated with the gross profits on domestic investment (Y_d). The required profit differential to equate foreign and domestic investment may then be expressed as Y_f/Y_d = 1/(1—t_f), which is a positive function of the foreign tax rate (t_f).⁷⁶ If, in an extreme case, the foreign tax rate is zero, Y_f can be equal to Y_d; if it is 20 per cent, Y_f must be higher by one fourth, if it is 25 per cent by one third, and if it is 50 per cent, Y_f must be twice Y_d. Given a rate of return on alternative foreign investments, say, 50 per cent higher than the domestic rate of return (Y_f/Y_d = 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 equity ⁸¹

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.

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

Table 4.

Requirements for Effective Reciprocity

System in Capital- Exporting Country	System in Capital-Importing Country
	Separate entity	Partial integration	Full integration
Separate entity	Reciprocity	Compensating withholding tax by split rate country. No dividend credit extended by dividend credit country	No integration benefit extended by full integration country
Partial integration	—	Reciprocity	Compensating withholding tax by split rate country. No dividend credit or integration benefit extended by dividend credit country or full integration country
Full integration	—	—	Reciprocity

View Table

Table 4.

Requirements for Effective Reciprocity

System in Capital- Exporting Country	System in Capital-Importing Country
	Separate entity	Partial integration	Full integration
Separate entity	Reciprocity	Compensating withholding tax by split rate country. No dividend credit extended by dividend credit country	No integration benefit extended by full integration country
Partial integration	—	Reciprocity	Compensating withholding tax by split rate country. No dividend credit or integration benefit extended by dividend credit country or full integration country
Full integration	—	—	Reciprocity

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.

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 dividends		100.0	100.0
Avoir fiscal		50.0	50.0
French withholding tax		22.5	—
Taxable dividends		150.0	150.0
Personal tax (30 per cent)
	Tax before credit	45.0	45.0
	Credit	22.5	50.0
	Net tax	22.5	-5.0
Net dividends		105.0	105.0

View Table

		Foreign Investor	French Investor
Cash dividends		100.0	100.0
Avoir fiscal		50.0	50.0
French withholding tax		22.5	—
Taxable dividends		150.0	150.0
Personal tax (30 per cent)
	Tax before credit	45.0	45.0
	Credit	22.5	50.0
	Net tax	22.5	-5.0
Net dividends		105.0	105.0

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.