International Business Taxation

International*Business*Taxation

A*Study*in*the*Internationalization*

of*Business*Regulation

SOL*PICCIOTTO

Emeritus*Professor,*University*of*Lancaster

©*1992*Sol*Picciotto

©*2013*Sol*Picciotto

Print*edition:*Cambridge*University*Press

Electronic*edition:*Sol*Picciotto

ISBN*0*297*82106*7*cased*ISBN*0*297*82107*5*paperback

TABLE*OF*CHAPTERS

Table!of!Contents iii

Preface!to!the!Digital!Edition viii

A!cknowledgements !!!x

Introduction xi

1.*History*and*Principles ***1

2.*The*Tax*Treaty*System **38

3.*The*International*Tax*System*at*the*Crossroads **64

4.*International*Tax*Avoidance **77

5.*The*Dilemma*of*Deferral **97

6.*Tax*Havens*and*International*Finance 117

7.*AntiWHaven*Measures 142

8.*The*Transfer*Price*Problem 171

9.*The*Worldwide*Unitary*Taxation*Controversy 230

10.*The*Internationalization*of*Tax*Administration 250

11 Global*Business*and*International*Fiscal*Law 307

Appendix:!UN,!OECD!and!USA!Model!Treaties 335

Bibliography 370

Table!of!Cases!Cited 392

Contents iii

TABLE*OF*CONTENTS

Chapter!1!!!!History!and!Principles

1.*Global!Business!and!International!Taxation 1

2.!The!Rise!of!Business!Taxation 2

(a)*Taxing*Residents*on*Income*from*All*Sources* 4

(i)*Britain!and!the!Broad!Residence!Rule 4

(ii)*Germany:!Residence!Based!on!Management! 4

(b)*Taxing*the*Profits*of*a*Business*Establishment:*France* 10

(c)*The*USA:*The*Foreign*Tax*Credit* 11

3.!The!Campaign!against!International!Double!Taxation 14

(a)*Britain*and*Global*Business 14

(b)*National*and*International*Double*Taxation 16

4.!Origins!of!the!Model!Tax!Treaties 18

(a)*The*Economists'*Study*and*the*Work*of*the*Technical*Experts 19

(b)*The*1928*Conference*and*the*Model*Treaties 22

(c)*The*Fiscal*Committee*and*InterWWar*Treaties 24

5.!Allocation!of!the!Income!of!Transnational!Companies 27

(a)*The*Carroll*Report*and*the*Problem*of*the*Transfer*Price 27

(b)*The*1935*Allocation*Convention 31

(c)*Limitations*of*the*Carroll*Report*and*the*League*Approach 32

6.!Conclusion 35

Chapter!2!!!!The Tax!Treaty!System 38

1.!Postwar!Development!of!the!Bilateral!Treaty!Network 39

(a)*The*USWUK*Treaty*Negotiation 39

(b)*International*Oil*Taxation 42

(c)*International*Investment*and*Tax*Equity*or*Neutrality 45

2.!The!Role!of!International!Organizations 48

(a)*The*Mexico*and*London*Drafts*and*the*UN*Fiscal*Commission 49

(b)*The*OECD*Fiscal*Affairs*Committee 52

(c)*Developing*Countries*and*the*UN*Group*of*Experts 55

(d)*International*CoWordination*and*Tax*Treaty*Negotiation 58

Chapter!3!!!!The International!Tax!System!at!the!Crossroads 64

1.*The!Interaction!of!National!and!International!Equity 65

2.!The!International!Crisis!of!Tax!Legitimacy 68

Contents iv

(a)***The*Movement*for*Tax*Reform 68

(b)***European*Community*Harmonization 72

Chapter!4!!!International!Tax!Avoidance 77

1.*The!Legal!Regulation!of!Economic!Relations 77

(a)*Liberal*Forms*and*their*Limits 79

(b)*Fairness,*Efficiency*and*Legitimacy*in*Taxation 82

2.!Taxation!of!Revenues!and!Opportunities!for!Avoidance 83

3.*The!Economics,!Politics!and!Morality!of!Avoidance 86

(a)*The*Business*Purpose*Rule 87

(b)*General*Statutory*AntiWAvoidance*Rules 89

(c)*Abuse*of*Legal*Forms 90

(d)*Tax*Planning 91

4.!International!Investment!and!Tax!Avoidance 93

Chapter!5!!!!The!Dilemma!of!Deferral 97

1.*The!UK:!Control!over!the!Transfer!of!Residence 98

(a)*The*Islands 99

(b)*Family*Trusts:*the*Vestey*cases 100

(c)*Companies:*Controls*over*Foreign*Subsidiaries 102

(d)*Modification*of*the*Residence*Rule 104

2.!The!US:!Tax!Deferral!on!Retained!Foreign!Earnings 106

(a)*Individuals 106

(b)*Foreign*Corporations 106

(c)*US*Corporations:*Foreign*Branches*and*Subsidiaries 107

(d)*The*Deferral*Debate 109

(e)*The*Controlled*Foreign*Corporation*and*Subpart*F 111

3.!The!Limits!of!Unilateral!Measures 114

Chapter!6!!!!Tax!Havens and!International!Finance 117

1.*Offshore!Finance 119

(a)*The*Growth*of*Deregulated*Offshore*Sectors 119

(b)*The*Inducements*and*Temptations*of*Offshore*Finance 123

(c)*Respectability*and*Supervision 125

(i)*Problems*of*Supervision 126

(ii)*Dilemmas*of*UK*Policy*Towards*Havens 129

2.!Tax!Havens 131

3.!Intermediary!Company!Strategies 135

Contents v

Chapter!7!!!AntiDHaven!Measures 142

1.!Controlled!Foreign!Corporations 144

(a)*The*Spread*of*AntiWCFC*Provisions 144

(b)*Defining*CFG*Income 146

(i)*The*Income*Liable*to*Tax 146

(ii)Control*and*Residence 148

(c)*The*Effect*of*AntiWCFC*Measures 149

2. AntiZAvoidance!and!Tax!Treaties 151

(a)*AntiWBase*Provisions 153

(b)*AntiWConduit*Provisions 156

(i)*Denial of*Benefits*under*Tax*Treaties 156

(ii)*Treaty*Benefits*and*Investment*Flows 159

3.Combating!TreatyZShopping 160

(a)*Limitation*of*Benefits*Clauses 160

(b)*Renegotiation*or*Termination*of*Treaties*with*Havens 164

Chapter!8!!!The!Transfer!Price!Problem 171

1.!Separate!Accounts!and!the!Arm's!Length!Fiction 173

(a)*The*US:*From*Consolidation*to*Adjustment*of*Related*Company*Accounts 175

(b)*France:*Taxing*Profits*Transferred*to*a*Foreign*Parent 176

(c)*The*League*of*Nations*and*Arm's*Length 177

(d)*The*UK:*Profit*Split*and*Arm's*Length 180

(e)*Germany:*Organic*Unity*and*Profit*Split 180

(f)*Other*National*Provisions 183

(g)*The*Advantages*of*Adjustment 183

2. Elaborating!the!Arm's!Length!Principle 185

(a)*The*US*Regulations*of*1968 185

(b)*International*Concern*about*Transfer*Price*Manipulation 188

3. The!Indeterminacy!of!Arm's!Length 193

(a)*Arm's*Length*Price*or*Arm's*Length*Profit 193

(i)*Identification*of*Specific*Transactions* 193

(ii)*ProfitWSplit:*Criterion*or*Check? 194

(b)*Tangibles:*The*Search*for*Comparables 197

(i)*The*US*Experience 197

(ii)*The*Administrative*Burden*of*Scrutiny 200

(c) Safe*Harbours*and*Intrafirm*Financial*Flows 201

(i)*Thin*Capitalization 202

(ii)*Global*Trading*and*Transfer*Parking 206

Contents vi

(iii)*Proportionate*Allocation*of*Financing*Costs 208

(d)*Central*Services:*Joint*Costs*and*Mutual*Benefits 210

(e)*Intangibles*and*Synergy*Profits 212

(f)*The*Commensurate*with*Income*Standard*and*the*US*White*Paper 216

(i)*Restriction*of*the*CUP*Method 217

(ii)*Periodic*Adjustments 218

(iii)*The*Arm's*Length*Return*Method 218

4. Transfer!Prices!in!Theory!and!Practice 221

(a)*CostWSharing*and*ProfitWSplit 222

(b)*Economic*Theory*and*Business*Practice 224

5. Conclusion 228

Chapter!9!!!!The!Worldwide!Unitary!Taxation!Controversy 230

1. Formula!Apportionment!in!the!USA 230

(a)*Constitutionality 231

(b)*Harmonization*of*State*Formula*Apportionment 232

2.!!State!Unitary!Taxes!Applied!to!Worldwide!Income 235

3. The!Constitutionality!of!Worldwide!Combination 239

4. The!Political!Campaign!against!WUT 241

5. The!Global!Apportionment!Alternative 246

Chapter!10!!!!The!Internationalization!of!Tax!Administration 250

1. The!Development!of!Administrative!CoZoperation 250

2. Obtaining!and!Exchanging!Information 257

(a)*Obtaining*Information*Abroad 257

(i) Seeking*Information*Unilaterally 257

(ii)*Conflict*with*Foreign*Secrecy*Laws 262

(b)*Information*Exchange*under*Tax*Treaties 272

(i)*Procedures 272

(ii)*Safeguards 278

(iii)*Information*from*Havens 280

(c)*Simultaneous*Examination*and*CoWoperation*in*Assessment 282

3.CoZordinating!Treaty!Interpretation!and!Application 284

(a)*Competent*Authority*Procedure 287

(i) Specific*Cases 287

(ii)*Advance*Approval*for*Transfer*Prices 291

(iii)*Procedural*Rights*and*Arbitration 291

(b)*Treaty*Interpretation*by*Mutual*Agreement 295

Contents vii

4. Assistance!in!Collection 299

(a)*General*International*Law 299

(b)*Treaty*Provisions 301

5.Conclusion 305

Chapter!11!!!!Global!Business!and!International!Fiscal!Law 307

1. Tax!Jurisdiction,!State!Sovereignty!and!International!Law 307

2. Tax!Treaties!and!Domestic!Law 310

(a)*Harmonizing*the*Interpretation*of*Treaty*and*Statute 311

(i)*Interpretation*According*to*Context*and*Purpose 311

(ii)*National*Law*and*the*Treaty*Regime 316

(iii)*Statute*Conflicting*with*Prior*Treaty 320

(b)*Overriding*and*Renegotiating*Treaties 323

(i)*Effects*of*US*Tax*Law*Changes*on*Treaties* 325

(ii)*Treaty*Overrides*and*Treaty*Shopping 329

(iii)*Treaty*Breach,*Suspension*and*Renegotiation 332

3.!A!New!Institutional!Framework!for!International!Taxation 333

Appendix!!Model!Treaties 335

1.*OECD*and*UN*Model*Double*Taxation*Conventions 335

2.*US*Treasury*Department's*Model*Income*Tax*Treaty 353

Bibliography 370

Tables!of!Cases!Cited 392

PREFACE*TO*THE*ELECTRONIC*EDITION

This*is*a*reWpublication*in*electronic*form*of*this*book,*which*was*first*published*in*print*some*20*years*

ago,* by*Weidenfeld* &* Nicolson,* in* the* Law! in! Context series.* It* has* been* made* possible* by* the* kind*

agreement*of*Cambridge*University*Press,*which*acquired*the*rights*to*all*the*books*in*the*series.*I*have*

been*able*to*reformat*the*text*from*the*original*electronic*files,*as*the*book*was*written*on*an*early*BBC*

computer*(using*cassette*tape*storage),*subsequently*converted*to*MSWreadable*text*files.*The*formatting*

follows*the* print* edition* as* closely* as* possible,* particularly* for* pagination.* A* few*misprints* have* been*

corrected,*and*conversely*there*may*be*others*in*this*text*which*have*escaped*my*attention.*All*that*has*

been*omitted*from*the*print*edition*is*the*Index,*which*is*not*necessary*for*a*searchable*electronic*text.

I*am*grateful*that*the*Press*agreed*to*revert*electronic*rights*to*me,*having*decided*that*such*an*edition*

would* not* be* commercially* viable* for* them.* This* has* rescued* the* book* from* a* limbo* which* is* the*

unfortunate* fate* of* many* millions* of* others.* Although* some* reforms* of* copyright* law* are* finally*

beginning*to*facilitate*access*to*`orphan*woUNV¶WKLVFDWHJRU\ZRXOGVWLOOEHOLNHO\WRH[FOXGHPDQ\ERRNV

such*as*this*one*which,*although*out*of*print,*has*a*known*copyrightWowner.*Although*many*publishers*

and*some*authors*fear*digital*technologies*as*a*threat,*I*am*among*those*who*welcome*the*opportunities*

they*provide,*especially*to*unlock*access*to*a*vast*realm*of*knowledge*and*culture.

This*text* has* not* been* revised,*although* production* of*an* updated*edition* has* been* suggested*to*me*at*

various*times,*by*some*readers*and*publishers.*My*view*is*that*much*of*the*value*of*this*text*lies in*its*

detailed* discussion* of* the* historical* development* of*international* tax* coordination.* An* updated* edition*

would*either*have*had*to*be*considerably*expanded,*trying*the*attention*of*even*dedicated*readers,*or*to

have* lost* some* of* the* detail.* In* any* case,* my* concern* with tax* was* only* part* of* a* wider* interest* in*

international*economic*regulatLRQDVLQGLFDWHGE\WKLVERRN¶V subWtitle.*My*work*on*this*broader*canvas*

resulted*in*the*publication*of*another*more*recent book*Regulating!Global!Corporate!Capitalism in*2011,*

This includes*a*chapter*on*international*tax,*which*I*hope*provides*for*interested*readers*both*an*updating*

and*a*simplification*of*the*themes*explored*in*this*earlier*book.

There* have* certainly* been*many* changes*to*the*international*tax* system*in*the*twenty* years* since*this*

book*first*appeared.*Yet,*in*my*view*regrettably,*these*have*applied*superficial*palliatives*to*its*many*ills*

rather*than*attempting*radical*surgery.*I*am*far*from*being*the*only*analyst*to*point*to*the*major*flaws*and*

limitations* of*the*tax*treaty* system,* which* provides*the* skeleton* of*international*tax* coordination.*The*

further* deepening* of* international* economic* integration,* or* economic* globalization,* has* further*

highlighted*these*flaws.*This*was*pointed*out*in*a*lecture*(drawing*considerably*from*the*material*in*this*

book)* which* I* gave* to* the* annual* conference* of*the* International* Centre* for* Tax* and* Development* in*

December*2012* (available* from*its*website*at*http://www.ictd.ac/en.*Hence,*it*is*not*surprising*that*the*

past*decade*has*seen*international*tax,*and*especially*the*issue*of*avoidance*and*evasion,*increasingly*hit*

the* headlines.* A* significant* contribution* to* this* higher* visibility* has* been* made* by* campaigning*

organisations,* with* a* seminal* report* by* Oxfam* (2000)* leading* to* the* formation* of* the* Tax* Justice*

Network.* The* fiscal* crises* following* on* the* great* financial* crash* of* 2007W9* further* highWlighted* the*

importance* of* devising* effective* and legitimate* tax* arrangements,* not* least*in* relation* to* transnational*

corporations,*dealt*with*in*this*book.

I*am*pleased*that*the*intellectual*work*put*into*this*book*helped*make*a*contribution*to*this*awakening*

interest*and*activism,*and* I*hope*also*contributed*to*making*the*debates*better*informed.*This*contrasts*

with*the*deafening*silence*that*greeted*the* first*publication*of*this*book*in*mainstream*tax* scholarship.*

This*was* no* doubt* partly* because* I*could* be* regarded*as*an*interloper,*attempting*to* shine*lights* from*

Preface!to!the!Electronic!Edition ix

international*political*economy*and*international*economic*regulation*into*the*hitherto*murky*recesses*of*

WD[ODZ ,DQWLFLSDWHGDVPXFKLQVD\LQJLQWKHERRN¶V ,QWURGXFWLRQWKDW , IHDUHGWKDWspecialists*would*

feel*that*I*had*not*adequately*dealt*with*particular*technicalities,*while*others*might*find*parts*of*the*book*

too*detailed*and*technical.*That*so*many*people*have*nevertheless*enjoyed*and*benefited*from* reading*the*

book*has* reassured*me*that*writing*it*was*worthwhile,*as*well*as*encouraging*me*to* reissue*it*in*this*new*

version.

Sol!Picciotto

Leamington!Spa/DonostiaZSan!Sebastian

January!2013

ACKNOWLEDGEMENTS

The* research* for* this* book* originated* as* part* of* a* larger* project* on* the* coordination* of*jurisdiction*to*

regulate*international*business,*which*is*continuing.*I*am*grateful*to*the*Nuffield*Foundation,*the*Research*

and* Innovations*Fund*of*the*University*of*Warwick,*and*the*Legal*Research* Institute*of*the* School*of*

Law,* for*grants*which*have*assisted*this*researchi*as*well*as*to*the*University*of*Warwick*for*study*leave*

during*which*some*of*it*was*carried*out.

I*am*grateful*to*many*tax*officials*and*specialists*for*their*assistance*and*for*taking*time*to*explain*and*

discuss*their*work*and*opinions*on*professional*matters*with*me.*Help*of*various*kinds*was*given*by*far*

too* many* people*to*mention.* Those* who* were* kind* enough* to* give* time* for* interviews*include:* Peter*

Fawcett,*Peter*Harrison*and*P.*H.*Linfoot* of*the*UK* Inland*Revenuei*Mr*Sweeting*and*Robert*Tobin,*

Revenue* Service*Representatives* of*the*US* Internal*Revenue* Servicei*Arthur*Kanakis,* Sterling* Jordan,*

Paul*Rolli*of*the*IRSi*Mark*Beams,*Ann*Fisher,*and*Stan*Novack*of*the*Office*of*International*Tax*Counsel*

of*the*US*Treasuryi*Harrison*Cohen* of*the*US*Congress* Joint*Tax*Committeei* John*Venuti* of*Arthur*

Andersen*and*Robert*Cole,*of*Cole,*Corette*(both*formerly*of*the*US*Treasury)i*JeanWLouis*Lienard*and*

Jeffrey*Owens*of*the*OECD*Fiscal*Committeei*Pietro*Crescenzi*of*the*European*Commissioni*John*Blair*

and*Dick*Esam*of*the*International*Department*of*the*Confederation*of*British*Industryi*Mme*Suzanne*

VidalWNaquet* of*the*Fiscal*Commission*of*the* International*Chamber*of*Commercei*Mr*Aramaki*of*the*

Japanese* Ministry* of* Financei* Anne* Mespelaere* and* Noel* Horny,* French* Attaches* Fiscauxi* M.*

Froidevaux,*legal*adviser*to*the*Trade*Development*Bank*in*Genevai*M.*Luthi*of*the*Swiss*Federal*Tax*

Office's* international* departmenti* Frau* Portner* of*the* German* Federal*Ministry* of* Finance* and* Stefan*

Keller*of*the*Federal*Foreign*Ministry.

Liz*Anker* and* Jolyon*Hall* at*the*University* of*Warwick*library* have* been* helpful*in*tracking* down*

obscure*sources*and*keeping*an*eye*open*for*interesting*itemsi*and*I*have*also*had*much*assistance*from*

librarians*at*the*Inland*Revenue*library,*the*Public*Records*Office*and*the*Library*of*Congress.*I*would*

like* to*thank* colleagues* who* have* read,* and* provided* helpful* comments* on* drafts* of* parts* of the* book,*

especially*Julio*Faundez*and*Joe*McCahery.*Robin*Murray*first*awakened*my*interest*in*the*transfer*price*

question*and*has*long*provided*a*source*of*lively*stimulation.*Many*colleagues*at*the*University*of*Warwick,*

especially*in*the*School*of*Law and*the*Department*of*Sociology,*have*made*it*a*congenial*intellectual*

environment,*despite*the*increasing*pressuresi*while*colleagues*and*friends*at*the*Law*Faculty*of*Nagoya*

University,*especially*Professors*Kaino,*Matsui*and*Taguchi,*were*extremely*hospitable*and*helpful*during*

part*of*my*study*leave.*Hugo*Radice,*Robert*Picciotto*and*Joe*Jacob*also*provided*hospitality*and* help*

during*visits*to*the*USA.*Tim*Green*and*Wiebina*Heesterman*have*been*unfailingly*patient*in*unravelling*

wordWprocessing*problems,*while*Helen*Beresford,*Barbara*Gray,*Jill*Watson*and*Margaret*Wright*have*

provided*superbly*efficient*administrative*support*which*has*enabled*me*to*keep*on*top*of*my*teaching*and*

administrative*duties*while*continuing*work*on*this*book.*Of*course,*responsibility*for*the*arguments*and*

views*expressed*in*this*book,*as*well*as*for*the*errors*which*undoubtedly*remain,*is*wholly*mine.

For* helping* to* provide* a* domestic* environment* that* was* also* intellectually* stimulating,* my* deepest*

affection*goes*to*my*wife,*Catherine*Hoskyns,*and*our*wonderful*daughter,*Annai*also*to*other*short*and*

longWstay*visitors,*especially*Mark,*Fiona*and*Pauline.

INTRODUCTION

The*taxation*of*international*business*is*a*vital*political*and*social*issue,*as*well*as* raising*

many*fascinating*legal,*political*and*economic*questions.*Taxation*is*the*point*of*most*direct*

interaction* between* government* and* citizens,* the* state* and* the* economy.* Yet* the* technical*

complexities* of* taxation* often* make* informed* debate* difficult.* This* book* aims* to* provide* a*

survey* of* the* development* and* operation* of* international* business* taxation* which* is*

sufficiently* detailed*to* provide* an* adequate* understanding* of*its* complexities,* yet* analytical*

enough*to*bring*out*the*important*policy*issues.

The*international*interaction* of*tax* systems* has* been* recognized* since* at*least*the* First*

World*War*as*an*important*element*in*international*finance*and*investment.*With*the*growth*

of*state*taxation*of*income,*including*business*income*or*profits,*each*state*had*to*adapt*its*

tax* measures*to*its*international* payments* and*investment* flows.*Conflicts* and* differential*

treatment* between* states*led*to* pressures* from* business* for*the* elimination* of* international*

double*taxation.*Although*early*hopes*of*a*comprehensive*multilateral*agreement*allocating*

jurisdiction*to*tax*were*soon* dashed,*a*loose*system* for*the*coWordination*of*tax*jurisdiction*

was*laboriously*constructed.

This* was* composed* of*three* related* elements.* First,* national*tax* systems* accepted,*to* a*

greater*or*lesser*extent,*some*limitations*on*their*scope*of*application.*Second,*a*process*of*

coWordination*by*international*agreement*emerged,*in*the* form*of*a*network*of*bilateral*tax*

treaties,*based*on*model*conventions,*adapted*to*suit*the*political*and*economic*circumstances*

of* each*pair* of* parties.*The*third* element* was*the* growth* of* a* community* of*international*

fiscal*specialists,*composed*of*government*officials,*academic*experts*and*business*advisors*

or* representatives.* It* was* they* who* devised* the* model* conventions,* through* lengthy*

discussion* and* analysis* and* countless* meetings.* They* also* negotiated* the* actual* bilateral*

treaties* based* on* the* models,* the* experience* of* which* in* turn* contributed* to* subsequent*

revisions*of*the*models.*Finally,*the*allocation*to*national*tax*jurisdictions*of*income*derived*

from*international*business*activities*has*depended,*to*a*great*extent,*on*bargaining*processes*

also*carried*out*by*such*specialists,*on*behalf*of*the*state*and*of*business.

These* international* tax* arrangements* were* an* important* feature* of* the* liberalized*

international*system*which*stimulated*the*growth*of*international investment*after*the*Second*

World* War.* This* growth* of* international* business,* and* especially* of* the* largely*

internationally* integrated* corporate* groups,* or* Transnational* Corporations* (TNCs),* led* to*

increasing* pressures* on* the* processes* of* international* business* regulation.* In* the* field* of*

taxation,*the*loose*network*of*bilateral*tax*treaties*proved*a*clumsy*mechanism*for*coordinating*

tax*jurisdiction.* They* defined* and* allocated* rights*to* tax:* broadly,* the* business* profits* of* a*

company* or* permanent* establishment* could* be* taxed* at* source,* while* the* returns* on*

investment*were*primarily*taxable*by*the*country*of*residence*of*the*owner*or*investor.*This*

compromise* concealed* the* disagreement* between* the* major* capitalWexporting* countries,*

especially* Britain* and* the* United* States,* and* other* countries* which* were* mainly* capital*

importers.*The* former*claimed*a* residual* right*to*tax*the*global*income*of*their*citizens*or*

residents,* subject* only*to* a* credit* for* foreign*taxes* paid* or* exemption* of*taxed*income:*in*

Introduction xii

economic*terms,*this*was*to*ensure*equity*in*taxation*of*the*returns*from*investment*at*home*

and* abroad.* CapitalWimporting* countries* on* the* other* hand* emphasized* their* right* to*

exclusive*jurisdiction*over*business*carried*out*within*their*borders,*whatever*the*source*of*

finance*or*ownership.

This* divergence* was* exacerbated* as international* investment* became* predominantly*

direct* rather* than* portfolio* investment,* since* internationallyWintegrated* firms* are* able* to*

borrow*in*the*cheapest*financial*markets*and*retain*a*high*proportion*of*earnings,*in*the*most*

convenient* location,* rather* than* financing* foreign* investment* from* domestic* earnings* and*

repatriating* all* foreign* profits.* However,* such* firms* were* able* to* exploit* the* avoidance*

opportunities*offered*by*the*interaction*of*national*tax*laws*and*the*inadequate*coWordination*

established*by*the*international*arrangements.*Specifically,*it*was*possible*to*defer*taxation*

of*investment*returns*by*countries*of*residence,*on*foreign*earnings*retained*abroad*and*not*

repatriatedi*while*maximizing*costs*charged*to*operating*subsidiaries*so*as*to*reduce*source*

taxation*of*business*profits.*An*important*element*in*such*strategies*was*the*development*of*

facilities*in* convenient* jurisdictions,* some* of* which* had* already* emerged* as* tax* havens* for*

individual*and*family*wealth.*This*quickly*became*transformed*by*the*related*but*even*more*

important*phenomenon,*the*offshore*financial*centre.

The*problem*of*fair*and*effective*taxation*of*international*business*was*necessarily*related*

to*the*increasing*tensions*within*national*tax*systems.*The*growing*burden*of*public* finance*

has*tended*to*fall*primarily*on*the*individual*taxpayer,*as*states*extended*incentives*to*business*

investment,*especially*from*abroad,*and*as*international*business*in*many*industries* reduced*

its* effective* tax* rate* by* use* of* intermediary* companies* located* in* tax* havens.*While* these*

arrangements* had* some* legitimacy* in* relation* to* the* retained* earnings* of* genuinely*

international* firms,* they* became* increasingly* available* for* others,* including* national*

businesses,*as*well*as*individual*evaders*and*criminal*organizations.

Thus,* attention* became* focused* on* the* possibilities* for* international* avoidance* and*

evasion* available* for* those* who* could* take* advantage* of* transfer* price* manipulation,*

international* financing* and* tax* and* secrecy* havens.* Since* the* countries* of* residence* of*

international* investors* already* claimed* a* residual* jurisdiction* to* tax* global* earnings,* their*

response* was* to* strengthen* their* measures* for* taxation* of* unrepatriated* retained* earnings.*

However,*such*unilateral*measures*quickly*ran*into*jurisdictional*limitations,*due*to*the*lack*of*

any* internationally* agreed* criteria* for* defining* and* allocating* the* tax* base* of* international*

business.*The*original*debate*about*international*double*taxation*had*considered,*and*largely*

rejected,* the* possibility* of* a* global* approach,* which* would* have* required* international*

agreement* both* on* the* principles* for* defining* the* tax* base,* as* well* as* a* formula* for* its*

apportionment.* Instead,* the* tax* treaty* system* had* embodied* the* approach* of* separate*

assessment* by* national* tax* authoritiesi* however,* it* was* accepted* that* they* could* rectify*

accounts* presented* by* a* local* branch* or* subsidiary* if* transactions* between* affiliates* did* not*

represent*the*terms*that*would* have*applied* between*independent* parties* operating* at* 'arm's*

length'.* Such* adjustments* would*represent* effectively* a* caseWbyWcase* allocation* of* globally*

earned* profits,* and* would* require* negotiation* and* agreement* between* the* firm* and* the*

competent*authorities* of*the*countries*involved.*As*the* problems* of*international* allocation*

became*exacerbated,*the*questions*of*effectiveness*and*legitimacy*of*these*arrangements*came*

to*the*fore.

From* the* earliest* discussions* of* international* taxation,* government* officials* had*

emphasized*that*measures*to*combat*international*tax*avoidance*and*fraud*must*complement*

the* provisions* for* prevention* of* double* taxation.* Business* representatives* were* more*

ambivalent,* and* emphasized* the* need* for* freedom* in* international* financial* flows.* Model*

conventions* for* administrative assistance* between* tax* authorities,* both* in* assessment* and*

collection* of* taxes,* were* drawn* upi* but* they* were* implemented* only* to* a* limited* extent,*

generally* by* means* of* one* or* two* simple* articles* in* the* treaties* on* avoidance* of* double*

taxation.*These* have nevertheless* formed*the* basis* for*an*increasingly*elaborate* system* of*

administrative*coWoperation.*The* secretive*and* bureaucratic*character* of*this*administrative*

Introduction xiii

system*has*been*the*target*of*some*criticism*by*business*representatives.*However,*they*have*

opposed* proposals* to* rationalize* and* legitimate* antiWavoidance* measures,* notably* a* new*

multilateral*treaty* for* administrative* assistance* drafted* within*the* framework* of*the* OECD*

and*the*Council*of*Europe,*which*was*opened*for*ratification*in*1988.

The* question* of*international* equity* was* also* raised* by*the* controversy* over*Worldwide*

Unitary*Taxation*(WUT)*which*emerged* from*the*end*of*the*19705.*This*resulted*from*the*

application* by* some* states* of* the* United* States,* especially* rapidlyWgrowing* states such* as*

California,* of*their* system* of* formula* apportionment*in* a* systematic* way*to*the* worldwide*

income*of*TNCs.*ForeignWbased*TNCs,*which*had*tried*to*establish*a*foothold*in*important*US

markets*frequently*at*the*expense*of*substantial*local*losses,*complained*that*the*levying*of*

state*income*taxes*on*a*proportion*of*their*worldwide*income*was*discriminatory.*It*was*also*

alleged*that* such* global* approaches*to* allocation* were* contrary*to*the* separate* accounting*

and*arm's*length*pricing*principles*embodied*in*the*tax*treaty*system.*This*revived*interest*in*

the* history* of* the* international* arrangements,* which* showed* that* separate* accounting* had*

never*excluded*the*allocation*of*either*profits*or*costs*by*some*sort*of* formula*method.*The*

international*adoption*of*a*unitary*approach*was*excluded*in*the*early*discussions*because*of*

the* great* difficulty* anticipated* in* reaching* agreement* for* uniformity,* both* in* assessment*

methods*as*well*as*in*the*actual*formula*to*be*used.*However,*it*had*always*been*accepted*

that* the* allocation* of* profits* and* costs* of* internationallyWintegrated* businesses,* even* on* the*

basis*of*separate*accounts,*might*be*done*by*a*formula*method.*Instead*of*an*internationallyW

agreed*general*formula,*this*meant*negotiations*on*a*caseWbyWcase*basis.*This*was*considered*

workable*by*most*of*the*tax*officials*and*business*advisors*who*operated*the*system,*who*

felt*that*specific*technical*solutions*could*be*found,*but*an*openlyWagreed*international*scheme*

would*be*politically*impossible.*However,*the*growth*of*global*business*and*the*increasing*

complexity* of*its* financing* and*tax* planning* arrangements* have* put*increasing* pressures* on*

this*system.

These* pressures* have* combined* with*the* concern* about*international* avoidance*to* raise*

very*directly*the*issues*of*international*equity*W where*and*how*much*international*business*

should* be* taxed.* It* is* these* social* and* political* issues* that* have* long* been* buried* in* the*

technical* intricacies* of* the* international*taxation* system.* I* hope*that*this* study* will* enable*

some* of*these*issues*to* be* brought*into* public* debate* and* discussion.*At*the* same*time,*it*

aims* to* provide* a* systematic* introduction* to* the* major* issues* of* international* taxation* of*

business* income* or* profits* that* will* be* of* interest* to* students* and* teachers* either* in* law,*

economics* or* political* science.*The* study* attempts*to*integrate* perspectives* from* all*these*

disciplines,*and*to*make*a*contribution*based*on*a*specific*study*to*a*number*of*areas*of*social*

science theory,*notably*the*historical*development*and*changing*character*of*the*international*

state*system*and*international*legal*relations,*and*the*dynamics*of*international*regulation*of*

economic*activities.* I*am* very*aware*that*the*ambitious* nature* of*my* undertaking*may*lead*

specialists*to*feel*that*I*have*not*adequately*dealt*with*particular*technicalities,*while*others*

may*find*parts*of*the*book*too*detailed*and*technical.*This*is*a*small*price*to*pay,*I*believe,*for*

the* rewards* in* increased* understanding* of* the* issues* that* come* from* a* more* integrated*

interdisciplinary* approach.* To* facilitate* matters* for* a* potentially* varied* readership,* I* have*

provided*introductory*and*concluding*summaries*in*most*chapters,*as*well*as*the*outline*in*

this*Introduction.

Sol*Picciotto*6!June!1991

University*of*Warwick

1

HISTORY!& PRINCIPLES

The*taxation*of*business*profits*or*income*originates*essentially*from*the*early*part*of*

the* 20th* century.* As* state* revenue* needs* became* increasingly* significant* with* the*

growth* of*military* and*welfare* spending,*most*industrial*capitalist* countries*moved*

from*reliance*on*a*multiplicity*of*specific*duties,*in*particular*high*customs*tariffs,*to*

general, direct* taxes* on* income.* The* acceptance* of* direct* taxes* rests* on* their*

application,* as* far* as* possible* equally,* to* income* or* revenues* from* all* sources,*

including* business* profits.* Since* many* businesses* operated* on* global* markets,* this*

raised*the*question*of*the*jurisdictional*scope*of*taxation.

During* the* first* half* of* this* century,* international* business* profits* resulted*

mainly* from* foreign* trade* and* portfolio* investment* abroadi* concern* therefore*

focussed*mainly*on*defining*where*profits*from*international sales*were*deemed*to*be*

earned,* and* where* a* company* financed* from* abroad* should* be* considered* taxable.*

The* question* of* export* profits* was* broadly* resolved* by* developing* a* distinction*

between* manufacturing* and* merchanting* profit,* and* allocating* the* latter* to* the*

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The*problem*of*international*investment*was*more*difficult,*and*gave*rise,*as*will*be*

discussed* in* more* detail* below,* to* conflicts* between* the* residence* and* source*

principles.* The* compromise* arrangement* which* emerged* consisted* in* restricting*

taxation*at*source*to*the*business*profits*of*a*Permanent*Establishment*or*subsidiary,*

while*giving*the*country*of*residence*of*the*lender*the*primary*right*to*tax*investment*

income.* This* formula* was* inappropriate* or* ambiguous* in* relation* to* the* type* of*

investment*that*came*to*dominate*the*postW1945*period:*foreign*direct*investment*by*

internationallyWintegrated*Transnational*Corporations*(TNCs).*