INTERNATIONAL CAPITAL TAXATION

1. INTERNATIONAL CAPITAL TAXATION Chapter prepared for Reforming the Tax System for the 21st Century: The Mirrlees Review by Rachel Griffith, IFS and University College, London James R. Hines, University of Michigan Peter Birch Sørensen, University of Copenhagen

2. OVERVIEW OF CHAPTER • 1) Review of theory of capital income taxation in open economies • 2) Empirical evidence on the effects of taxation on capital flows and profit shifting • 3) The debate on tax competition versus tax coordination • 4) International and European efforts at tax coordination • 5) The UK tax regime for cross-border capital flows • 6) Options for domestic reform of the UK regime for taxing international investment • 7) Proposals for more comprehensive domestic reforms of the UK system of capital income taxation • This presentation will focus on 5), 6) and 7).

3. THE UK TAX REGIME FOR CROSS-BORDER CAPITAL FLOWS • ● Statutory corporate tax rate currently 28% (above the EU average, but the lowest amongst G7 countries) • ● Worldwide income taxation: Foreign earnings liable to UK tax. A credit is granted for foreign taxes paid, up to a limit given by the UK tax on the foreign income • ● Deferral: The foreign profits of UK resident companies are generally not taxed until the time of repatriation • ● CFC rules: Retained profits of subsidiaries located in foreign low-tax countries may be taxed on a current basis in the UK • ● Taxation of inbound investment: UK withholding tax rates are generally very low and often zero • ● The UK has one of the world’s largest network of bilateral tax treaties, making it an attractive location for international investment

4. SOME PROBLEMS WITH THE CURRENT UK TAX REGIME • ● The foreign tax credit system is complex and may put British multinationals at a competitive disadvantage in the international market for corporate control • ● Because of deferral, the UK system of worldwide income taxation does not prevent capital flight • ● The British CFC regime has been challenged by the European Court of Justice and must be reformed • ● Like other OECD countries, Britain struggles with the transfer pricing problem • ● The current UK corporate tax system does not ensure neutrality with regard to the choice of organizational form and the choice of the mode of investment finance

5. REFORMING THE UK SYSTEM OF INTERNATIONAL DOUBLE TAX RELIEF • The OECD allows international double tax relief by means of exemption or by a foreign tax credit. Which system is preferable from a national viewpoint? • Premise: The assets of multinationals are highly specific, so their productivity depends on who owns and controls them • Assets located in low-tax countries may be taken over by MNEs headquartered in exemption (’territorial’) countries even if the assets could be used more productively by MNEs based in countries with worldwide taxation

6. REFORMING THE UK SYSTEM OF INTERNATIONAL DOUBLE TAX RELIEF • By switching from worldwide taxation to territoriality, a country will enable its MNEs to take over assets that they can use more efficiently than companies based in other countries. Territoriality (’National Ownership Neutrality’) will thus tend to maximise the profitability of domestic MNEs. • If any increase in outbound investment triggered by a switch to territoriality is offset by an equally productive amount of inbound foreign investment, domestic tax revenue will stay the same → a territorial tax system will maximise the sum of tax revenue and after-tax profit. • Most FDI does in fact involve a reshuffling of ownership (M&As) rather than a net transfer of saving across countries, suggesting that territoriality may come close to maximising national welfare

7. SHOULD BRITAIN SWITCH TO TERRITORIALITY? • Benefits from dividend exemption: • Simpler to administer • British MNEs become more competitive in the international market for corporate control (ownership neutrality) • The tax distortion to repatriation decisions is elimated • Potential problem: Deductibility of overhead costs against domestic profits could imply a direct subsidy to foreign investment. However, • expense allocation could imply an additional tax on foreign investment • other exemption countries typically do not require expense allocation

8. AN ALTERNATIVE ROUTE: ABOLITION OF DEFERRAL? • Benefits from abolition of deferral: • Eliminates incentive to invest in low-tax countries for companies that maintain British residence • Eliminates the tax distortion to repatriation decisions • Reduces incentives for profit-shifting • Problems: • Violates ownership neutrality • Provides incentive to move corporate headquarters abroad • For these reasons we do not recommend worldwide taxation without deferral

9. REFORMING THE BRITISH CFC REGIME • Special features of current UK CFC regime: • Applies to ’active’ as well as ’passive’ business income • ’Motive test’ • ECJ ruling in the Cadbury Schweppes case (September 2006): The British CFC regime violates the freedom of establishment within the EU • Proposal by UK Treasury (June 2007): • ’Controlled Company’ rules only to be applied to ’mobile’ income (passive investment income, royalties, rents) • The new CC regime applies to domestic as well as foreign subsidiaries of the UK parent company

10. DEALING WITH INTERNATIONAL PROFIT SHIFTING • Should Britain support a Common Consolidated Tax Base (CCTB) allocated by formula apportionment? • The case for the EU Commission’s proposal for a CCTB: • Would in principle eliminate the scope for profit-shifting within the EU • Would reduce the tax compliance costs for EU MNEs • Note, however, that under formula apportionment the corporation tax is transformed into a tax on the factors included in the formula (e.g., assets, payroll, sales)

11. SOME PROBLEMS WITH THE CCTB PROPOSAL • Difficult to delineate a group of related companies • If intangible assets are included in the formula, the transfer pricing problem may return through the backdoor • Transactions between the EU and the rest of the world will still give rise to transfer pricing problems • Fiscal externalities when a single EU country adjusts a transfer price of a transaction with a non-EU country • The CCTB will require a harmonisation of transfer pricing rules. But if this were feasible, many of the problems with the current separate accounting regime would disappear • Two parallel tax bases (the CCTB is just an option) • Conclusion: The CCTB may solve some problems, but would also create new ones

12. PROPOSALS FOR MORE COMPREHENSIVE REFORMS • The corporate tax system: • Allowance for Corporate Equity (ACE), i.e. deduction for • an imputed normal return on the company’s equity base • Options for reform of the personal tax system: • ’Income tax regime’: A Dual Income Tax • 2) ’Consumption tax regime’: A Dual Income Tax with a deduction for a normal rate of return

13. THE RATIONALE FOR AN ACE IN THE OPEN ECONOMY • A source-based tax on the normal return is shifted onto domestic immobile factors. It is more efficient to tax these factors directly • Note: • There is no rationale for raising the statutory corporate tax rate when the ACE is introduced since the owners of domestic factors will be better off • There is no problem of distinguishing between debt and equity for tax purposes: Any liability generating an interest deduction is categorized as debt rather than equity.

14. THE TRANSITION TO THE ACE SYSTEM • Theoretically attractive option: Grant the ACE allowance only for additions to the equity base after the time of reform • Practical problem: Companies might liquidate and then start up again to get the ACE on their entire equity base • Pragmatic alternative: • Calculate the equity base as the written-down value of assets in the tax accounts, less outstanding debts • Abolish existing personal dividend tax credit to limit the revenue loss and windfall gains from the reform

15. PROBLEMS SOLVED AND LEFT UNSOLVED BY THE ACE • Problems solved: • Elimination of distortion from tax on the normal return • Equal (corporate) tax treatment of debt and equity • No possibility of profit-shifting through thin capitalisation • Elimination of distortion from accelerated depreciation • Remaining problems: • Distortive effect of tax on mobile (firm-specific) rents • Problems of defining the source of income (transfer-pricing) • Note: The present value of the ACE allowance equals investment minus borrowing. In principle the ACE is thus equivalent to an R+F base cash flow tax

16. COORDINATING THE CORPORATE AND THE PERSONAL INCOME TAX (I): A PROPOSAL FOR AN ’INCOME TAX REGIME’ • All capital income should be taxed at a low flat tax rate below the top marginal rate applied to labour income • 2) As an option, owners of unincorporated businesses should be allowed to impute a return to their business equity. The imputed return would be taxed as capital income while the residual business income would be taxed as labour income • 3) To prevent tax avoidance through income shifting, the tax rate structure should roughly satisfy the constraint

17. PRAGMATIC REASONS FOR SETTING A LOW FLAT TAX RATE ON CAPITAL INCOME • Reduces the risk of capital flight • Compensates for lack of inflation adjustment • Reduces inter-asset distortions • Reduces lock-in effects of realizations-based capital gains taxation • Reduces ownership ’clientele’ effects arising from marginal tax rate differentials • Reduces scope for tax arbitrage exploiting marginal tax rate differentials • Simplifies administration by allowing tax collection through final withholding taxes • Note: The flat personal capital income tax is residence-based. Enforcement of the residence principle could be improved if the UK unilaterally offered to share the revenue gained through information provided by foreign tax authorities

18. COORDINATING THE CORPORATE AND THE PERSONAL INCOME TAX (II): A PROPOSAL FOR A ’CONSUMPTION TAX REGIME’ • Dividends and realized capital gains on shares are taxed at a flat personal rate, but only in so far as they exceed an imputed normal return to the shares • 2) In general, interest income is exempt from personal tax • 3) Owners of unincorporated businesses may opt to deduct an imputed normal return the their business equity from taxable business income. • 4) To prevent tax avoidance through income shifting, the tax rate structure should roughly satisfy the constraint

19. NEUTRALITY PROPERTIES OF THE CONSUMPTION TAX REGIME • No intertemporal distortion to savings incentives • No distortion from investment tax on normal returns • 3) Neutrality between debt and equity • 4) Neutrality between alternative organisational forms • 5) Neutrality with regard to realization decisions (holding period neutrality through carry-forward of unutilized rate-of-return allowances) • Note: The consumption tax regime extends the philosophy of the ACE to the personal income tax