Artigo publicado no Tax Notes International, Vol. 89, Num. 10, p. 925-935, March/2018.
Autor: Ramon Tomazela Santos
TERRITORIAL TAX SYSTEMS: MOTIVATIONS AND KEY CONSIDERATIONS FOR EFFECTIVE CHANGE
This article addresses the trend toward the development of territorial tax systems,1 a migration that has included many European countries and, more recently, the United States with the enactment of the Tax Cuts and Jobs Act (P.L. 115-97).
The preference of some countries for a partial territorial tax system can be attributed not only to the increasing integration of the global market in the new era of digital economy, but also to the fierce competition among countries for tax revenues, especially following a prolonged global economic crisis that lasted almost a decade.
This article will first address the main reasons behind the current wave of jurisdictions opting for territorial tax systems and then examine the challenges faced by countries as they adapt their tax systems to a new international framework. Ultimately, this article will argue that an effective transition to a territorial tax system, whether full or partial, requires (i) the
1 This movement to territorial income taxation regimes is confirmed by noting that 29 of the 35 OECD member countries grant total or partial exemption from income tax for qualifying foreign-source dividends. See Stephen Phua, “Putting Territoriality in Its Place: Singapore’s Perspective on Tax Competitiveness,” 71 Bulletin for International Taxation 53 (2017); and PwC, “Evolution of Territorial Tax Systems in the OECD”
(2003), at 1-15).
introduction of a systematic and comprehensive set of source rules, and (ii) the strengthening of transfer pricing rules.
I. THE SHIFT TOWARD TERRITORIAL TAX SYSTEMS
The United States has traditionally led other developed countries toward the adoption of a worldwide tax system — one that reaches foreign- source income earned by resident taxpayers including both individuals and legal entities.2 In 1962, during the administration of President John F. Kennedy, the United States enacted the first controlled foreign corporation rules, known as subpart F, and inserted section 956(c)(1)(C) into the IRC. Several countries, including Germany (1972), Canada (1975), Japan (1978), France (1980), and the United Kingdom (1984), followed suit.
However, the scene began to change between 1994 and 2006, when the U.S. government adopted measures to soften the rigidity of its CFC rules and made room for “check-the-box” planning.
For different reasons, Europe took even stronger steps to change its policies. In the Cadbury Schweppes case, C-196/04 (CJEU 2006), the Court of Justice of the European Union declared that CFC rules could only target “wholly artificial arrangements” or they would violate the freedom of establishment.
Thus, the CJEU started to impose severe limitations on the application of CFC rules by European member states. The EU policy became that CFC rules can only reach artificial structures that do not reflect economic reality and can only target arrangements in which the sole purpose is to obtain a tax advantage.
More recently, the U.S. tax reform package approved by President Trump represents a return to a partial territorial tax system. Under the new regime, U.S. corporations will be entitled to deduct the full amount of foreign- source dividends received from 10 percent-owned foreign corporations. In practice, the effect of the deduction is that those foreign-source dividends are exempt from U.S. corporate income tax.
2 Reuven S. Avi-Yonah, International Tax as International Law — An Analysis of the International Tax Regime 25 (2007).
Along with the shift to a partial territorial tax system, the TCJA directs the reduction of the corporate income tax rate from 35 percent to 21 percent and the introduction of a mandatory repatriation of deferred foreign income held overseas by U.S. multinational enterprises. Foreign profits earned before 2018 will be subject to a deemed repatriation regime in which corporate income tax will be levied at a rate of 15.5 percent on offshore cash equivalents and 8 percent on all other offshore assets (illiquid assets). To dilute the economic impact of the measure, U.S. MNEs will be permitted to elect to pay the tax debt in installments over eight years.
The merits of the TCJA can be easily identified. The high corporate income tax rate previously charged by the United States encouraged international tax planning strategies, such as corporate inversions, transfer pricing manipulation, and foreign tax credits schemes, all of which ultimately led to extremely high compliance costs in comparison with the tax revenues actually obtained by the U.S. government on overseas profits.3 Before the TCJA, the United States had the highest corporate income tax rate among OECD countries;
average corporate income tax rates in the OECD vary between 20 and 30 percent. With the enactment of the recent tax reform, the United States now has its lowest corporate income tax rate in almost 80 years.
At first glance, it may seem like the corporate income tax rate charged by the United States was not a real problem because some prominent U.S. MNEs were able to reduce their effective tax rates to very low levels. The very trigger of the base erosion and profit-shifting project was public outrage over the low corporate income tax rates paid by U.S. MNEs like Apple, Google, GE, and Starbucks on foreign-source income amid the harsh backdrop of the economic crisis. Moreover, some European MNEs paid effective corporate income tax rates higher than similar U.S. MNEs, regardless of the partial territorial tax system in force in many EU countries through participation exemption regimes.
Regardless, it is undeniable that the high corporate income tax rate affected the economic behavior of U.S. companies in a manner detrimental to the
3 Ramon Tomazela Santos, “US Tax Reform: The Potential Tax Implications for Brazilian Taxpayers,” 71 Bulletin for International Taxation 82 (2017).
country’s economic growth and the efficiency of its tax system. The reduction of the corporate income tax rate, combined with efforts to remove gaps exploited by taxpayers, appears to be a reasonable step in trying to help the U.S. tax system recover. Until recently the U.S. tax system faced the worst of both worlds
— it did not raise significant tax revenues from the taxation of foreign profits and, at the same time, it did not benefit from the socioeconomic benefits generated by profit repatriation.
Against this backdrop, a move to a partial territorial system may significantly reduce the problems caused by international tax avoidance, aggressive tax planning strategies, transfer pricing schemes, and corporate inversions, while also eliminating the alleged negative impact of the worldwide tax system on the competitiveness of U.S. corporations.
The main reasons for the global migration to a territorial tax regime, which will be analyzed in detail below, are the following:
• international tax competition;
• a growing wave of corporate inversions;
• the negative impact of worldwide taxation on business competitiveness on the global scene; and
• the socioeconomic benefits of profit repatriation.
A. International Tax Competition
International tax competition is inherent in a world in which countries with autonomous and diverse tax systems coexist. Globalization and income mobility have expanded the opportunities for the migration of production factors and for capital flight involving the allocation of income to business units and enterprises in other countries.4 The adoption of practices intended to attract foreign investments is also becoming more widespread. For
4 Marco Aurélio Greco, “Crise do Imposto Sobre a Renda na sua Feição Tradicional,” in Estudos Tributários 417-431 (1999).
these reasons, countries have been increasingly feeling the harmful economic effects of tax competition.
Moreover, the fact that MNEs now carry on their activities as integrated economic units located in multiple jurisdictions has made it easier for businesses to transfer their headquarters to countries with more attractive tax systems (including via corporate inversions as is discussed below).5
In this environment, several countries began to experiment with unilateral measures to mitigate the effects of tax competition and the changing economy. One measure that stands out for this discussion is the use of an income tax exemption granted to foreign dividends. At the present stage of economic development, with MNEs experiencing increased mobility and when the migration of corporate headquarters can produce positive externalities, the trend toward territorial tax systems developed through the softening of CFC rules and the granting of income tax exemptions for foreign dividends received from investee companies seems to be a reasonable tax policy choice.6
B. Corporate Inversions
Experience tells us a high corporate income tax rate combined with a worldwide tax system can encourage the adoption of tax planning strategies and corporate inversions, which involve the parent company of a corporate group being replaced at the top of the investment chain by a company incorporated elsewhere, preferably in a country without CFC rules.
Corporate inversions have been a sensitive political issue in the United States since 2002 when Stanley Works, a leading manufacturer of industrial tools, announced its move to Bermuda.7 Since then, companies headquartered in the U.S. have increasingly attempted to sever that geographical
5 Phua, supra note 1, at 54.
6 Avi-Yonah, “Back to the Future? The Potential Revival of Territoriality,” 62 Bulletin for International Taxation 472 (2008).
7 Daniel N. Shaviro, Fixing U.S. International Taxation 35 (2014).
link in search of tax savings.8 In response, the U.S. Congress enacted a specific antiavoidance rule intended to curb tax-driven corporate inversions.9
However, most of the world’s countries have not adopted rules to prevent corporate inversions. The lack of rules against corporate inversions, particularly given the absence of international coordination among countries as to a minimum standard for CFC rules, leads to MNEs being drawn to jurisdictions without CFC rules or that use milder CFC rules, which only encompass abusive transactions.
The migration to partial territorial tax regimes that provide an income tax exemption for foreign dividends can significantly reduce the incentives to corporate inversions.10
C. Negative Impact on Business Competitiveness
The adoption of a partial territorial tax system allows countries to encourage the internationalization of domestic companies by reducing the overall tax burden upon the repatriation of profits to the parent companies.11 By formally enshrining the principle of capital import neutrality, the exemption method recognizes that domestic taxpayers may be developing economic activities in countries with different levels of economic development and infrastructure, thereby preventing the residual taxation in the residence state from leveling the tax burden of taxpayers who are not carrying on business in similar situations.12 Hence, a partial territorial tax system can be considered a
8 Mitchell A. Kane, “A Defense of Source Rules in International Taxation,” 32 Yale J. on Reg. 312 (2015).
9 As Avi-Yonah writes, “in the US, this can be shown by the trend of inversion transactions, in which US MNEs reincorporated in Bermuda in part to avoid Subpart F.
The trend was stopped by legislation in 2004, but the competitiveness issue continues.”
Supra note 6.
10 According to Samuel C. Thompson Jr., territoriality would grant the benefits of a de jure inversion to all U.S. companies. See Samuel C. Thompson Jr., “Territoriality Would Make All U.S. Companies De Facto Inverters,” Tax Notes, Dec. 14, 2015, p. 1404.
11 Jürgen Lüdicke, “Exemption and Tax Credit in German Tax Treaties - Policy and Reality,” in Tax Polymath: A Life in International Taxation 281 (2011).
12 Manuel Pires, International Juridical Double Taxation of Income (1989), at 176.
form of support to companies operating abroad, contributing to their competitiveness at the international level.
In contrast, the immediate taxation of foreign profits via an overly strict and comprehensive worldwide tax regime (full imputation system) places domestic MNEs at a competitive disadvantage compared with competitors from countries with territorial tax systems.13
The competitiveness issue arises because a company that carries on economic activity in another country through a subsidiary or a CFC will have to pay local income tax based on the same rules that apply to local companies.
However, if the parent company is located in a country that adopts a comprehensive worldwide tax system (full imputation system) and full-inclusion CFC rules, the parent will also have to pay corporate income tax in its residence state on profits obtained by investee companies abroad, regardless of any actual profit distribution, with a right to offset the income tax paid abroad if certain legal requirements are met.14
Notably, the main objection to CFC rules, which focuses on the harmful consequences for the competitiveness of domestic companies operating abroad, only arises because of its unilateral adoption by some countries. In other words, the problem caused by strict CFC rules lies in their isolated adoption by some countries, which affects their domestic companies operating abroad. If all competitors were subject to the same residual taxation of foreign profits at the parent company level, the effect on competitiveness would be limited to differences in tax rates across countries, a problem inherent in the sovereignty
13 Avi-Yonah summarizes the argument: “The usual arguments against abolishing deferral are that it will put US multinationals at a competitive disadvantage, that it will lead to inefficient outcomes because less efficient foreign MNEs will obtain projects that should have been owned by more efficient US MNEs, and that it will lead to migration of US MNEs to other countries and to the establishment of new MNEs in other jurisdictions with more favorable tax rules.” Avi-Yonah, “Back From the Dead:
How to Prevent Transfer Pricing Enforcement,” University of Michigan Law School Scholarship Repository: Law & Economics Working Papers, No. 85 (2013), at 3.
14 Luís Eduardo Schoueri, “Tributação Internacional das Empresas Nacionais e Desenvolvimento: Novos Rumos?” in Tributação e Desenvolvimento — Homenagem ao Professor Aires Barreto 483-484 (2011).
of states. This is why, as a solution to problems in the international tax regime, Avi-Yonah proposed full-inclusion CFC rules under which all countries would tax the global income of MNEs whose ultimate parent company resides in that country, with an offset of tax credits for corporate income taxes paid in other countries by investee companies in the same corporate group.15
D. Socioeconomic Benefits of Profit Repatriation
In theory, the exemption granted to foreign dividends can promote the development of the internal market and economic growth. The adoption of a territorial tax system and the reduction of the corporate income tax rate in the United States is expected to produce additional socioeconomic benefits because the strengthening of economic activities may contribute to improved employment levels and salary increases. It is no coincidence that President Trump chose to focus on socioeconomic benefits when touting the tax reform package.
Any loss of tax revenues caused by the territorial tax system can typically be offset by positive long-term results, as usually occurs after tax breaks. However, as the TCJA also reduces the corporate income tax rate, tax revenue losses and impact on government deficits are expected.
In comparison, collecting corporate income tax on profits earned abroad using a worldwide tax system with deferral may cause adverse economic effects, such as the permanent retention of profits abroad without distribution to domestic shareholders. Adopting a partial territorial tax system may prevent distortions in the financial management of the company caused tax laws, such as the retention of profits beyond the point at which reinvestment is (CFC rules aside) the smart business choice.
It is important to bear in mind that the retention of profits abroad solely to avoid the levy of the income tax on repatriated profits can affect the optimal allocation of financial resources. Indeed, when foreign profits are kept within the company abroad, domestic shareholders cannot use dividends for other economic purposes.
15 Avi-Yonah, Advanced Introduction to International Tax Law 94 (2015).
Finally, according to Joseph E. Stiglitz, profit retention within a legal entity can reduce economic efficiency. Directors of an investee company will have access to more financial resources than the company would have after the repatriation and thus be less motivated to focus on efficiency in administrative and business decisions.16
II. PROBLEMS RAISED BY TERRITORIAL TAXATION
Avi-Yonah notes that the migration to a partial territorial regime may further stimulate the artificial transfer of profits to foreign companies, which may then be repatriated from the host country to the home country without triggering corporate income tax. According to Avi-Yonah, the biggest deterrent against the adoption of profit-shifting strategies stems from the difficulty of repatriating funds to the parent company or shareholders, precisely because of the imposition of income tax on dividends from companies operating overseas. In his opinion, if tax law grants an income tax exemption for foreign dividends, MNEs will have a greater economic incentive to transfer profits or activities to other countries since it will be possible to repatriate the funds at any time without an additional tax burden in the home state.17
Thus, the effective migration to a territorial tax system requires the strengthening of source rules for some types of income, as well as the tightening of the current transfer pricing rules.18 Neither of these two goals is an easy task.
A classic territorial tax system only taxes income earned within a country’s borders, regardless of the seat of the company. Thus, in a classic territorial tax system, local businesses may have an incentive to declare that some types of income were generated abroad, to prevent the levy of the local
16 Joseph E. Stiglitz, Economics of the Public Sector 663 (2000).
17 Avi-Yonah, supra note 6, at 473. See also Avi-Yonah and Gianluca Mazzoni, “The Trump Tax Reform Plan: Implications for Europe,” 71 Bulletin for International Taxation 11 (2017).
18 According to Avi-Yonah: “This trend has its attendant problems as well. The main argument against the US dividend exemption proposal is that, like any move in the direction of territoriality, it puts more pressure on the source rules and on transfer pricing.” Supra note 6, at 473.
income tax. In this scenario, source rules play an important role in identifying the tax system applicable to each income. Likewise, in a partial territorial tax system, which exempts foreign dividends from the corporate income tax, MNEs may also have an incentive to migrate some sources of income and productive activities overseas and then repatriate the corresponding amounts as exempt dividends.
Therefore, source rules and transfer pricing rules are required to counter this incentive for offshoring income.
A. Lack of Effective, Comprehensive Source Rules 1. Source Rules in General
Generally, the source of income is determined by legal criteria that define the scope of a jurisdiction’s tax law based on objective connecting factors.
While the requirement of residence is rooted in subjective connecting factors, the requirement of source is based on objective connecting factors directly linked to the taxable event.
By adopting source rules, a country can exercise its right to tax income whose source is located within its territory. Since earnings stem from economic events – which are inexorably linked to a source of income production – connecting factors demarcate the state’s jurisdiction to tax.
Conceptually, the source of income can be analyzed from two different perspectives: source of production and source of payment.19
On one hand, the source of production has an economic character since it is identified as the causal relationship between an economic item and its productive factors. More specifically, it refers to the geographical location (territorial limitation) where income was actually generated – the place where
19 Agostinho Toffoli Tavolaro, “Tributação Internacional: Elementos de Conexão,” in Direito Tributário: Estudos Avançados em Homenagem a Edvaldo Brito 186-188 (2014).
the act or transaction that produced the income occurred – tying taxation to the activities carried out within the defined territory.20
On the other hand, the source of payment establishes a connection with the location of the funds that were used for the actual payment of the income. Because financial resources necessary for the payment of income to a nonresident must be taken from the asset of an individual or legal entity, this criterion establishes a connection between the income and the competent state for its taxation based on the location of the source of payment.21
Although sometimes both elements establish an objective connection with the same country, often the source of production and the source of payment are located in different jurisdictions, leading to a source-source conflict. Moreover, one tax system may adopt different connection factors, depending on the type of income. Each jurisdiction must select the source of production or the source of payment as key factors permitting the taxation of income paid or generated within its territory. Countries may even require the cumulative presence of both connecting factors for some types of income.
The identification of the income source should be the object of a detailed analysis by the interpreter of the law based on the particular facts and the relevant domestic law, recognizing that many countries do not use a single and uniform criterion for all types of income. On the contrary, given the lack of a theoretical and fundamental doctrine to justify the assignment of income to a specific geographic location, source rules are usually a series of arbitrary provisions based on the categorization of a given item of income.22 Not
20 Gerd Willi Rothmann, “Tributação Internacional sem Sujeito Passivo: Uma Nova Modalidade do Imposto de Renda Sobre Ganhos de Capital?” 13 Grandes Questões Atuais do Direito Tributário 108-109 (2006).
21 Schoueri, “Princípios no Direito Tributário Internacional: Territorialidade, Fonte e Universalidade,” in Princípios e Limites da Tributação 336-337 (2005).
22 Stephen E. Shay, J. Clifton Fleming Jr., and Robert J. Peroni, “The David R. Tillinghast Lecture: ‘What’s Source Got to Do With It?’ Source Rules and U.S. International Taxation,” 56 Tax L. Rev. 81, 138 (2002).
surprisingly, Edward D. Kleinbard argues that source rules are often
“meaningless” and “largely artificial.”23
In most countries, the legislator has the competence to choose the connecting factors that bind income to the territory.24 However, except for a few specific categories of income, most countries do not have a clear set of rules for determining the source of income. This can raise pressing questions in practice.
To illustrate the effect of source rules in practice, we discuss below two examples that are of particular importance in the field of taxation.
2. Example
To clarify the difference between the source of production and source of payment, imagine a company in Brazil has immovable property within the country that it decides to rent to a nonresident. The rent received by the company in Brazil will be paid by a source of payment located abroad, but the economic source of production of the income is the immovable property in Brazil.
Article 25 of Brazil’s Law No. 9249/1995 provides that profits, income, and capital gains earned abroad must be computed in determining the taxable income for the company’s balance sheet as of December 31 of each calendar year. The expression “income earned abroad” seems to indicate that if the source of production of the income is located abroad, then the income would only be subject to tax in Brazil on December 31. For the purposes of applying this legal provision, it is insufficient that the mere source of payment is abroad; if the source of income production is located in Brazil, the amount received will be
23 Edward D. Kleinbard, “Stateless Income,” 11(9) Florida Tax Review 699, 752, and 750 (2011) (stating that “stateless income tax planning compounds the meaninglessness of income tax source rules” and “the global tax norms that define the geographic source of income or expense are largely artificial constructs”).
24 The legislator is not completely free to impose source taxation. Constraints on arbitrary and source taxation include international tax competition, the threat of reciprocal treatment, a refusal by other countries to apply double taxation relief for arbitrary source taxation, and the nondiscrimination principle. Shay, Fleming, and Peroni, supra note 22, at 112.
subject to corporate taxes in Brazil on an accrual basis. Thus, the rental income received by the Brazilian company in our example must be taxed on an accrual basis in Brazil (that is, article 25 of Law No. 9249/1995 does not apply).
Conversely, if the Brazilian company decides to rent immovable property located abroad to a nonresident, the rental income must be considered as “income earned abroad.”
Identifying the exact location of the source of production of income is an extremely controversial topic.25 This holds for both economists and tax scholars; the source of income is neither a coherent economic concept nor a normative jurisdictional theory.
3. Royalties, Licensing, and Related Matters
Next, consider the particularly difficult arena of intellectual property sourcing. Imagine that a company incorporated in Brazil receives income arising from a trademark used abroad by a nonresident under a licensing agreement.
Should the amount received should be considered income earned abroad?
Most jurisdictions follow a place of production rule, holding that the primary source of production for royalties derived from a trademark license agreement is the country where the intellectual property was developed. The royalty is monetary compensation to the owner of the intangible asset. The brand owner bears devaluation risks, maintenance costs, marketing expenses, and legal protection fees, all of which contribute to the generation of the royalty income. Thus, the origin of the income arising from trademark licensing is usually the country where the brand was developed and registered with the patent and trademark office, especially because the trademark licensing would not be possible without the development of the brand.
Notably, simply registering the licensed brand in the country where it is being commercially exploited by the licensee does not change the
25 As explained by Hugh J. Ault and David F. Bradford: “The idea that income has a locatable source seems to be taken for granted, but the source of income is not a well- defined economic idea.” Ault and Bradford, “Taxing International Income: An Analysis of the U.S. System and Its Economic Premises,” in Taxation in the Global Economy 30 (1990).
conclusions above; the decisive criterion for determining the (primary) source of production is where the brand was developed. Otherwise, simply changing the registration of the trademark from one country to another would change its source of production. That result is not consistent with the policy of identifying the source of income and its economic allegiance.
What about income that the nonresident licensee receives in its own country as a result of economic activity involving the use of the licensed brand (that is, the sale of goods or services with the licensed brand)? This income is business profit and should not be confused with royalty income that only remunerates the use of the trademark. The royalty income will be paid out of the business profits obtained by the licensee abroad. The source of production for the royalty income itself continues to be, at least predominantly, the country where IP was developed.
On this issue, Eric Kemmeren explains:
“the cause of the royalty income received is the creation of the intellectual property. Especially with respect to royalty income, the overwhelming relevance of the intellectual element in the production of income is obvious. The state where the intellectual element is found is the state of origin of the royalty income.
Through exploitation of the intangible, the producer of the intangible creates income. The user of the intangible does not produce the royalty income, at least not predominantly. He only uses the intellectual element of someone else producing another item of income, for example, business income if he uses the intangible in his own enterprise”.26
As Kemmeren highlights, the place of the intangible’s production is the focal element in the origin analysis for the royalty income. However, the use of the trademark contributes – at least to some extent – to the production of the royalty income because it is an economic phenomenon that cannot be completely isolated. The predominant source of production is where the brand was developed and the brand owner bears related costs and risks. Nevertheless,
26 Eric C.C.M. Kemmeren, Principle of Origin in Tax Conventions — A Rethinking of Models 452 (2001).
from an economic perspective, the market may also contribute to generating the income.
Avi-Yonah suggests that it is commonly accepted that part of the royalty income should be allocated to the country where the brand was developed and part to the market country where the final product was sold. This shows that from an economic perspective, both criteria contribute to generating the income.27 Still, despite some areas of agreement, he goes on to emphasize that “no universal consensus exists about what the source rule for royalties should be.”28
As Avi-Yonah notes, one outlier in this arena is the United States.
Domestic U.S. law attributes the source of production of royalty income to the country where the intangible was used (place of use rule). This rule helps some businesses with their tax planning efforts. For example, U.S. pharmaceutical companies often do research in the United States that leads to products that are sold around the world. If the source of production was deemed to be where the drug was developed, U.S. pharmaceutical companies would not have been able to obtain foreign tax credits for income tax paid abroad on these sales.29
4. Source Rules in Territorial Systems
As the foregoing demonstrates, numerous difficulties can arise when determining the source of production of an item of income, both from economic and legal standpoints. The effective migration to a territorial tax system requires a comprehensive, organic, and systematic set of rules for determining the source of income.
Source rules are certainly very important in a worldwide tax system, since they help to delineate the proper scope of the unilateral credit method used for double taxation relief.30 However, in a territorial tax system, source rules are a vital necessity because MNEs may have an incentive to assign the source of income to a foreign country and then repatriate the amount as exempt
27 Supra note 2, at 44-45.
28Id., at 44.
29Id.
30 Shay, Fleming, and Peroni, supra note 22.
dividends. In a territorial tax system, source rules are critical to preventing tax planning strategies that taxpayers may try to use to route domestic-source income through a foreign corporation, thereby converting domestic-source income into foreign-source dividend income.
B. The Need for Strong Transfer Pricing Rules
The second issue that must be considered when moving to a territorial tax system (total or partial) is the need for strong transfer pricing rules.
1. Article 9 of the OECD Model
Generally, transfer pricing rules try to prevent the artificial transfer of profits through cross-border transactions between associated enterprises.
Transfer pricing rules based on the arm’s-length standard31 are enshrined in more than 3,000 existing double tax treaties based on the OECD model income tax treaty, whose concept attempts to replicate the pricing behavior of independent parties and is regarded as “the Holy Grail” of international taxation.32
Article 9 of the OECD model allows adjustments in the taxable profit of an enterprise to reflect the true taxable profit that would have been earned if the transaction occurred between independent parties.33 In contrast, when transactions between associated enterprises are performed at arm’s length, in
31 I use the expression “arm’s-length standard” instead of “arm’s-length principle”
because it is not truly rooted in a direct legal principle, Rather the “arm’s length”
concept is derived from the principle of equality. See Schoueri, “O Arm’s Length Como Princípio ou Como Standard Jurídico,” in Estudos de Direito Tributário em Homenagem ao Professor Gerd Willi Rothmann 216 (2016); and Rothmann, “Standard Jurídico,” in Enciclopédia Saraiva do Direito, Vol. 70 at 500-501 (1977).
32 Raffaele Petruzzi, “The Arm’s Length Principle: Between Legal Fiction and Economic Reality” in Transfer Pricing in Post-BEPS World 2
(2016).
33 Luc de Broe, International Tax Planning and Prevention of Abuse: A Study Under Domestic Tax Law, Tax Treaties and EC Law in Relation to Conduit and Base Companies 502 (2008).
accordance with open market commercial terms, article 9 prevents adjustments in the taxable profits.34
Article 9(1) of the OECD model provides that a tax authority can adjust the taxable income of an entity by adding the portion of income eliminated by pricing manipulation in a transaction between associated enterprises to the income to be taxed in that country.35 Obviously, the amount of the tax adjustment can only be determined based on the domestic tax law of the contracting state because tax treaties do not have the power to determine the tax obligation.
Importantly, article 9 of the OECD model does not give states carte blanche to apply transfer pricing rules regardless of their compatibility with the arm’s-length standard. In fact, although double tax treaties only limit the right to tax and cannot be used to perform profit adjustments without a legal basis in domestic laws, the national legislators are not completely free to use any method they choose to determine whether a transaction between associated enterprises follows or ignores the arm’s-length standard. Rather, to comply with article 9 of the OECD model, profit adjustment mechanisms in the domestic law must reflect the market standard – that is, open-market conditions.36
If this was not the case, article 9 of the OECD model would be absolutely superfluous; the end result would be the same regardless of the existence of a tax treaty between the two contracting states. In the absence of a double tax treaty, domestic tax laws would be freely applied to adjust the taxable profits because of the lack of boundaries curbing the right of either contracting states to tax. On the other hand, when a double tax treaty was in place, domestic tax laws would still be free to determine the profit adjustment according to any criteria in the domestic law that supposedly reflect the arm’s-length standard.
34 Andreas Fross, “Debt-Equity Ratios, Earning Stripping Rules and the Arm’s Length Principle” in International Group Financing and Taxes 42-43 (2012).
35 Geerten M. M. Michielse, “Treaty Aspects of Thin Capitalization,” 51 Bull. for Int’l Fiscal Documentation 568 (1997).
36 Santos, “As Regras Brasileiras de Subcapitalização e os Acordos Internacionais de Bitributação — A Incompatibilidade da Lei No. 12.249/2010 com o Princípio Arm’s Length e com a Cláusula de não Discriminação,” 234 Revista Dialética de Direito Tributário 110-119 (Mar. 2015).
This would render article 9 completely inoperative, superfluous, and insignificant – which makes no sense.
Therefore, to be compatible with article 9 of the OECD model, the profit adjustment set by domestic laws may not lead to an increase of the tax base above that required by the arm’s-length standard. The wording of the treaty provision clearly dictates that the tax adjustment must reflect “profits which would... have accrued to one of the enterprises.”
2. Transitioning to a Territorial System
The problem is that transfer pricing rules based on the OECD guidelines have several structural flaws that make it difficult to transition to a territorial tax system. The problems include:
• a lack of comparable transactions to use to identify the transfer price;
• the absence of a single correct result, given that the arm’s- length price is a range, which admits fluctuations;
• high compliance and monitoring costs (for example, the costs of finding comparable transactions may be higher than the profits derived the from actual transaction);
• the increasing complexity and sophistication of cross-border transactions (for example, difficulties in applying the rules to digital transactions);
• the vulnerability of transfer pricing rules to profit-shifting strategies involving intangible assets and contractual risks;
• a lack of legal certainty for foreign investors because the results of the application of transfer pricing rules are unpredictable and the amounts involved in related tax assessment notices have significantly increased;
• the inability of transfer pricing methods to capture synergy and other effects from the integration of legal entities into international corporate groups;
• the reality that MNEs operate in the international market in an integrated way, developing a single economic activity, which can make trying to establish a basis of comparison with independent parties illogical;
• a lack of effective coordination among countries to align transfer pricing outcomes (for example, mutual agreement procedures, advance pricing agreements, and tax rulings);
• the high costs involved in bilateral or multilateral advance pricing agreements;
• the poor and inadequate alignment between existing transfer prices rules based on the arm’s-length standard developed in 1917 and the rapidly changing business environment;
• the absence of a solid theoretical approach for the identification of value creation, as proposed by the OECD during the BEPS project; and
• the increasing complexity of the arm’s-length standard and the required functional analysis that has reached a level that borders on irrationality.
This list of problems makes it clear that the need for comprehensive transfer pricing rules is a severe obstacle to be overcome before moving to a territorial tax system. Absent strong transfer pricing rules, it would be possible to manipulate the rules to claim that specific items of income were obtained abroad and then repatriate the corresponding profit to the headquarters in the residence state without triggering the corporate income tax due to the exemption for foreign dividends.
As long as the transfer pricing problems remain, the mere move to a territorial tax system (without the reduction of the corporate tax rate) would increase the problem of aggressive tax planning structures being exploited by MNEs. The reduction of the corporate income tax rate mitigates the incentive to divert profits to related companies abroad, as tax savings obtained through artificial arrangements between the parent company and its subsidiary abroad will reduce accordingly. Thus, as long as income diverted to low-tax jurisdictions continue to be taxed by the CFC rules, the trade-off between costs and benefits in profit-shifting strategies become less attractive after the reduction of the corporate income tax rate. Disparities in tax rates will continue to exist, but the benefits derived therefrom will decrease in line with the tax rate cut. In any case, as long as transfer pricing rules remain low, the adoption of full-inclusion CFC rules (full imputation system) to tax the profits of the international corporate group in the residence state of the parent company would be a feasible solution.37 These rules can act as a backstop to the transfer pricing rules, capturing profits artificially shifted to other countries through cross-border transactions that were not properly valued according to domestic transfer pricing rules.
In light of the foregoing, it is evident that transfer pricing rules based on OECD guidelines have several structural flaws, which significantly complicate the process of migrating to territorial tax systems, despite the efforts by U.S. lawmakers to follow the trend.
III. CONCLUSIONS
Key reasons for the recent migration toward territorial tax regimes include pressure from international tax competition, the desire to combat aggressive tax planning structures, an effort to prevent corporate inversions, global competitiveness issues, and the socioeconomic benefits of profits repatriation.
37 According to Avi-Yonah: “Thus, in the foreseeable future, transfer pricing problems will remain, and solutions to the massive double non-taxation permitted under current rules are more likely to come from residence-based taxation of corporate groups, despite the uneasy nature of corporate residency determinations.” Avi-Yonah, supra note 15, at 33. In the same sense, see Samuel C. Thompson Jr., “An Imputation System for Taxing Foreign-Source Income,” Tax Notes Int’l, Feb. 28, 2011, p. 691.
However, the adoption of a territorial tax regime may lead MNEs to increase their adoption of profit-shifting strategies because the foreign profits could be repatriated without taxation.
Traditionally, such as in the U.S. before the TCJA, the biggest disincentive to engage in profit-shifting strategies has been the difficulty of repatriating foreign profits to domestic shareholders, precisely because of the levy of income tax on dividends distributed. If a country starts to grant an income tax exemption to foreign profits, MNEs may have a greater economic incentive to transfer profits, production, or business activities to other countries because it will be possible to repatriate the income earned abroad without triggering additional taxation in the home country.
Moving to a territorial tax system without triggering profit shifting requires building and enforcing a comprehensive set of source rules and strengthening the traditional system of transfer pricing rules.
Most countries do not have a comprehensive set of source rules.
Determining the proper source of income is extremely challenging for economists and tax professionals. Although coordination is desirable since source rules can play an important role in balancing the taxing claims of various jurisdictions,38 the legislature of each country must establish a consistent set of rules to regulate the subject. Absent that step, migrating to a territorial tax system can be extremely risky. This even applies to a quasi-territorial system in which the exemption is limited to foreign profits.
Strengthening transfer pricing rules is also an essential step in a move to a territorial tax system. Otherwise, MNEs could manipulate transfer prices to claim that income was generated abroad and then repatriate the profit without taxation by virtue of the exemption granted to profits obtained abroad.
Here, the main problem stems from the fact that international transfer pricing rules based on the OECD guidelines have several structural flaws – shortcomings that were not resolved by actions 8, 9, and 10 of the BEPS project, which was the OECD’s attempt to align transfer pricing outcomes with the value creation. This further confirms the need for major adjustments before a move to a territorial taxation system can produce the desired results.