International Tax Systems and Planning techniques

international business taxation & treaties and international tax systems and planning techniques and different bases of international tax system
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Dr.MattWood,United States,Teacher
Published Date:25-07-2017
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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             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  co-­ordination  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   co-­ordination  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   capital-­exporting   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.   Capital-­importing   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  internationally-­integrated  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  co-­ordination   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   repatriated;;  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  authorities;;  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  case-­by-­case  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  up;;  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  co-­operation.  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  anti-­avoidance  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  rapidly-­growing  states  such  as   California,  of  their  system  of  formula  apportionment  in  a  systematic  way  to  the  worldwide   income  of  TNCs.  Foreign-­based  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  internationally-­integrated  businesses,  even  on  the   basis  of  separate  accounts,  might  be  done  by  a  formula  method.  Instead  of  an  internationally-­ agreed  general  formula,  this  meant  negotiations  on  a  case-­by-­case  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  openly-­agreed  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  -­  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   abroad;;   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   EOLQW(VW3VKPHQW¶ DQHH3WRDUPD( VDWWULEXWDEOHVDOHCLIWKHZDVWDWHLPSRUWLQJ   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  post-­1945  period:  foreign  direct  investment  by   internationally-­integrated  Transnational  Corporations  (TNCs).      Introduction   2   1.  Global  Business  and  International  Taxation.   The  first  TNCs  had  already  emerged  by  1914,  resulting  from  the  growth  of  world   trade   and   investment,   and   the   increased   concentration   of   large-­scale   business   institutionalised  in  the  corporate  form,  in  the  period  1865-­1914,  from  the  end  of  the   American  Civil  War  to  the  outbreak  of  the  First  World  War.  However,  long-­term   international  investment  at  that  time  primarily  took  the  form  of  loans,  in  particular  the   purchase  of  foreign,  especially  government,  bonds.  It  has  been  estimated  that  of  the   total  44  billion  of  world  long-­term  foreign  investment  stock  in  1914,  no  more  than   one-­third,   or   some   14   billion,   could   be   classified   as   foreign   direct   investment   (Dunning  1988,  p.72).  Even  this  figure  includes  as  investments  involving  `control¶ many   which   were   significantly   different   from   subsequent   international   direct   investments.  British  lenders  concerned  with  the  high  risk  of  foreign  enterprises  used   syndicated  loans,  for  example  to  invest  in  US  breweries  in  the  1890s  (Buckley  &   Roberts  1982,  53-­6).  A  common  pattern  in  mining  was  for  a  syndicate  to  secure  a   concession  to  be  transferred  to  a  company  floated  for  the  purpose,  thus  securing   promotional  profits  as  well  as  a  major  stake  for  the  founders,  as  for  example  the   purchase  of  the  Rio  Tinto  concession  from  the  Spanish  government  by  the  Matheson   syndicate  in  1873  (Harvey  and  Press  1990).  Similarly,  Cecil  Rhodes  raised  finance   from  a  syndicate  headed  by  Rothschilds  to  enable  the  centralization  and  concentration   of  Kimberley  diamond  mining  after  1875  under  the  control  of  De  Beers  Consolidated   Mines;;  and  Rhodes  and  Rudd  again  raised  capital  in  the  City  of  London  for  the   development  of  gold  mining,  setting  up  Gold  Fields  of  South  Africa  Ltd.  in  1887,  and   in  1893  Consolidated  Gold  Fields,  to  pioneer  the  mining  finance  house  system,  in   which  control  of  the  company's  affairs  typically  was  divided  between  operational   management  on  the  spot  and  financial  and  investment  decisions  taken  in  London.   These   were   the   successes   among   some   8,400   companies   promoted   in   London   between  1870  and  1914  to  manage  mining  investments  abroad  (Harvey  and  Press   1990).     A  high  proportion  of  foreign  direct  investment  prior  to  the  First  World  War  was   directed  to  minerals  or  raw  materials  production  in  specific  foreign  locations,  and  did   not   involve   internationally-­integrated   activities.   These   were   certainly   the   major   characteristics   of   British   international   investments,   which   were   dominant   in   that   period:  Britain  accounted  for  three-­quarters  of  all  international  capital  movements  up   to  1900,  and  40%  of  the  long-­term  investment  stock  in  1914  (Dunning,  in  Casson   1983).  Indeed,  by  1913  the  UK's  gross  overseas  assets  were  worth  nearly  twice  its   gross  domestic  product,  and  the  gross  income  from  abroad  (including  taxes  paid  in   the  UK  by  foreign  residents)  has  been  estimated  at  9.6%  of  GDP  (Mathews,  Feinstein   and  Odling-­Sime  1982).  Some  40%  of  British  investment  was  in  railways,  and  a   further  30%  was  lent  directly  to  governments.   Nevertheless,  it  was  in  the  period  1890-­1914  that  the  first  TNCs  were  established,  in          Introduction   3   the  sense  of  international  groups  of  companies  with  common  ownership  ties  (Wilkins   1970,  Buckley  &  Roberts  1982).  However,  the  coordination  of  their  activities  was   relatively  undeveloped:  they  were  indeed  referred  to  at  the  time  as  `international   combines  and  there  was  not  always  a  clear  distinction  between  an  international  firm   and  an  international  cartel  (Franko  1976).  In  the  1920s  there  was  a  resumption  of   foreign   direct   investment,   especially   by   US   firms   in   some   new   manufacturing   industries,   notably   automobile   assembly.   The   crash   of   1929   and   the   ensuing   depression  caused  fundamental  changes.  Not  only  did  it  result  in  the  virtual  ending  of   new  net  international  investments  until  after  1945,  it  caused  changed  attitudes  which   affected  the  prospects  for  its  resumption.  State  policies,  especially  exchange  controls,   as  well  as  the  caution  of  investors,  limited  international  capital  movements.  After   1946,  new  foreign  investment  was  largely  by  major  corporations,  usually  building  on   previous   ties   with   specific   foreign   markets.   Above   all,   this   direct   investment   characteristically   involved   relatively   little   new   outflow   of   funds:   the   investment   frequently  took  the  form  of  capitalization  of  assets  such  as  patents  and  knowhow,   with  working  capital  raised  locally,  and  subsequent  expansion  financed  from  retained   earnings  (Whichard  1981,  Barlow  &  Wender  1955).   This  investment  growth  was  facilitated  by  tax  treaties  whose  basic  principles  emerged   before  1939  and  which  quickly  spread  after  1945.  These  treaties  did  not  directly   tackle  the  issue  of  allocation  of  the  tax  base  of  internationally-­organised  business   among  the  various  jurisdictions  involved.  Instead,  they  allocated  rights  to  tax  specific   income  flows:  the  country  of  source  was  essentially  limited  to  taxing  the  business   profits  of  a  local  branch  or  subsidiary,  while  the  country  of  residence  of  the  parent   company  or  investor  was  entitled  to  tax  its  worldwide  income  from  all  sources,   subject  at  least  to  a  credit  for  valid  source  taxes.  This  was  intended  to  ensure  equality   of   taxation   between   investment   at   home   and   abroad;;   however,   capital-­importing   countries  and  TNCs  argued  for  primacy  of  source  taxation,  to  ensure  tax  equality   between  businesses  competing  in  the  same  markets  regardless  of  the  countries  of   origin  of  their  owners  (see  Chapter  2  below).     This  debate  viewed  investment  as  a  flow  of  money-­capital  from  a  home  to  a  host   state:  it  was  therefore  already  irrelevant  to  the  growth  of  direct  investment  in  the   1950s,   which   took   place   largely   through   reinvestment   of   retained   earnings   and   foreign  borrowing;;  and  became  even  more  inappropriate  with  the  growth  of  global   capital  markets  from  the  1960s.  TNCs  pioneered  the  creative  use  of  international   company  structures  and  offshore  financial  centres  and  tax  havens  for  international  tax   avoidance.  Thus,  they  were  able  to  reduce  (sometimes  to  zero)  their  marginal  tax   rates,  at  least  on  retained  earnings  (Chapters  5  and  6  below).  This  in  turn  tended  to   undermine  the  fairness  and  effectiveness  of  national  taxation  (Chapter  4  below).  The   tax  authorities  of  the  home  countries  of  TNCs  responded  by  measures  attempting  to   claw  back  into  tax  the  retained  earnings  of  `their TNCs,  initially  with  unilateral   provisions  which  were  later  coordinated  (Chapter  7  below).  These  have  met  with           ¶ ¶Introduction   4   partial  success,  but  have  also  encountered  great  technical  and  political  difficulties,   reflecting  continued  jurisdictional  problems.     International  arrangements  for  taxation  of  international  business  still  assume  that,   subject   to   a   reasonable   right   for   source   countries   to   tax   genuine   local   business   activities,  the  residual  global  profits  belong  to  the  `home country  of  the  TNC;;  but   there  are  no  clear  criteria  for  the  international  allocation  of  costs  and  profits  between   home   and   host   countries   (Chapter   8   below).   More   seriously,   however,   this   assumption  is  becoming  increasingly  inappropriate  as  TNCs  have  become  much  more   genuinely  global,  combining  central  strategic  direction  with  a  strong  emphasis  on   localization  and  diversity,  with  complex  managerial  structures  and  channels  aiming  to   combine  decentralised  responsibility  and  initiative  with  global  planning  (Bartlett  and   Ghoshal  1989).  Shares  in  them  have  become  internationally  traded  and  owned;;  they   often   draw   on   several   centres   for   design,   research   and   development   located   in   different   countries   in   each   major   region;;   and   even   their   top   managements   are   becoming  multinational.  Businesses  such  as  banks  and  stockbrokers  involved  in  24-­ hour  trading  on  financial  markets  around  the  world  have  become  especially  global,   and  able  to  take  advantage  of  even  tiny  price  differences  in  different  markets.  While   the  international  coordination  of  business  taxation  has  come  a  long  way,  it  seems  still   to  lag  significantly  behind  the  degree  of  globalization  developed  by  business  itself.   2.  The  Rise  of  Business  Taxation   The   move   towards   direct   taxation   of   income   or   revenue   was   a   general   trend,   especially   in   the   years   during   and   following   the   first   world   war;;   but   specific   variations  developed  in  different  countries,  in  particular  in  the  application  of  income   or  profits  taxes  to  businesses  and  companies.   2.a  Taxing  Residents  on  Income  from  All  Sources   A  number  of  states  have  applied  their  income  taxes  to  the  income  derived  by  their   residents  from  all  sources,  even  abroad,  although  sometimes  this  does  not  apply  to   income  as  it  arises,  but  only  when  remitted  to  the  country  of  residence.  The  definition   of  residence,  already  difficult  for  individuals,  creates  special  problems  in  relation  to   business  carried  out  by  artificial  entities  such  as  companies;;  while  the  formation  of   international  groups  of  companies  raises  the  question  of  whether  a  company  owning   another  should  be  treated  as  a  mere  shareholder,  or  whether  the  group  could  be   treated  as  resident  where  the  ultimate  control  is  exercised.   (i)  Britain  and  the  Broad  Residence  Rule.   Britain  was  distinctive,  since  it  already  had  a  general    income  tax,  introduced  by  Pitt           ¶Introduction   5   and  Addington  during  the  Napoleonic  Wars.  Although  this  never  produced  more  than   about  15%  of  government  revenues  during  the  19th  century,  it  was  important  in   establishing  a  single  general  tax  on  every  person's  income  from  all  sources.  Increases   during  the  Boer  War  led  to  pressures  for  a  graduated  rather  than  a  flat-­rate  tax,  and  a   supertax  was  instituted  in  1909  in  Lloyd  George's  `people's  budget  entering  into   effect  only  after  a  constitutional  conflict  with  the  House  of  Lords.  Between  1906  and   1918  the  basic  rate  rose  from  one  shilling  to  six  shillings  in  the  £  (i.e.  from  5%  to   30%),  with  a  supertax  of  4/6  (a  top  rate  of  55%),  and  the  total  yield  increased   seventeen-­fold  (Sabine  1966).     Pitt's  property  and  income  tax  of  1798  was  levied     upon  all  income  arising  from  property  in  Great  Britain  belonging  to  any  of   His  Majesty's  subjects  although  not  resident  in  Great  Britain,  and  upon  all   income  of  every  person  residing  in  Great  Britain,  and  of  every  body  politick   or  corporate,  or  company,  fraternity  or  society  of  persons,  whether  corporate   or  not  corporate,  in  Great  Britain,  whether  any  such  income  ...  arise  ...  in   Great  Britain  or  elsewhere (39  Geo.3  c.13,  sec.  II).     This  broad  applicability  was  repeated  in  Schedule  D  of  Addington's  Act  of  1803,  and   1 again  when  income  tax  was  reintroduced  by  Peel  in  1842.  It  therefore  applied  from   the  beginning  to  bodies  corporate  as  well  as  individuals,  so  that  when  incorporation   by  registration  was  introduced  after  1844,  the  joint-­stock  company  became  liable  to   tax  on  its  income  like  any  other  `person  Not  until  1915  were  companies  subjected  to   a  special  tax,  the  wartime  Excess  Profits  duty,  which  was  levied  on  top  of  income  tax   (and  accounted  for  25%  of  tax  revenue  between  1915-­1921).  After  1937,  companies   were  again  subjected  to  a  profits  tax  and  then  (in  1939)  an  excess  profits  tax,  both   levied  on  top  of  income  tax;;  from  1947  the  profits  tax  was  levied  with  a  differential   between   distributed   and   undistributed   income   (until   1958).   Only   in   1965   was   a   Corporation  Tax  introduced  which  actually  replaced  both  income  tax  and  profits  tax.     The   personal   character   of   the   income-­tax,   and   its   early   emergence,   therefore   established  the  principle  of  taxation  of  British  residents  on  their  worldwide  income.   The  liberal  principle  of  tax  justice,  which  legitimised  the  general  income  tax,  was   thought  to  require  that  all  those  resident  in  the  UK  should  be  subject  to  the  same  tax   regardless  of  the  nature  or  source  of  their  income.     However,  when  the  possibility  of  incorporation  began  to  be  more  widely  used,  in  the   last  quarter  of  the  19th  Century,  problems  arose  in  relation  to  the  liability  to  British   tax  of  companies    whose  activities  largely  took  place  abroad.  In  1876  the  issue  was                                                                                                           1  Schedule  D  contains  the  broadest  definition  of  income  chargeable  to  tax,  and  is  the  provision  in   relation  to  which  the  residence  test  has  continued  to  be  mainly  relevant:  for  the  important  differences   in  assessment  between  Case  I  and  Cases  IV  and  V  of  Schedule  D,  see  below.    Repealed  in  1816,  the   income  tax  was  reintroduced  as  a  limited  measure  in  1842,  to  supplement  revenue  lost  through   reduction  of  import  duties.     ¶ ¶ ¶Introduction   6   appealed  to  the  Exchequer  court,  in  two  cases  involving  the  Calcutta  Jute  Mills  and   the  Cesena  Sulphur  mines.  Both  were  companies  incorporated  in  England  but  running   operations  in  India  and  Italy  respectively;;  each  had  executive  directors  resident  at  the   site  of  the  foreign  operations,  but  a  majority  of  directors  in  London,  to  whom  regular   reports  were  made.  The  judgment  of  Chief  Baron  Kelly  showed  an  acute  awareness   that  the  cases  involved  `the  international  law  of  the  world";;  but  he  considered  that  he   had  no  alternative  but  to  apply  what  he  thought  to  be  the  clear  principles  laid  down  by   the  statutes.  The  court  held  that  in  each  case,  although  the  actual  business  of  the   company  was  abroad,  it  was  under  the  control  and  disposition  of  a  person  (the   company)  whose  governing  body  was  in  England,  and  it  was  therefore  `resident in   Britain  and  liable  to  tax  there.  Aware  that  many  of  the  shareholders  were  foreign   residents,  and  that  therefore  a  majority  of  the  earnings  of  the  company  belonged  to   individuals  not  living  in  Britain  and  therefore  `not  within  the  jurisdiction  of  its  laws   the  court  contented  itself  with  the  thought  that  if  such  foreigners  chose  to  place  their   1 money  in  British  companies,  they  `must  pay  the  cost  of  it   However,  it  was  made  clear  that  the  decisions  were  not  based  on  the  fact  that  the   companies  were  formed  in  Britain,  but  that  the  real  control,  in  the  sense  of  the   investment  decisions,  took  place  in  London.  This  was  confirmed  by  the  House  of   Lords  decision  in  the  De  Beers  case  (De  Beers  v.  Howe  1906).  De  Beers  was  a   company  formed  under  South  African  law;;  not  only  that,  but  the  head  office  and  all   the  mining  activities  of  the  company  were  at  Kimberley,  and  the  general  meetings   were  held  there.  Nevertheless,  the  House  of  Lords  held  that  `the  directors'  meetings  in   London  are  the  meetings  where  the  real  control  is  always  exercised  in  practically  all   the   important   business   of   the   company   except   the   mining   operations   Hence,   although  the  company  was  not  a  British  `person  it  was  resident  in  Britain  and  liable   to  British  tax  on  its  entire  income  wherever   earned.   Further,  in  Bullock  v  Unit   Construction  Co.  (1959),  East  African  subsidiaries  were  held  to  be  managed  and   controlled  by  their  parent  company  in  London  and  therefore  resident  in  the  UK,  even   though  this  was  contrary  to  their  articles  of  association.   The  decisions  on  residence  still  left  open  the  question  of  definition  of  the  tax  base;;   since,  although  the  British  income-­tax  was  a  single  comprehensive  tax,  it  required  a   return  of  income  under  a  series  of  headings  -­  five  schedules  each  containing  separate   headings   or   `cases   On   which   income   were   UK-­resident   businesses   liable:   in   particular,  were  they  liable  to  tax  on  the  trading  profits  of  the  foreign  business  or  only   on  the  investment  returns?    This  distinction  had  important  implications  which  were   not  fully  clear  either  in  legal  principle  or  in  the  minds  of  the  judges.  Included  in   liability  to  tax  under  Schedule  D  were  the  profits  of  a  trade  carried  on  in  the  UK  or   elsewhere  (Case  I  of  Schedule  D),  and  the  income  from  securities  (case  IV)  or                                                                                                           1  Since  the  British  income  tax  was  considered  to  be  a  single  tax,  companies  were  permitted  to  deduct  at   source  the  tax  due  on  dividends  paid  to  shareholders  and  credit  the  amounts  against  their  own  liability:   see  section  3.b  below.     ¶ ¶ ¶ ¶ ¶ ¶Introduction   7   `possessions (case  V)  out  of  the  UK.  A  UK  resident  could  in  principle  be  liable   under  Case  I  for  the  profits  of  a  trade  carried  on  abroad;;  but  the  House  of  Lords  in   Colquhoun  v  Brooks  (1889)  also  gave  the  term  `possessions in  Case  V  a  broad   interpretation,  to  include  the  interest  of  a  UK  resident  in  a  business  carried  on  abroad   (because  the  case  concerned  a  partnership  which  itself  was  resident  abroad,  although   the  sleeping  partner  was  UK-­resident).  The  distinction  was  significant,  since  under   Case  I  profits  are  taxable  as  they  arise,  while  income  under  cases  IV  and  V  was   taxable  only  when  actually  remitted  to  the  UK;;  the  importance  of  the  distinction  was   reduced  after  1914,  when  most  overseas  income  was  brought  into  tax  on  the  `arising¶ basis.  However,  if  a  UK  company  or  UK  shareholders  set  up  a  foreign-­resident   company  to  carry  on  the  foreign  business,  the  courts  took  the  view  that  UK-­resident   shareholders  did  not  own  the  business  itself  but  only  the  shares  in  the  company.  Even   a  sole  shareholder  was  considered  to  have  only  the  right  to  a  dividend  (Gramophone   &  Typewriter  Ltd.  v.  Stanley  1908),  unless  the  foreign  company  was  a  mere  agent  of   the  British  company  (Apthorpe  v.  Peter  Schoenhofer,  1899;;  see  also  Kodak  Ltd.  v.   Clark,  1902).  The  UK  owners  would  thus  be  liable  to  tax  only  on  the  dividends   declared  by  the  foreign-­resident  company,  and  not  on  its  business  or  trading  profits,   which  could  therefore  be  retained  by  the  firm  without  liability  to  UK  tax.     The  tax  commissioners  were  normally  willing  to  find  that  a  company  operating  a   business  abroad  was  liable  to  tax  under  Case  I  if  directors  in  the  UK  took  the   investment  decisions.  However,  confusion  seems  to  have  been  caused  by  the  view   taken  in  Mitchell  v.  Egyptian  Hotels  (1914),  apparently  based  on  a  misunderstanding   of  Colquhoun  v.  Brooks,  that  Case  I  only  applied  if  part  of  the  trade  took  place  in  the   UK.  Nevertheless,  a  majority  of  the  judges  in  the  Egyptian  Hotels  case  were  willing   to   hold   that   the   same   facts   that   showed   a   company   to   be   resident   in   the   UK   established  that  part  of  its  trade  was  in  the  UK.  This  was  the  basis  of  the  view  taken   by  the  Inland  Revenue,  which  in  its  evidence  to  the  Royal  Commission  of  1953  stated   that  for  a  company  to  be  chargeable  under  Case  I  it  must  be  resident  in  the  UK  (using   the  central  management  and  control  test)  and  have  part  of  its  trade  in  the  UK;;  but  that   `in  practice  the  two  tests  coalesce  Despite  the  fundamental  confusion  in  the  legal   position,  caused  especially  by  the  disagreements  among  the  judges  in  the  Court  of   Appeal  and  House  of  Lords  in  the  Egyptian  Hotels  case,  this  important  legal  principle   1 was  not  further  clarified  by  test  case  or  statute.   Nevertheless,   British   investors   in   a   foreign   business   could   not   escape   potential   liability  to  income  tax  on  its  trading  profits  unless  the  whole  of  its  activities  and  all   the  management  and  control  took  place  abroad.  This  could  be  arranged,  however,  and   it  was  even  possible  for  a  company  registered  in  Britain  to  be  resident  abroad.  In   Egyptian  Delta  Land  and  Investment  Co.  Ltd  v.  Todd  (1929)  a  British  company  set  up   in   1904   to   own   and   rent   land   in   Egypt   had   in   1907   transferred   the                                                                                                     1  See  the  discussion  in  Sumption  1982  ch.  9  and  the  analysis  by  Sheridan  1990.     ¶ ¶ ¶Introduction   8   entire  control  of  the  business  to  Cairo,  and  appointed  a  new  Board  whose  members   and  secretary  were  all  resident  in  Cairo,  where  its  meetings  were  held  and  the  books,   shares  register  and  company  seal  kept;;  to  comply  with  the  Companies  Acts  the   registered  office  remained  in  London  and  a  register  of  members  and  directors  was   kept  there  by  a  London  agent  paid  by  fee,  but  the  House  of  Lords  held  that  this  did   not   constitute   UK   residence.   Later,   tax   planners   could   set   up   foreign-­resident   companies  to  ensure  that  individuals  resident  in  the  UK  could  escape  tax  on  the   trading  profits  of  a  foreign  business.  Thus,  the  entertainer  David  Frost  in  1967  set  up   a  foreign  partnership  with  a  Bahamian  company  to  exploit  interests  in  television  and   film  business  outside  the  UK  (mainly  his  participation  in  television  programmes  in   the  USA);;  the  courts  rejected  the  views  of  the  Revenue  that  the  company  was  a  mere   sham  to  avoid  tax  on  Frost's  global  earnings  as  a  professional  -­  the  company  and   partnership  were  properly  managed  and  controlled  in  the  Bahamas  and  their  trade  was   1 wholly  abroad.   The  decision  in  the  Egyptian  Delta  Land  case  created  a  loophole  which  in  a  sense   made  Britain  a  tax  haven:  foreigners  could  set  up  companies  in  the  UK,  which  would   not  be  considered  UK  resident  under  British  law  because  they  were  controlled  from   overseas,  but  might  be  shielded  from  some  taxation  at  source  because  they  were   incorporated  abroad.  This  possibility  was  ended  by  the  Finance  Act  of  1988  (s.  66),   which  provided  that  companies  incorporated  in  the  UK  are  resident  for  tax  purposes   in  the  UK.  However,  the  control  test  still  applies  to  companies  incorporated  outside   the  UK,  as  well  as  to  unincorporated  associations  such  as  partnerships,  and  remains   2 relevant  for  tax  treaties.  This  brings  the  UK  substantially  into  line  with  many  states   (especially  European  Community  members),  which  use  both  incorporation  and  place   of  management  as  tests  of  residence  (Booth  1986,  169).     The  test  of  `central  management  and  control¶ developed  by  the  British  courts  has   never  been  defined  by  statute,  despite  calls  for  such  a  definition  by  judges  and  by   Committees  (Booth  1986,  p.25).  In  practice,  the  Inland  Revenue  has  interpreted  it  to   mean  the  place  where  the  key  strategic  decisions  of  Directors  are  taken,  as  against  the   `passive control  exercised  by  shareholders  (Simon  1983,  D  101-­111).  This  provided   a  basis,  however  shaky,  for  the  British  authorities  to  exercise  some  jurisdiction  over   the  worldwide  profits  of  multinational  company  groups  (TNCs)  controlled  from  the   UK.  In  the  1970s,  however,  as  the  pace  of  internationalization  accelerated,  and  TNCs   evolved  more  complex  patterns,  the  Revenue  developed  doubts  as  to  the  effectiveness                                                                                                     1  Newstead  v.  Frost  (1980);;  until  1974  income  derived  by  a  UK  resident  person  from  the  carrying  on  of   a  trade,  profession  or  vocation  abroad  was  taxable  under  Case  V  only  on  remittance:  ICTA  1970  s.  122   (2)(b)  repealed  by  FA  1974  s.  23.   2  In  general,  Britain's  pre-­1963  treaties  use  as  the  the  test  of  company  residence  `central  management   GDQFRWURRKQO¶LOHUHZUWWUHFHQHDPWLHVHVWHX2(K&R'GPUHO VSDVHKSODFHHFCWLHIRHIIY management":  see  below.     ¶Introduction   9   of  the  definition.  In  particular,  the  control  test  enabled  companies  to  arrange  financial   or  servicing  functions  in  affiliates  whose  central  management  and  control  could  be   said  to  be  located  offshore,  and  thus  reduce  UK  tax  by  deducting  interest  charges,   management  fees  or  insurance  premiums  from  the  UK  trading  profits  of  their  related   entities  (dealt  with  in  Chapters  5  and  6  below).  In  1981,  the  Revenue  published  a   consultative  document  favouring  a  move  to  the  test  of  `effective  management  which   had  been  used  in  tax  treaties  and  had  been  thought  to  amount  to  much  the  same  in   practice  as  `central  management  and  control  Criticism  of  these  proposals  led  to  their   withdrawal.  The  Revenue  restated  its  interpretation  of  the  `central  management test,   while   at   the   same   time   affirming   that   it   now   took   the   view   that   the   `effective   management principle  used  in  many  tax  treaties  (based  on  the  OECD  model  treaty)   involved  a  different  test,  and  therefore  by  implication  the  UK  would  apply  this   different  test  where  its  tax  treaties  used  the  `effective  management principle,  at  least   1 for  the  purposes  of  the  treaty.   This  is  the  chequered  history  to  date  of  the  principle  of  taxation  of  the  world-­wide   profits  of  British-­based  companies,  founded  on  the  doctrine  of  control,  viewed  from   the  angle  of  the  investor  of  capital.  The  original  logic  of  the  British  approach  flowed   from  the  liberal  principle  that  all  British  residents  should  be  subject  to  the  same   income  tax  regardless  of  the  source  of  their  income.  In  view  of  Britain's  position  prior   to  1914  as  by  far  the  largest  source  of  global  investment  funds,  it  was  not  surprising   that  the  Inland  Revenue  should  wish  to  apply  the  income  tax  to  all  businesses  whose   investment  decisions  were  taken  in  London,  and  this  view  was  generally  backed  by   the  courts;;  although  there  was  more  uncertainty  about  whether  liability  should  extend   to  trading  profits  if  wholly  earned  abroad,  rather  than  the  investment  returns  or   dividends  actually  paid.  At  the  same  time,  foreign-­based  companies  were  liable  to  tax   on  income  arising  in  the  UK,  including  that  arising  from  carrying  on  a  trade  or   business  there.  This  potential  overlap  with  the  jurisdiction  of  other  countries  does  not   seem  initially  to  have  caused  any  significant  problems,  no  doubt  because  the  British   tax  was  low  (until  the  Lloyd  George  budget  and  then  the  War),  compliance  was   relatively  lax,  and  similar  taxes  did  not  exist  in  other  countries.  In  the  case  of  foreign-­ based  companies  manufacturing  abroad  and  selling  in  Britain,  the  Revenue  developed   the  distinction  between  manufacturing  and  merchanting  profit,  and  the  tax  was  levied   2 on  the  profits  from  the  mercantile  activity  actually  carried  out  in  Britain.                                                                                                     1  Statement  of  Practice  6/83,  replaced  in  an  expanded  form  by  SP  1/90;;  see  Note  in  1990  British  Tax   Review  139.   2  Income  Tax  Act  1918,  Rule  12  of  All  Schedules  Rules,  now  Taxes  Managment  Act  1970,  ss.80-­81,   see  Ch.  8  section  1.d  below.    See  also  Firestone  Tyre  &  Rubber  v.  Llewellin  (I.T.)  (1957)  for  the   reverse  case,  where  contracts  were  concluded  by  a  foreign  parent  outside  the  UK  for  the  sale  of  tyres   manufactured  by  its  UK  subsidiary:  the  foreign  parent  was  held  to  be  trading  in  the  UK  through  its   subsidiary  as  agent,  since  the  essential  element  was  not  the  place  where  the  contract  was  concluded,   but  the  manufacturing  subsidiary's  links  with  the  foreign  clients.     ¶ ¶ ¶ ¶ ¶Introduction   10   (ii)  Germany:  Residence  based  on  Management.   Britain  was  both  typical  and  exceptional  in  its  approach  to  residence.  Many  countries   which  developed  a  broadly-­based  income  tax  applied  it  to  all  residents,  including   other  capital-­exporting  countries  such  as  Sweden  and  the  Netherlands;;  but  in  the  case   of   companies   the   preferred   test   of   residence   was   the   location   of   the   `seat   of   management  which  placed  less  emphasis  on  ultimate  financial  control  (Norr  1962).   This  test  meant  that  parent  companies  were  less  likely  to  be  liable  to  taxation  on  the   business  profits  of  their  foreign  subsidiaries.   Notably  in  Germany,  the  Corporate  Tax  Law  introduced  under  the  Reich  in  1920   1 introduced   the   combined   test   of   the   `seat of   a   company,   or   its   place   of   top   2 management.  However,  in  contrast  with  the  British  test  of  `central  management  and   control  the  `place  of  top  management test  did  not  include  control  of  investment   decisions,  but  focussed  on  actual  business  management.  Thus,  companies  effectively   managed  from  Germany  but  incorporated  abroad  (often  to  avoid  high  German  tax   3 rates  on  their  foreign  business)  could  be  taxed  in  Germany  on  their  business  profits;;   and  the  Tax  Administration  Law  of  1934  explicitly  provided  that  a  foreign  subsidiary   whose  business  was  integrated  with  that  of  its  German  parent  company  should  be   4 regarded   as   managed   and   therefore   resident   in   Germany.   However,   majority   ownership  was  not  necessarily  top  management,  even  if  the  majority  shareholder  was   5 informed  and  consulted  about  important  investment  decisions.   The  rule  `required  a  complete  financial  and  organizational  integration  and  the  courts   finally   held   that   it   meant   that   the   parent   company   must   itself   be   carrying   on   a   business  of  the  same  type  as  that  of  its  dependent  `organ and  with  which  it  was   integrated.   In   one   case,   for   example,   the   parent   company   coordinated   four   subsidiaries  operating  railways:  it  supplied  them  with  rolling  stock,  and  generally   managed  their  financial,  legal,  investment  and  administrative  activities.  Its  operations   were  held  to  constitute  representation  of  the  group  to  the  outside  world,  and  thus  of  a   6 different  type  from  the  actual  business  carried  on  by  the  affiliates  themselves.  Thus,   the  German  residence  rule  did  not  apply  to  a  foreign  holding  company,  and  in                                                                                                     1  The  seat  is  the  registered  head  office,  which  for  a  company  formed  under  German  law  must  be   somewhere  in  Germany.   2  The  tax  statutes  of  the  various  German  states  preceding  this  law,  dating  back  to  the  Prussian  Income   Tax  Law  of  1891  which  established  the  liability  of  corporations  to  income-­tax,  were  based  only  on  the   company's  seat:  Weber-­Fas  1968,  p.218.   3  Weber-­Fas  1968,  p.  240  provides  a  translation  of  some  of  the  main  decisions  of  the  German  tax   courts  on  this  provision;;  see  also  Weber-­)DVFV7WDQDI2UHRW¶JKHKUDCKDZRVLQ\UOOLJGHOR\HYSHG to  prevent  the  cascade  effect  of  turnover  tax  being  applied  to  sales  between  related  companies,  a   common  occurence  since  merged  businesses  often  remained  separately  incorporated  because  of  a  high   tax  on  mergers:  see  Landwehrmann  1974,  pp.244-­5,  and  the  Shell  decision  of  1930,  discussed  in   Chapter  8  section  1.e  below.   4  Steueranpassungsgesetz  s.15,  Reichsgesetzblatt  1934-­I  p.928.   5  Reichsfinanzhof  Decision  III  135/39  of  11  July  1939,  translated  in  Weber-­Fas  1968  p.246.   6  Decision  of  the  Reichsfinanzhof  of  1  April  1941,  I  290/40:  1942  Reichssteuerblatt  p.  947.     ¶ ¶ ¶¶ ¶ ¶Introduction   11    practice   became   "essentially   elective (Landwehrmann   1974,   p.249).   Following   concern  at  the  rapid  growth  in  the  use  of  foreign  intermediary  companies  in  the  1960s   to  shelter  the  income  of  foreign  subsidiaries,  Germany  enacted  an  International  Tax   Law  in  1972  permitting  taxation  of  the  receipts  of  certain  types  of  foreign  base   companies  as  the  deemed  income  of  their  German  owners  (see  Chapters  5,  7  and  8   below).   Other   countries   with   a   residence-­based   income   tax   explicitly   exempted   business   profits   either   if   earned   or   sometimes   only   if   taxed   abroad.   Generally,   therefore,   companies  could  avoid  home  country  taxation  of  their  foreign  business  profits,  if   necessary   by   interposing   a   holding   company   or   ensuring   top   management   was   abroad.  Even  if  they  had  to  set  up  foreign  subsidiaries  to  do  so,  they  did  not  have  to   go  to  the  great  lengths  of  ensuring  the  foreign  companies  were   controlled  from   abroad  that  were  necessary  under  British  law.   2.b  Taxing  the  Profits  of  a  Business  Establishment:  France   A   different   approach   emerged   in   countries   where   taxation   of   business   and   commercial  profits  emerged  as  part  of  a  schedular  system,  taxing  income  under  a   series   of   headings.   In   France,   despite   several   attempts   from   1871   onwards,   the   general  income-­tax  was  not  introduced  until  1914,  as  a  personal  tax  on  the  income  of   individuals.   This   was   followed   in   1917   by   taxes   on   other   types   of   revenue:   commercial  and  industrial  profits,  agricultural  profits,  pensions  and  annuities  and   non-­commercial   professions,   but   these   were   considered   as   separate   and   parallel   schedular  taxes,  or  impots  cedulaires.  These  were  added  to  the  old  taxes  on  income   from  land  and  mines,  and  the  tax  on  movable  property  (securities,  loans  or  deposits).   Not  until  1948  were  these  separate  schedular  taxes  replaced  by  a  company  tax.   Hence,  under  the  French  system,  the  income  tax  from  the  beginning  applied  only  to   individuals,  while  business  activities  were  always  taxed  separately  and  according  to   the  sources  of  the  revenue.  This  separation  of  the  taxation  of  individual  income  from   the  schedular  taxes  applying  to  specific  types  of  revenue  gave  the  latter  a  `real rather   1 than  a  `personal character.  The  old  property  taxes  were  considered  as  arising  where   the  land,  building  or  mine  was  situated.  In  the  case  of  industrial  or  commercial   profits,  liability  to  tax  arose  in  respect  of  profits  made  by  an  establishment  situated  in   France,  regardless  of  whether  it  was  operated  by  a  company  or  other  business  entity   incorporated  or  resident  in  France.  Equally,  a  French  company  was  not  liable  to  tax  in   respect  of  the  profits  of  its  establishments  abroad.  However,  France  did  include  in  the   income   of   companies   and   establishments   the   interest   and   dividends   received   on   securities  (considered  to  be  movable  property),  whether  the  debtor  was  in  France  or                                                                                                     1  Court  1985  discusses  the  influence  of  the  French  and  continental  European  schedular  taxes  on  the   early  tax  treaties,  as  well  as  more  recent  policy.     ¶ ¶ ¶Introduction   12   abroad.   Equally,   the   individual   income   tax   was   levied   on   the   income   of   those   domiciled  in  France  regardless  of  its  source.     The  emphasis  in  French  taxation  on  the  revenue  derived  from  an  activity  or  from   property  (movable  or  immovable)  thus  focussed  on  the  place  where  the  activity  took   place  or  the  property  was  located,  i.e.  the  source  of  the  revenue,  rather  than  the  place   of  residence  of  the  taxpayer.  It  therefore  enabled  a  more  differentiated  approach  to   the   question   of   tax   jurisdiction,   by   using   the   concept   of   the   earnings   of   an   `establishment¶ .  Other  systems  also  shared  this  approach,  including  Belgium,  some   Central  European  countries,  Italy  and  other  Mediterreanean  countries,  and  many  in   Latin  America.  In  Belgium,  the  duty  on  persons  carrying  on  a  profession,  trade  or   industry  was  held  by  the  courts  in  1902  to  apply  to  the  global  income  of  a  company   carrying  on  business  partly  abroad.  This  immediately  led  to  business  pressures  to   exempt  foreign-­source  income,  and  although  this  failed,  the  law  was  changed  to   reduce  to  half  the  duty  on  profits  earned  by  foreign  establishments  (International   Chamber   of   Commerce   1921).   In   general,   however,   countries   with   this   type   of   schedular  income  tax  emphasised  taxation  of  income  at  source,  so  that  companies   were  not  taxed  on  the  business  profits  of  their  foreign  establishments.  However,   schedular  income  taxes  encouraged  manipulation  between  different  types  of  source,   and  the  lower  yields  meant  greater  reliance  for  public  finance  on  indirect  taxes.  Tax   reforms  following  the  second  world  war  generally  introduced  an  integrated  income   tax;;  although  corporation  and  individual  income  taxes  were  usually  kept  separate,   usually   the   tax   paid   by   companies   on   the   proportion   of   profits   distributed   as   dividends  could  be  at  least  partially  imputed  to  shareholders  as  a  credit  against  their   personal  income  tax  liability  (see  below  section  3).   2.c  The  USA:  the  Foreign  Tax  Credit   In  the  United  States,  the  constitutional  limitation  of  the  Federal  taxing  power  meant   that  no  general  revenue  tax  was  possible  until  the  16th  Amendment  was  ratified  in   1913,  although  a  1909  `excise tax  on  corporate  profits  had  been  held  valid  by  the   courts.  The  ratification  of  the  16th  amendment  finally  enabled  federal  taxation  to   switch  from  indirect  to  direct  taxes,  and  a  sharp  reduction  of  import  duties  was   accompanied  by  the  introduction  of  a  graduated  individual  income  tax.  The  Revenue   Act  of  1917  introduced  a  tax  on  corporations  of  6%  of  net  income,  which  was   doubled  a  year  later,  plus  an  excess  profits  tax.  This  was  a  graduated  tax  on  all   business  profits  above  a  `normal rate  of  return;;  by  1918  US  corporations  were   paying   over   2.5   billion,   amounting   to   over   half   of   all   Federal   taxes   (which   constituted  in  turn  one-­third  of  Federal  revenue).  This  led  to  a  rapid  growth  of  the   Bureau  of  Inland  Revenue,  and  the  institutionalization  of  a  technocratic  bureaucracy   with  a  high  degree  of  discretion  in  enforcing  tax  law,  in  particular  in  determining   what  constituted  `excess  profits  Equally,  the  high  corporate  taxes  turned  the  major   corporations  into  tax  resisters  (Brownlee  1989,  1617-­1618).     ¶ ¶ ¶Introduction   13   Both  the  individual  and  the  corporate  income  tax  in  the  US  were  based  on  citizenship:   US  citizens,  and  corporations  formed  under  US  laws,  were  taxed  on  their  income   from  all  sources  worldwide.  Companies  formed  under  the  laws  of  other  countries   were,   however,   only   liable   to   tax   on   US-­source   income.   Thus   the   place   of   management  or  control  of  a  corporation  was  irrelevant  under  the  US  approach.  Profits   made  abroad  were  therefore  not  liable  to  US  tax  if  the  business  were  carried  out  by  a   foreign-­incorporated  company,  but  all  corporations  formed  in  the  US  were  subject  to   tax  on  their  worldwide  income,  including  dividends  or  other  payments  received  from   foreign  affiliates.  However,  this  was  mitigated  by  the  introduction  into  US  law  of  a   novel  feature,  the  provision  of  a  credit  against  US  tax  for  the  tax  paid  to  a  foreign   country  in  respect  of  business  carried  on  there  (Revenue  Act  1918,  ss.222  &  238).     The  foreign  tax  credit  was  introduced  following  complaints  by  American  companies   with  branches  abroad  that  high  US  taxes  disadvantaged  them  in  relation  to  local   competitors.  It  seems  to  have  been  the  suggestion  of  Professor  Adams  of  Yale,  at  the   time  the  economic  adviser  to  the  Treasury  Department,  who  accepted  the  concept  that   a  foreign  country  had  the  prior  right  to  tax  income  arising  from  activities  taking  place   there.  A  foreign  tax  could  previously  be  deducted  as  an  expense  before  arriving  at   taxable  income.  To  allow  it  to  be  credited  not  only  meant  a  greater  reduction  in  US   tax  liability,  it  entailed  an  acknowledgment  of  the  prior  right  of  the  foreign  country  to   tax  profits  earned  there  at  source.     However,   in   order   to   prevent   liability   to   US   taxes   being   pre-­empted   by   other   countries,  this  was  quickly  subjected  to  limitations,  in  the  1921  Revenue  Act.  The   credit  was  amended  to  prevent  it  being  used  to  offset  tax  on  US-­source  income,  by   providing  that  it  could  not  exceed,  in  relation  to  the  US  tax  against  which  it  was  to  be   credited,  the  same  proportion  that  the  non-­US  income  bore  to  US  income.  The  extent   to  which  foreign  taxes  may  be  credited  has  been  subject  to  different  limitations  at   various  times:  initially  the  credit  was  `over-­all  allowing  combination  of  all  income   from  foreign  jurisdictions;;  but  in  1932  a  `per-­country limitation  was  introduced,  so   that  the  credit  for  taxes  paid  in  each  country  could  not  exceed  the  US  taxes  due  on   income  from  that  country,  although  some  carry-­back  and  carry-­forward  was  allowed   after  1958,  and  taxpayer  election  between  the  overall  and  per-­country  limit  was   allowed  from  1961  to  1976.  The  U.S.  Tax  Reform  Act  of  1986  introduced  a  new   combination  of  the  per-­country  and  overall  limitation  by  establishing  `baskets  of   income to  separate  high-­taxed  and  low-­taxed  foreign  income  for  credit  purposes.   Other  countries  which  have  introduced  the  foreign  tax  credit  have  also  used  a  variety   of  approaches  to  limitation.  Further,  in  the  case  of  alien  residents  of  the  US,  the  1921   Act  provided  that  it  was  only  allowable  if  their  country  offered  US  residents  the  same   credit.  However,  the  tax  credit  was  extended  by  allowing  taxes  paid  by  US-­owned   foreign-­incorporated     ¶ ¶ ¶Introduction   14   subsidiaries  to  be  credited  against  the  tax  of  their  US  parent,  in  relation  to  dividend   remittances  from  them  (see  further  Chapter  5  below).  Although  the  Netherlands  had   allowed  a  tax  credit  from  1892  for  traders  deriving  income  from  its  then  colonies  in   the  East  Indies,  the  American  measure  seems  to  have  been  the  first  general  unilateral   foreign  tax  credit  (Surrey  1956,  p.818).   3.  The  Campaign  against  International  Double  Taxation   The  introduction  of  direct  taxes  on  business  income,  and  the  rise  in  their  rates  after   1914,  immediately  brought  home  to  businessmen  the  relative  incidence  of  such  taxes   as   a   factor   in   their   competitive   position.   To   those   involved   in   any   form   of   international  business,  the  interaction  of  national  taxes  became  an  immediate  issue,   and  led  to  the  identification  of  the  problem  of  `international  double  taxation   3.a  Britain  and  Global  Business   This  was  perhaps  most  acutely  felt  in  Britain,  due  to  the  way  taxation  of  residents  had   come  to  cover  the  worldwide  income  of  all  companies  `controlled from  Britain.  As   the  rate  of  tax  rose  steeply  in  Britain,  and  other  countries  also  introduced  income   taxes,  globally-­active  businesses  based  in  the  UK  quickly  became  conscious  of  their   exposure  to  multiple  taxation.  Although  there  had  been  some  complaints  when  an   income-­tax   was   introduced   in   India   in   1860,   which   were   renewed   after   other   countries   within   the   Empire   also   did   so   in   1893,   it   was   not   until   1916   that   a   temporary  provision  for  partial  relief  was  introduced  (UK  Royal  Commission  1919-­ 20,  Appendix  7c)  .  The  Board  of  Inland  Revenue  negotiated  arrangements  within  the   British  Empire  to  allow  the  deduction  from  the  rate  of  UK  tax  of  the  rate  of  Dominion   or   colonial   tax   on   the   same   revenue,   up   to   half   of   the   UK   tax   rate,   and   these   arrangements  were  embodied  in  the  1920  Finance  Act  (s.27).  Nevertheless,  despite   strong  pressure  from  business  interests,  the  Revenue  would  not  accept  the  exemption   of  foreign  source  income,  nor  even  a  credit  along  US  lines.  This  view  was  approved   by  the  report  of  the  Royal  Commission  on  Taxation  of  1920.     Business  pleaded  for  equality  in  the  conditions  of  competition  with  foreign  firms   importing  into  the  UK.  The  administrators  responded  that  tax  equity  required  the   same  treatment  of  the  income  of  all  UK  residents  no  matter  what  its  source.  They   acknowledged  that  a  case  could  be  made  to  relieve  foreign  investors  in  companies   controlled   from   Britain,   but   this   would   depend   on   international   arrangements   to   facilitate  movements  of  capital,  and  require  negotiation  with  the  foreign  countries  of   residence.  The  Revenue  considered  that  the  relief  arrangements  negotiated  with  the   Dominions  were  justified  because  there  was  hardship  in  contributing  twice  for  what         ¶ ¶Introduction   15    could   be   considered   to   be   the   same   purpose   -­   `the   purposes   of   the   British   Empire";;with  other  countries  there  was  no  such  shared  purpose.  In  addition,  the   differences  in  national  tax  systems,  as  well  as  language  and  travel  problems,  would   make  the  negotiation  of  international  arrangements  very  difficult.  Nevertheless,  the   Revenue   conceded,   it   might   become   expedient   to   grant   some   relief,   to   obtain   favourable   treatment   from,   or   avoid   retaliation   by,   foreign   countries.   The   Royal   Commission  suggested  that  such  arrangements  could  perhaps  be  negotiated  by  a   series  of  conferences,  possibly  under  the  auspices  of  the  League  of  Nations.     To  those  involved  in  international  business,  the  unfairness  of  overlapping  taxation  of   the  same  income  seemed  plain,  and  the  solution  to  the  problem  seemed  quite  simple.   Sir  William  Vestey,  the  beef  magnate,  argued  strongly  in  his  evidence  to  the  British   Royal   Commission   that   he   should   be   put   in   a   position   of   equality   with   his   competitors.  He  singled  out  the  Chicago  Beef  Trust,  which  paid  virtually  no  UK  tax   on  its  large  sales  in  Britain:  not  only  did  it  escape  UK  income  tax  on  its  business   profits  by  being  based  abroad,  it  also  avoided  tax  on  its  sales  in  Britain  by  consigning   its  shipments  f.o.b.  to  independent  importers,  so  that  its  sales  were  considered  not  to   1 take  place  in  Britain.  The  Vestey  group  had  moved  its  headquarters  to  Argentina  in   1915,  to  avoid  being  taxed  at  British  wartime  rates  on  its  worldwide  business,  but  Sir   William  expressed  his  preference  to  be  based  in  London.  He  argued  for  a  global   approach  to  business  taxation:     In  a  business  of  this  nature  you  cannot  say  how  much  is  made  in  one  country  and   how  much  is  made  in  another.  You  kill  an  animal  and  the  product  of  that  animal  is   sold  in  50  different  countries.  You  cannot  say  how  much  is  made  in  England  and   how  much  is  made  abroad.  That  is  why  I  suggest  that  you  should  pay  a  turnover  tax   on  what  is  brought  into  this  country.  ...  It  is  not  my  object  to  escape  payment  of  tax.   2 My  object  is  to  get  equality  of  taxation  with  the  foreigner,  and  nothing  else.   The   process   of   lobbying   on   behalf   of   business   was   quickly   internationalised,   principally  through  the  International  Chamber  of  Commerce  (the  ICC),  which  was  set   up  in  Paris  in  1920  (although  its  prehistory  goes  back  to  1905).  From  its  founding   meeting  the  question  of  international  double  taxation  was  high  on  the  ICC's  agenda   (as  it  has  remained  ever  since),  and  it  set  up  a  committee  which  began  its  task  with  a   simple   faith   that   an   evident   wrong   could   be   simply   righted.   As   its   chairman,   Professor  Suyling  put  it  in  the  committee's  report  to  the  2nd  ICC  Congress  in  Rome   in  1923:     If  only  the  principle  that  the  same  income  should  only  be  taxed  once  is  recognised,   the  difficulty  is  solved,  or  very  nearly  so.  It  only  remains  then  to  decide  what   constitutes   the   right   of   one   country   to   tax   the   income   of   a   taxpayer   in                                                                                                     1  The  Trust  was  of  course  subject  to  US  taxes,  but  unlike  the  UK,  these  did  not  apply  to  subsidiaries   formed  abroad,  e.g.  in  Argentina.   2  UK  Royal  Commission  on  Income  Tax  1920,  Evidence,  p.452  Question  9460.    Introduction   16   preference  to  any  other  country.  It  does  not  seem  probable  that  there  would  be  any   serious  difference  on  the  matter.   Support  for  action  was  given  by  a  resolution  passed  at  the  International  Financial   Conference   at   Brussels   in   1920,   and   the   matter   was   referred   to   the   Financial   Committee  of  the  League  of  Nations.  Unfortunately,  however,  significant  differences   quickly  became  apparent,  both  as  to  what  constitutes  international  double  taxation,   and  how  to  prevent  it.   3.b  National  and  International  Double  Taxation   International  double  taxation  is  normally  defined  in  the  terms  stated  much  later  by  the   OECD  Fiscal  Committee:   The  imposition  of  comparable  taxes  in  two  (or  more)  states  in  respect  of  the  same   subject-­matter  and  for  identical  periods.  (OECD  1963,  para.  3).   This  definition  obviously  hinges  on  the  important  word  `comparable  As  we  have   seen,  there  were  significant  differences  between  countries  both  in  the  way  they  taxed   business  profits,  and  in  what  they  considered  to  be  double  taxation.  The  issue  of   international  double  taxation  was  therefore  one  aspect  of  the  more  general  question  of   what  constitutes  double  taxation.     Double  taxation  is  a  pejorative  term  for  an  elusive  concept.  Legal  or  juridical  double   taxation  only  occurs  if  the  same  tax  is  levied  twice  on  the  same  legal  person.  This  is   rare,  although  more  frequently  different  taxes  are  levied  on  the  same  income  of  one   person:   for   instance,   individual   income   normally   bears   both   social   security   contributions   and   general   income   taxes.   The   problem   is   exacerbated   by   the   interposition  of  fictitious  legal  persons,  mainly  the  trust  and  the  company.  If  an   individual  invests  or  runs  a  business  through  a  company,  and  income  tax  is  levied   both  on  the  company's  profits  and  on  that  proportion  of  those  profits  paid  to  the   individual  as  dividends,  it  could  be  said  that  the  same  stream  of  income  has  been   taxed  twice,  although  in  the  hands  of  different  legal  persons.  This  is  referred  to  as   economic  double  taxation,  and  there  are  different  views  as  to  whether  it  should  be   relieved,  and  if  so,  how.   A  single  income  tax  applied  to  both  individuals  and  companies,  as  was  the  case  in  the   UK   from   1842   to   1965,   most   directly   raises   the   question   of   economic   double   taxation.  Hence,  in  the  UK  relief  was  given  by  allowing  companies  to  deduct  at   source  the  income  tax  on  due  on  dividends  paid  to  shareholders  and  credit  the  total   sums  against  the  tax  due  on  the  company's  own  profits.  This  approach  essentially   treats  the  company  as  a  legal  fiction,  a  mere  conduit  for  investment.  On  the  other   hand,  under  the  so-­called  `classical  approach  favoured  until  now  by  the  USA,  the   Netherlands,  and  other  countries,  the  company  is  considered  to  be  separate  from  the   shareholders  who  invest  in  it,  and  therefore  both  individuals  and  corporations  are   separately  taxed  on  their  income.  This  means  that  distributed  profits  are  taxed  more   heavily  than  those  retained  within  the  corporation.  Systems  which  wholly  or  partially     ¶ ¶

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