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Taxing Income Earned Outside All Jurisdictions

Posted on August 8, 2016 by Shu Chin Ng

Shu Chin NgShu Chin Ng is an LLM candidate at New York University School of Law.

The author wishes to thank professor H. David Rosenbloom for his helpful comments on previous drafts of this article, and Hiroyuki Kurihara, Iris Schomäcker, and professor Yoshihiro Masui for their help with their respective countries' laws. All errors are the author's.

This article was selected as a winning entry in Tax Analysts' annual student writing competition.

In this article, the author proposes the creation of a world tax authority to tax the income from international areas such as the high seas and outer space.


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Man has managed to commercialize almost all the land on the planet. However, uncommercialized areas beyond the jurisdiction of any country, such as the high seas and space, remain.

Commercial activity in those international areas has historically been limited to specialized industries usually addressed through special tax regimes. However, wider commercial activity in international areas is imminent. Companies are preparing to mine the seabed beyond continental shelves for mineral nodules.1 Microsoft Corp. recently unveiled Project Natick to manufacture and operate underwater data centers,2 and Luxembourg has said it will invest in asteroid mining.3 Those projects and others like them will give rise to profitable enterprises in international areas.

Those activities raise tax problems because they will not fall under the regimes meant to address specific industries and will instead fall under countries' general tax systems. Depending on a country's laws, the activities could be subject to tax. Countries' different approaches allow some companies to earn income subject to tax nowhere, leading to economically inefficient, tax-driven transactions.

If international areas are to be commercialized equitably, changes must be made to the international tax system. This article argues that a world tax authority, not individual countries, should tax the income from international areas. The high seas and space are the common heritage of mankind and are not meant to be exploited solely by any one country. If income sourced from those areas is to be taxed, mankind as a whole should have the taxing authority.


I. Background


Theoretically, a country taxes companies either on their worldwide income or on income sourced in that country. In practice, most tax systems exhibit a mix of resident and source country rules.4

A. Resident Country Treatment

 


In determining whether income is subject to tax, some countries generally consider source immaterial and tax all income earned by their residents regardless of where it is earned. For income earned outside the country's territory, special rules are likely to apply, so residence countries will generally face fewer difficulties in taxing income sourced in international areas.

 

B. Source Country Treatment

 


Other countries tax income sourced in their jurisdiction. Consequently, source countries' treatment of income earned in international areas would depend on whether a particular country considers those areas part of its jurisdiction.

 


  • 1. International Areas Outside Jurisdiction




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Source countries will not ordinarily tax income earned in international areas because those areas are considered outside their territories. A country that taxes based on its jurisdiction over an area would be unable to tax activities occurring in international areas. Under international law, no country may assert sovereignty over any part of the high seas or outer space, including the moon and other celestial bodies.5 Because the source country's power to tax depends on its jurisdiction over the object of taxation,6 asserting jurisdiction to tax international areas would violate international law.

The application of source country rules to activities in international areas is illustrated by Whampoa Dock, a Hong Kong case.7 The taxpayer was a ship salvager that received a fee for salvaging a vessel that had run ashore in the Paracel Islands. The services rendered included refloating the vessel and making it seaworthy, and towing the vessel from the Paracel Islands to Hong Kong, including through Hong Kong territorial waters as well as international waters. Because all but the last 3 miles of the profit-producing salvage operations took place outside Hong Kong, the court held that the profits arose outside the country.

Source countries are likely to treat income earned in international areas similarly. Because the income is not likely to be considered to arise in the country, it is not likely to be subject to tax there.


  • 2. International Areas Within Jurisdiction




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A country can have limited jurisdiction over activities on the high seas and assert taxing rights based on source principles if a vessel flies the country's flag under specific conditions.8 A similar regime applies in space.9 Consequently, a source country could assert that income earned on board vessels flying its flag should be considered sourced within its borders and hence subject to its tax.

However, a company can easily and legally circumvent that jurisdiction.10 It can eliminate a source country's assertion of tax by not registering a vessel at all. However, not possessing a flag can cause operational difficulties because flagless vessels are not protected by international law and could be subject to seizure.11

If the company wants to register the vessel and receive the protection of international law, it can register in a country that subjects income sourced in international areas to no or low taxes, a common tactic. "Flag of convenience" countries permit foreign shipowners to register their ships in countries where they have little connection12 and that tax income derived from ships at low or zero rates.

C. Mixed-Basis Country Treatment

 


Few countries use a pure source- or residence-based system. Most tax the worldwide income of resident persons, with reduced taxation for foreign income to account for the inevitable double taxation that results from using a pure residence-based system.13

 

Examining the mixed-basis country is particularly relevant in light of the international trend toward more favorable treatment of foreign-source income.14 Many developed countries have shifted to exemption systems, especially for dividends paid from a foreign subsidiary.15

This article will not discuss credit systems because no nontaxation problems arise under them. By contrast, exemption systems are far likelier to encounter problems in taxing income from international areas. A hypothetical best illustrates that.

Suppose company XCo, resident in Country A, wants to mine deep sea minerals using a structure in the Atlantic Ocean, an international area. The structure is not registered in any country and therefore is not subject to the jurisdiction of any country. XCo can carry out the mining using one of two methods that would potentially result in zero taxation:

  • Direct Method. XCo conducts the mining activity directly. This method is similar to creating a branch operation in a foreign country, although there are important differences under some countries' laws. If A's tax system exempts foreign branch income, XCo generally will not be subject to tax on its activities in international areas. However, XCo might not be eligible for some countries' exemption schemes. For example, XCo might not be taxed under U.K. law but likely would be under Singaporean law.
  • Conduit Method. XCo incorporates a foreign subsidiary in Country B, which has a favorable tax regime. The mining activities could be conducted through the subsidiary. If A exempts dividends from a foreign subsidiary and B is a source country that does not tax activities in international areas, the income generally will not be subject to tax in either country. That foreign dividend exemption is common, especially if A and B have a tax treaty.16 However, XCo might not be eligible for some countries' exemption schemes, depending on the requirements A imposes. For example, XCo's dividends would likely be tax exempt in Germany but not in Japan.


Countries treat economically similar income from international areas differently based on the structures of their tax systems. For some countries, however, it is simple to structure activities in international areas so that the income is taxed nowhere, a phenomenon that occurs even in major economies with sophisticated tax laws.


II. Problems With the System


The tax treatment of income sourced in international areas is problematic for three reasons. First, it permits activities in international areas to avoid taxation globally, causing economic distortion and leading to inefficient resource allocation. Companies might also be able to exploit the gap by shifting profits to international areas to benefit from lower effective tax rates. That problem is exacerbated by the trend of countries moving from pure residence systems toward more source- and mixed-basis systems.

Second, how source countries should treat income-producing structures in international areas is unclear. They can tax income produced from those structures only if they have a jurisdictional claim over them, which can be difficult to determine.

Third, even if the difficulties in taxing activities sourced in international areas are resolved, countries will still face the practical problem of enforcing their tax laws in those enormous areas.

A. Potential Nontaxation

 


The tax treatment of activities in international areas potentially allows some income to go entirely untaxed. If a company is fortunate enough to be resident in a pure source-basis country or in some mixed-basis countries, it can easily structure activities to receive that treatment.

 

That is problematic under the single tax principle, which states that cross-border income should be taxed exactly once.17 It is based on the theoretical observation that if income is taxed more or less than that, the increased or reduced tax burden would create an inefficient incentive to invest in cross-border or domestic transactions.18 That behavior would erode the country's tax base because taxes could be avoided by investing abroad instead of domestically.19

The single tax principle has been disputed, but countries and world organizations do seem to follow it,20 although possibly as an attempt to justify an increase in revenue collected rather than as a principle of international tax law.

Even if the single tax principle is correct, it is debatable whether it should be applied in this context. Nontaxation of income sourced in international areas is caused by the laws of a company's country of residence, not by a cross-border mismatch of tax laws. The single tax principle is meant to address cross-border mismatches, not domestic treatment of income.21 It should not be used to criticize a country's exemption of income based on its sovereign right to set its own tax policies.22

Regardless of the correctness of the single tax principle generally or its application to income earned in international areas specifically, the ill effects resulting from complete nontaxation still exist.

B. Legal Uncertainty in Classification

 


Activities occurring on a registered ship or vessel would be subject to the registered country's taxing jurisdiction, even if the ship operates in international areas. However, international law addresses only ships or vessels and provides no guidance on the appropriate treatment of other structures in the high seas.23 Although countries may define ships, vessels, and their registration under their laws, it is unclear whether there are limits. Moreover, international conventions define ships and vessels differently, with some conventions not defining them at all.24 That is problematic because a source country's jurisdiction over a structure depends on whether the structure is registered as a ship there.

 

The appropriate treatment for objects in space is clearer. Under the Treaty on Principles Governing the Activities of States in the Exploration and Use of Outer Space, Including the Moon and Other Celestial Bodies, a country retains jurisdiction and control over objects launched into space if carried on its registry.25 Consequently, a company can register its structures and thereby submit to a country's taxing jurisdiction in exchange for protection under international law.

C. Enforcement Difficulties

 


Enforcing tax laws in international areas will be difficult for all countries. For a country to enforce its tax laws, it must have access to taxpayers' assets. Even if assets in international areas are technically under a country's jurisdiction, practically speaking they are not. International areas are so large that if the assets are mobile, countries might not be able to find or seize them.

 

Auditing a company's physical assets to determine whether they correspond to the information in the accounts and books will be equally difficult. Enforcing tax laws against individuals earning income in international areas is also likely to be difficult. It is pointless to enact tax laws for international areas if countries are unable to enforce them.


III. Possible Solutions


There are two possible ways to tax income earned in international areas. First, countries could adopt various unilateral solutions to address specific problems caused by their own tax systems. Second, they could create a world tax authority with jurisdiction over international areas, a multilateral solution that would solve all the problems.

A. Unilateral Action

 


Although unilateral solutions are easier to implement and would alleviate individual country problems, they are unlikely to be as effective as a multilateral solution. Further, although those solutions might help address legal questions, they cannot resolve enforcement concerns.

 

Source countries are unable to tax income arising in international areas. They can solve that problem by modifying their rules to re-source that income within their borders. For example, instead of taxing profits arising in or derived from Hong Kong, the country could tax all corporate profits not arising in or derived from foreign countries, which would allow it to tax income from international areas. However, more than one source country implementing that plan would result in double taxation. A solution that can be implemented by only one country is inadequate.

Some mixed-basis countries have difficulty taxing income sourced in international areas. To solve that, they can emulate features of other mixed-basis countries that have no difficulty taxing the income. For example, Singapore's rules might provide a good model because they require that foreign-source income be taxed before it can benefit from exemptions.

Unilateral solutions are easier to achieve because they do not require consensus among countries. If a multilateral approach is preferred, countries might still wish to enact legislation unilaterally to address concerns while consensus is built. A multi-country plan order might organically spring from individual country practices, which could pressure noncooperating countries to join the plan.

Problematically, countries have no incentive to address the nontaxation of activities occurring in international areas, with those that facilitate nontaxation reaping economic benefit. Empirical evidence has shown that tax havens experience more economic growth than comparably situated countries,26 even if they permit shifting income without shifting substance. That effect would be even stronger if the system required some substance to be shifted along with income. If that happened, foreign direct investment would increase employment and technological transfers and improve the skills of the local population.27 Given that strong incentive, countries that use the source-basis system or exempt foreign active income would have no reason to modify their systems to address nontaxation of activities in international areas.

Other countries might try to force source countries to change their tax systems, but coercion is undesirable. The OECD's drive against harmful tax competition was effective in pressuring smaller countries to reform their systems in accordance with the organization's demands,28 but that kind of pressure can be considered an infringement on sovereignty.29

Further, even if all countries reform their systems to tax income from international areas, they would still have difficulty enforcing those laws because the activities are for practical purposes beyond their jurisdiction.

B. Multilateral Action: A World Tax Authority

 


Creating a world tax authority is possible but would be politically challenging. Despite that, it would be best able to address all the tax questions raised by activities in international areas. Its mission should be broad to avoid difficulties in determining the appropriate treatment of non-covered activities.

 


  • 1. Taxation




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The tax imposed by the world tax authority should be expansive so that all activities in the international areas are clearly subject to it, which would avoid creating an economic incentive to invest in only some types of activities in international areas.

Double nontaxation would no longer be a concern if a world tax authority were created. There are several ways to address possible double taxation.

a. Specialized industries. The suggested world tax authority should exempt specialized industries because countries often have special rules to address them. Exemption might also encourage countries to agree to the creation of a world tax authority because it would reduce the risk of upsetting existing tax arrangements.

b. Residence countries. To prevent double taxation if both the world tax authority and a residence country tax the income from international areas, countries should provide either tax credits or exemptions for international areas.

c. Source countries. To prevent double taxation that might occur if a source country considers income from international areas to be sourced within its borders, countries must align their sourcing rules with the world authority's ability to tax.

d. Mixed-basis countries. There could be double taxation if a mixed-basis country refuses to exempt income from international areas, which might occur if the world authority's tax rate is too low. To prevent that, countries should amend their laws to allow branch income from international areas to fall under their exemption schemes. Further, unless countries allow their companies to invest in international areas using the conduit method, they should provide a foreign tax credit or exemption scheme for income from foreign dividends.


  • 2. Enforcement




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The world tax authority would need a strong enforcement mechanism. Day-to-day enforcement and tax assessment should be done by examining company books with the help of countries where companies are resident. By examining the books, the world tax authority could ensure the appropriate tax is paid for income sourced in international areas. If the world tax authority suspects evasion, it could conduct site visits and audits.

A world tax authority would be more efficient because it could reap economies of scale. Business activities in international areas as well as the related tax implications and applicable rules are likely to be unique. Auditing those activities, especially if site visits are necessary, would require specialized knowledge, and many individual countries would likely find it difficult to build that knowledge. Further, a single country, especially if smaller or developing, would find it impossible to patrol and catch renegade businesses intent on avoiding authorities. An international organization would be better suited for that task because it would have dedicated resources to inspect activities in international areas.


  • 3. Feasibility




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Although it might seem strange to allow a non-state actor to impose a tax, it has been done before. The International Seabed Authority (ISA) was created to regulate mineral resources in the seabed and ocean floor and subsoil, areas deemed "beyond the limits of national jurisdiction."30 Some ISA measures, including the levy entities must pay to exploit the area, can serve as a guideline on the feasibility of taxing income from international areas. For instance, entities must receive ISA approval before exploiting the area and must pay the ISA a minimum to operate through a royalty system, a combination of royalty and profit-sharing systems, or an alternative system.31 The revenue is used to pay administrative expenses, compensate developing countries suffering economically from activities in the area, and equitably share the benefits derived from activities in the area.32

Both developed and developing countries saw the benefits of ISA and reached political consensus to create it. Developing countries proposed the idea, which developed countries would not accept. Through numerous meetings and consultations initiated by the U.N. secretary-general, consensus was achieved, and the U.N. General Assembly eventually adopted an implementation agreement in 1994.33

That kind of conversation today might result in consensus on creating a world tax authority because, similar to the situation in 1994, all countries have an interest in solving the problem of the international areas.

Developing countries have an interest in pushing for the regulation and sharing of benefits from the activities in international areas. The discovery of minerals on the seabed that could be commercially exploited led to the United Nations Convention on the Law of the Sea (UNCLOS).34 Developing countries believed those resources had to be regulated and shared as the common heritage of mankind.35 As the commercial exploitation of international areas becomes more possible, developing countries are likely to consider it in their interest to widely distribute the resulting benefits.

It might seem like developed countries would object to the creation of a world tax regime to share the benefits of commercial exploitation of international areas because their technologically advanced companies are most likely to benefit from unhampered development of those areas. However, the negotiation and creation of the ISA indicate that creating a world tax authority for international areas is not as far-fetched as it might first appear.

Apart from the specific interests of developing and developed countries, the "common heritage of mankind" principle might provide an impetus to create a world tax authority. However, both the persuasiveness and interpretation of the principle are unclear.


  • 4. Common Heritage of Mankind




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Treaties require that international areas be used for the benefit of all mankind. UNCLOS and the space treaty, governing the high seas and outer space, respectively, contain language referring to the principle of the common heritage of mankind and require that the areas be used for the benefit of all mankind.36

While it is clear that those treaties embrace the principle, it is not clear whether international law uses it in a binding way.37 A country is bound by international law if it accedes to a treaty containing that law or the law attains the status of customary international law. Not all countries have signed the space treaty and UNCLOS; therefore, not all countries are bound by them. Countries also interpret the principle differently, so it cannot be deemed part of customary international law.38 Developed countries have expressed "general distaste" for the principle's use in treaties after a frustrating experience with the principle.39

The principle has several possible interpretations, including that the common heritage of mankind is a "generalized mission statement" or "obligation not to cause a detriment" to other countries.40 That reading is based on country practices in the context of space law but does not necessarily support the creation of a world tax authority.

The common heritage principle cannot merely oblige countries to avoid causing detriment to other countries. Both UNCLOS and the space treaty envision all of mankind benefiting from use of the international areas.41 Theoretically, all countries can enjoy the common heritage as long as no one uses international areas to the detriment of others. For example, all countries can benefit from exploitation of international areas by either taxing their companies that invest in those areas or using enterprises to exploit the resources found there. However, practically speaking, only the richest and most powerful countries will be able to benefit under that kind of system because only they have private companies and government enterprises with the means to profitably invest in international areas. A system that effectively benefits only the top 1 percent of countries could not have been intended by many countries party to UNCLOS and the space treaty.

That analysis is borne out by the history of the phrase "common heritage of mankind." It was introduced into UNCLOS because developing countries feared that only rich, developed countries with advanced technology would benefit from the resources in the high seas.42 Given that, the phrase cannot represent the idea that countries are obliged only to avoid harming other countries. A better interpretation would be that countries are obliged to share the benefits stemming from their exploitation of the international areas.

Consequently, if countries accept that benefits stemming from the exploitation of international areas must be shared by all under the common heritage principle, that would be a strong argument for taxing activities in international areas and redistributing the resulting revenue.


IV. Conclusion


There is little commercial activity in international areas, but that is likely to change dramatically. Countries should modify their tax laws to prevent companies from avoiding future taxation on their activities in international areas.

Easily implemented unilateral solutions cannot address all the issues, however. Countries should attempt the politically difficult task of creating a world tax authority, the only way to successfully address those concerns.


FOOTNOTES


1 Robert Ferris, "Deep Sea Mining Company Reveals New Gear," CNBC (Nov. 11, 2015).

2 John Markoff, "Microsoft Plumbs Ocean's Depths to Test Underwater Data Center," The New York Times, Jan. 31, 2016.

3 Jonathan Amos, "Luxembourg to Support Space Mining," BBC News (Feb. 3, 2016).

4 Kevin Holmes, International Tax Policy and Double Tax Treaties -- An Introduction to Principles and Application, Chap. 2.1 (2014).

5 United Nations Convention on the Law of the Sea (UNCLOS), article 88 (Dec. 10, 1982); and "Treaty on Principles Governing the Activities of States in the Exploration and Use of Outer Space, Including the Moon and Other Celestial Bodies," article 2 (Oct. 10, 1967) (space treaty).

6 Santa Clara Estates Company Case (supplementary claim), 9 R.I.A.A. 455 (British-Venezuelan Commission 1903).

7Commissioner of Inland Revenue v. The Hong Kong and Whampoa Dock Co. Ltd., [1960] H.K.L.R. 166. While the case might be criticized for how it addressed the possibility of apportionment, it is still good law on sourcing income earned on the high seas. See Michael Littlewood, "The Problem With the Dock Case," 29 H.K.L.J. 59, 72 (1999).

8See Yoshifumi Tanaka, The International Law of the Sea 152-155 (2015); and UNCLOS, supra note 5, at articles 91, 92.

9 Article 13 of the space treaty says countries "shall retain jurisdiction and control" over objects launched into outer space if those objects are carried on that country's registry. See space treaty, supra note 5.

10 Tanaka, supra note 8, at 157.

11 Alexander Severance and Martin Sandgren, "Flagging the Floating Turbine Unit: Navigating Towards a Registerable, First- Ranking Security Interest in Floating Wind Turbines," 39 Tul. Mar. L.J. 1, 15 (2014).

12 Tanaka, supra note 8, at 157.

13 Hugh J. Ault and Brian J. Arnold, Comparative Income Taxation: A Structural Analysis 446-448 (2010).

14 Adam H. Rosenzweig, "Source as a Solution to Residence," 17 Fla. Tax. Rev. 471, 473-474 (2015). See also The President's Advisory Panel on Federal Tax Reform, "Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System," at 103, 132 (2005).

15 Peter Mullins, "Moving to Territoriality? Implications for the U.S. and the Rest of the World," Tax Notes Int'l, Sept. 4, 2006, p. 839.

16See article 10 of the OECD Model Tax Convention on Income and on Capital (2015).

17 Reuven S. Avi-Yonah, "International Taxation of Electronic Commerce," 52 Tax L. Rev. 517, 534 (1997).

18Id. at 518.

19Id. at 519.

20 Avi-Yonah, "Who Invented the Single Tax Principle?: An Essay on the History of U.S. Treaty Policy," 59 N.Y.L. Sch. L. Rev. 305, 307 (2014-2015).

21 Avi-Yonah, supra note 17, at 517.

22 Mitchell A. Kane, "Strategy and Cooperation in National Responses to International Tax Arbitrage," 53 Emory L.J. 89, 114 (2004).

23 Rebecca K. Richards, "Deepwater Mobile Oil Rigs in the Exclusive Economic Zone and the Uncertainty of Coastal State Jurisdiction," 10 J. Int'l Bus. & L. 387, 402 (2011).

24 Severance and Sandgren, supra note 11, at 15-18.

25 Space treaty, supra note 5, at Article VIII.

26 James R. Hines Jr., "Do Tax Havens Flourish?" 19 Tax Pol'y & Econ. 65 (2005).

27 Elizabeth Chorvat, "The Tax Calculus of Corporate Locational Decisions," 32 Berkeley J. Int'l L. 292, 295 (2014).

28See OECD Committee on Fiscal Affairs, "Harmful Tax Competition: An Emerging Global Issue" (2008).

29See Vaughn E. James, "Twenty-First Century Pirates of the Caribbean: How the Organization for Economic Cooperation and Development Robbed Fourteen CARICOM Countries of Their Tax and Economic Policy Sovereignty," 34 U. Miami Inter-Am. L. Rev. 1 (2002).

30 UNCLOS, supra note 5, at article 1(1)(1).

31Id. at article 153, Annex III; and Agreement Relating to the Implementation of Part XI of the United Nations Convention on the Law of the Sea of 10 December 1982, at annex section 8(1)(c), (d) (1994) (UNCLOS implementation agreement).

32 UNCLOS, supra note 5, at article 173(2)(a); and UNCLOS implementation agreement, supra note 31, at section 7.

33 Tanaka, supra note 8, at 179.

34 U.N. Division for Ocean Affairs and the Law of the Sea, "The United Nations Convention on the Law of the Sea: A Historical Perspective" (1998).

35See Robin Rolf Churchill and Alan Vaughan Lowe, The Law of the Sea 223-229 (1999).

36 UNCLOS, supra note 5, at article 136; and space treaty, supra note 5, at article 1. Article 11 of the Agreement Governing the Activities of States on the Moon and the Other Celestial Bodies (Dec. 5, 1979) introduced the principle of the common heritage of mankind into space law. See Tanaka, supra note 8, at 171.

37 Jennifer Frakes, "The Common Heritage of Mankind Principle and the Deep Seabed, Outer Space, and Antarctica: Will Developed and Developing Nations Reach a Compromise?" 21 Wis. Int'l L.J. 409, 410-411 (2003).

38Id. at 411.

39Id. at 419-420.

40 Ricky J. Lee, Law and Regulation of Commercial Mining of Minerals in Outer Space 159 (2012).

41See space treaty, supra note 5, at article 1; and UNCLOS, supra note 5, at article 140(1).

42 Philip A. Burr, "The International Seabed Authority," 29 Suffolk Transnat'l L. Rev. 271, 274 n.21 (2006).


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