Tax Analysts Blog

Rethinking Double Taxation

Posted on Jun 8, 2016

Certain tenets of tax policy are so thoroughly ingrained in our thinking that to question them seems almost sacrilegious. Among these is the doctrine that corporate income should be taxed once and only once. Typically that singular occurrence of corporate tax is imposed by the country with the strongest jurisdictional claim over the relevant corporate entity (residence-based taxation) or the economic activity that gave rise to the income (source-based taxation). It naturally follows that double taxation is an abomination that must be eliminated at all costs. This reflexive aversion to double taxation heavily influences our nation’s tax laws. It also features prominently in the international norms set by multilateral bodies such as the OECD.

Not many people have the gumption to challenge this orthodoxy, even if limited to the confines of academic discourse. One person who does is New York University law professor Daniel Shaviro. His excellent book, Fixing U.S. International Taxation, published by the Oxford University Press, is at the top of my summer reading list. I highly recommend it, in part because it forces a rethink of your understanding of how international taxation is supposed to work. To that end, I’m taking this opportunity to repurpose a clever thought experiment taken from Shaviro’s book. (The details of the hypothetical are slightly modified for purposes of illustration.)

 Assume that a multinational enterprise is doing business in 20 different countries, excluding the country where it claims residence for tax purposes. Let’s call these 20 jurisdictions the source countries. Further, let’s assume each of those 20 governments intends to tax the firm’s income under a combined reporting system. Separate entity accounting is ignored, so we need not worry about whether the firm’s local affiliates are organized as branches or subsidiaries. As a result, the same aggregate pool of earnings would be subject to tax 20 different times. We’re also assuming that foreign tax credits don’t exist. In short, there is no relief from the agony of double taxation. Let’s call this Option A.

Your other choice, Option B, is premised on the same facts – except the firm’s earnings would be taxed only once, by the residence country. The source countries are unable to assert their taxing rights over the firm’s profits for whatever reason. Perhaps they bartered their taxing rights away in exchange for vague promises of increased foreign direct investment.

Which of these scenarios would you choose if your objective were to maximize the post-tax outcome for the multinational? Remember: Option A results in 20 countries taxing the same income. In contrast, Option B features a single country taxing that income once.

At first, I naturally thought the optimal choice was Option B. How could it be anything else? Option A would be a nightmare, of course, because everything goes to hell when you have double taxation, right? Except Shaviro throws us a curveball. We are to further assume that the tax rate in the residence country is 35 percent. Moreover, there’s no profit shifting, no deferral, and no other abatements to lessen the pain. In short, the firm is stuck paying the rack rate. And the tax rate in each of the 20 source countries is only 1 percent.

Contrary to my knee-jerk reaction, the taxpayer is clearly better off under Option A – blatant double taxation notwithstanding. Taxation by the source countries collectively would result in an effective tax burden of 20 percent, but Option B (where double taxation is eliminated) would result in a tax burden of 35 percent. Any rational person should be able to see why the former is preferable to the latter. It’s not even close.

Admittedly, the tax rates in this exercise are cherry-picked to prove a point. Blind adherence to dogma can sometimes lead to perverse outcomes. The implication is that resisting double taxation should never be the ultimate goal. Instead, it should serve as one valuable consideration among many, as government contemplates how to best  tax corporate profits. The net tax burden imposed on capital income is a more compelling concern than the number of times income is taxed -- or indeed, which nations do the taxing.

These are useful ideas to keep in mind following the OECD's base erosion and profit-shifting project. The major lesson we learned from that project is that source countries are likely to exert greater influence over corporate taxation in the years ahead. Yes, revenue and profit are two distinct concepts, but the public as a whole still expects to see greater geographical cohesion between where multinationals engage in economic activity, where they book profits, and where they pay taxes. Not everyone is convinced that our framework for taxing cross-border corporate income will endure for the long run, especially given that key source countries (e.g., China, India, and Brazil) have never bought into it in the first place. In the meantime, let’s not be too quick to expel new approaches to taxing capital income simply because they challenge the orthodoxy. Who knows what BEPS version 2.0 might lead to?

Read Comments (3)

Emsig BeobachterJun 9, 2016

If each of the 20 nations mentioned above used formulary apportionment to approximate their share of the total income (intercompany sales would be disregarded) then the firm would not be subject to double taxation. Perhaps total income would be slightly over apportioned, but then again the income could be under apportioned. The latter is more likely since each of the 20 countries would probably have some sort of minimum nexus standards to be reached before they would be able to impose their tax.

Mike55Jun 9, 2016

Interesting thought experiment to be sure. For what it's worth, I'd choose Option B.

The trouble with Option A is that, in practice, it operates as a tariff on the products/services of geographically dispersed companies. The hypothetical MNC in Option A would pay a tax rate of 20% on sales into any given country, while its localized competitors would pay only 1%. Further, this hypothetical MNC would have to ask itself whether entering a new market (where it'd start at a 19% disadvantage vs. local companies) is worth giving up 1% of it's cash flow immediately. The answer would likely be "yes" to the large markets, and "no" to the small and/or developing markets. This is especially problematic at a time when emerging markets appear to be the only potential drivers of global economic growth available in the immediate future.

The massive loss of tax revenue would also be a problem under Option A. I'm a big proponent of reducing taxes to drive growth, but it only when the chosen reductions are targeted towards the largest growth drivers. So if the tax reducing proposal is full/immediate expensing of business investments then yes, sign me up for that! If the proposal is instead unaltered source-based taxation that operates as a tariff on MNCs, made palatable only via massive rate reductions, then I suppose I'd rather have more government services instead.

Either way though, the underlying point that we shouldn't accept tax policy dogma as a given is an excellent one, and the article was absolutely a great read.

Edmund DantesJun 10, 2016

In the entire history of taxation, has a tax ever been imposed at a 1% rate? I know of no examples.

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