Use the Internet and / or Strayer Learning Resource Center to research the impact of international taxation on U.S. competitiveness. Suggest at least two (2) advantages and two (2) disadvantages of international taxation.

ACC 568 (Int’l Tax plnng)

“Is International Taxation Really Necessary?”

Use the Internet and / or Strayer Learning Resource Center to research the impact of international taxation on U.S. competitiveness. Suggest at least two (2) advantages and two (2) disadvantages of international taxation. Analyze the economics of international taxation. Based on your analysis, create an alternative to international taxation then evaluate how your alternative impacts foreign investments

CHAPTER 1

INTRODUCTION

1.01 Growth of International Trade
Technological improvements in communications and transportation continue to make the world smaller and create a climate that is ripe for international trade. Consider the changes during the past 50 years. Commerce Department data show that for all of 1960 the United States exported just under $26 billion and imported approximately $22 billion of goods and services. For the month of June 2011 alone, exports of goods and services were more than $170 billion while imports were more than $223 billion. How things have changed.

1.02 Economics of International Trade
Why do foreign taxpayers invest in the United States or U.S. taxpayers invest abroad? The following short excerpt from a venerable first-grade reader is instructive:

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Mr. Smith had a horse. He used to ride his horse to work. One day Mr. Smith said, “I want to get a car to go to work.”

Mr. Smith went to a place that sells cars. He asked, “Will you give me a car if I give you my horse?” The man who sells the cars wanted a horse. He took the horse and gave Mr. Smith a car. Both men were happy.*

Trade makes both parties better off. In this respect international trade is no different from domestic trade.

1.03 The Central Problem of International Taxation
When there is bilateral trade, the governments of both trading parties may want to collect a tax on any gains from the trade. To change slightly the example above, suppose that Mr. Smith exchanged cash instead of a horse for the car. Suppose further that the seller of the car is a U.S. citizen who resides in the United States, the car is manufactured in Canada, and Mr. Smith lives in Canada. The United States may claim the right to tax any gain on the sale of the car because of the seller’s residence or citizenship, and Canada may claim taxing authority because the car was manufactured in Canada and sold in Canada to a Canadian resident. Overlapping claims of taxing authority—sometimes referred to as juridical double taxation—can create coordination difficulties.

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To illustrate the necessity for coordination, suppose that Canada imposes a 50 percent tax on any gains occurring in Canada, and the United States imposes a 50 percent tax on any gains wherever they occur if earned by a U.S. resident (or citizen). Under these assumptions, the combined tax rate is 100 percent, the entire gain on the transaction would be taxed away, and it is likely that the transaction would never take place. The loss of the transaction would hurt both parties, others who would benefit from the trade (e.g., employees of, and suppliers to, the manufacturer) as well as the treasuries of Canada and the United States. The study of international tax is the study of coordinating the tax authority of sovereign countries.

In the example just considered, potential double taxation arises because one country claims taxing authority based on the residence (or citizenship) of the taxpayer and another country claims taxing authority based on where the income arises. Juridical double taxation can also arise when each of two countries claims a taxpayer as a resident or where each of two countries claims that income arises in that country. Countries generally attempt to combat juridical double taxation both through unilateral domestic legislation and bilateral tax treaties with other countries. See infraChapters 5 and 8.

1.04 Economics of Juridical Double Taxation
From an efficiency point of view, the aspirational goal for a tax system in general, or for the U.S.4rules governing international transaction specifically, is the implementation of a tax-neutral set of rules that neither discourage nor encourage particular activity. The tax system should remain in the background, and business, investment and consumption decisions should be made for non-tax reasons. In the international tax context, the concept of tax neutrality has several standards.

One standard is capital-export neutrality. A tax system meets the standard of capital-export neutrality if a taxpayer’s choice between investing capital at home or abroad is not affected by taxation. For example, if X Corp., a U.S. corporation, is subject to a 35 percent tax rate in the United States on its worldwide income, and the income from its French branch is also subject to a 30 percent French tax, a U.S. tax system with capital-export neutrality would credit the French tax against the potential U.S. tax liability and tax the French profits in the United States at a 5 percent residual tax rate. X Corp.’s tax rate is 35 percent regardless of the location of the investment. If the investment is located in the United States, taxes are paid to the U.S. treasury; if the investment is located in France, the French treasury would collect as tax 30 percent of the income and the United States would collect as tax 5 percent of the income. With perfect competition, capital-export neutrality results in an efficient allocation of capital. X Corp. will make its investment decision based on business factors rather than tax rates.

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The second neutrality standard is capital-import neutrality, sometimes referred to as foreign or competitive neutrality. This standard is satisfied when all firms doing business in a market are taxed at the same rate. For example, if the United States exempted X Corp.’s French income from U.S. taxation, there would be capital-import neutrality from a French perspective because X Corp. would be taxed at the same rate as a comparable French corporation doing business in France. Compared with a tax crediting mechanism, this exemption method violates capital-export neutrality. A U.S. taxpayer will pay lower overall taxes if the investment is made in France (30 percent rate) than if the investment is made in the United States (35 percent rate).

A third neutrality standard is national neutrality. Under this standard, the total U.S. returns on capital which are shared between the taxpayer and the U.S. Treasury are the same whether the capital is invested in the United States or abroad. That is, if the U.S. tax rate is 35 percent of a taxpayer’s income (with the taxpayer keeping the other 65 percent of the income), the imposition of foreign taxes will not alter that rate. Applying the national neutrality principle to the example above, any taxes paid to France by X Corp. would be deductible and not creditable against U.S. income tax liability; foreign income taxes would be treated in the same manner as any other domestic or international business expense. Notice the effect on the taxpayer is higher overall taxes because the deductibility of6French income tax does not reduce U.S. tax dollar-for-dollar.

The U.S. tax system has elements of all three standards of neutrality. The tax credit mechanism, discussed infra in Chapter 8, subject to limitation allows U.S. taxpayers operating abroad to reduce U.S. taxes by an amount equal to any income taxes paid to other countries on foreign income. This provision is driven by notions of capital-export neutrality. However, not all foreign taxes are creditable (e.g., foreign property taxes, value added taxes, capital taxes). To the extent that a U.S. taxpayer incurs foreign taxes that are not creditable, those foreign taxes normally can be deducted for U.S. tax purposes. This treatment and other restrictions on the foreign tax credit mechanism are in keeping with the concept of national neutrality. Finally to the extent that the United States generally exempts (at least while the earnings remain abroad) from U.S. taxation the earnings of foreign subsidiaries of U.S. corporations (so that they can compete against local businesses), the capital-import neutrality principle is advanced.

1.05 Overview of Worldwide International Tax Systems
Virtually every country has tax rules that govern the tax treatment of its residents operating abroad and foreign taxpayers operating in that country. While international taxing systems differ from country to country, there are some basic similarities and understandings. Sometimes these understandings7are set forth in bilateral income tax treaties working in tandem with domestic tax laws; in other cases, it is the domestic tax laws of a country that determine the appropriate tax treatment.

In general, a country exercises jurisdiction for legal purposes based on either nationality or territoriality. With respect to taxation, a country may claim that all income earned by a citizen or a company incorporated in that country is subject to taxation because of the legal connection to that country. The United States exercises such jurisdiction over its citizens and companies incorporated in the United States regardless of where income is earned. Business profits earned by a U.S. corporation in Italy are subject to tax in the United States (and normally in Italy as well). Salary earned by a U.S. citizen who is a resident of Switzerland from Swiss employment is subject to tax in the United States (and in Switzerland as well).

Basing tax jurisdiction on nationality can be justified by the benefits available to nationals. For example, in a very real sense U.S. citizens have an insurance policy; they can return to the United States whenever they want, and they have the protection of the U.S. government wherever they are abroad. Tax payments contribute to the availability of that “insurance.” U.S. corporations, regardless of their physical presence in the United States, enjoy the benefits of U.S. laws that define corporate relationships. However, the United States is somewhat unusual in relying on citizenship or8mere place of incorporation as a basis for jurisdiction.

In addition to nationality, countries often exercise jurisdiction based on territoriality. A territorial connection justifies the exercise of taxing jurisdiction because a taxpayer can be expected to share the costs of running a country which makes possible the production of income, its maintenance and investment, and its use through consumption. The principle of territoriality applies with respect to persons and objects (i.e., income). Country A may claim taxing authority over a citizen of country B if that individual is considered a resident of country A. Similarly, a company incorporated in country B may be subject to tax in country A if there are sufficient connections. For example, many countries (not including the United States) find a sufficient territorial connection if the place of effective management of a corporation is situated within their boundaries.

Territorial jurisdiction over a person is analytically similar to jurisdiction based on nationality. In both cases it is the connection of the person to a country that justifies taxing jurisdiction. In the case of nationality, that connection is a legal one (e.g., citizenship or incorporation). In the case of territorial jurisdiction over a person, the connection is factual (e.g., whether that person is actually resident in a particular country).

Even if a person is not a citizen or resident of a country, that country may assert territorial tax jurisdiction over income deriving from within the9territory of that country earned by a citizen or resident of another country. This is sometimes referred to as “source” jurisdiction because the source of the income is within a country. For example, a country may impose a tax on business profits of a nonresident earned within that country. Investment income, including dividends, interest, royalties, and rent, may also be subject to tax in the country in which such income arises. Typically, a country does not attempt to tax income with which it has no connection. For example, the United States normally does not tax income earned by a French corporation in France or in Germany.

The potential for double taxation occurs when conflicting jurisdictional claims arise. For example, country A may claim the right to tax a person (including a corporation) based on that person’s nationality or residence while country B stakes its claim of taxing authority because income is earned in country B. There is a norm of international taxation which the United States generally follows that cedes the primary taxing authority to the country of territorial connection (i.e., where the income is earned) and the residual taxing authority to the country of nationality or residence. Accordingly, the United States normally credits any income taxes paid in India on income earned in India by a U.S. citizen or resident against the income tax otherwise due in the United States, and only the excess, if any, of U.S. income tax on the foreign income over the foreign tax on such income is collected by the U.S. treasury. Similarly, many countries have10adopted more of a territorial approach to jurisdiction and exempt certain income (e.g., business profits) earned in another country from the tax base, rather than including such income in the tax base and then granting a credit for foreign taxes paid as the United States does.

The taxation of income based on territorial jurisdiction generally takes one of two forms. A country typically asserts full jurisdiction over business profits generated within that country by a nonresident (who in the case of the United States is not a US citizen), taxing those profits in the same manner as if they were earned by a resident of that country. Expenses associated with generating such income are normally deductible. Non-business, investment income, such as passive dividends, interest, royalties and rent, typically is subject to limited jurisdiction. Often such income is taxed by a country in which the income arises on a gross basis (i.e., no deductions permitted) at rates ranging from 0 to 30 percent. The lower rates that often apply to such income when compared with business profits reflect, in part, the fact that the territorial connection for a full-blown business within a jurisdiction is often more significant than the territorial connection for an investment where the only connection may be the payer’s residence. Moreover, the lower rate reflects the fact that the tax is on gross income. However, it should also be noted that a low tax rate on gross income may in fact result in a high tax rate on net income. Suppose country A imposes a 3011percent tax on $100 of passive royalty income earned by a resident of country B from a license with a country A licensee. If the country B resident incurs $60 of expenses to produce the $100 of gross income, the effective tax rate in country A is 75 percent (i.e., a $30 tax on $40 of net income).

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