International Commercial Laws Project

NAME KARAN VOHRA

PRNo. 11021021026 TOPIC International Tax Law SEMESTER 3RD, BBA SECTION B

Acknowledgement

I take this opportunity to express my sincere gratitude to the people who have been instrumental in the successful completion of this project.

I would like to show my greatest appreciation to Prof. Nitin Malhotra. I cant say thank you enough for his tremendous support and help. I feel motivated and encouraged every time I attend his lecture. Without his encouragement and guidance this project would not have materialized.

The guidance and support received from all the team members who contributed to this project, was vital for the success of the project. I am grateful for their constant support and help.

Declaration

I Karan Vohra, hereby declare that this project report

entitled International Tax Law, submitted by me, under the guidance of Prof. Nitin Malhotra of

SCMS, NOIDA has been made on my own and not submitted to any other University or Institute or published earlier.

DATE 17/10/2012

PLACE SCMS, NOIDA

SIGNATURE

International taxation
International taxation is the study or determination of tax on a person or business subject to the tax laws of different countries or the international aspects of an individual country's tax laws. Governments usually limit the scope of their income taxation in some manner territorially or provide for offsets to taxation relating to extraterritorial income. The manner of limitation generally takes the form of a territorial, residency, or exclusionary system. Some governments have attempted to mitigate the differing limitations of each of these three broad systems by enacting a hybrid system with characteristics of two or more. Many governments tax individuals and/or enterprises on income. Such systems of taxation vary widely, and there are no broad general rules. These variations create the potential for double taxation (where the same income is taxed by different countries) and no taxation (where income is not taxed by any country). Income tax systems may impose tax on local income only or on worldwide income. Generally, where worldwide income is taxed, reductions of tax or foreign credits are provided for taxes paid to other jurisdictions. Limits are almost universally imposed on such credits. Multinational corporations usually employ international tax specialists, a specialty among both lawyers and accountants, to decrease their worldwide tax liabilities. With any system of taxation, it is possible to shift or recharacterize income in a manner that reduces taxation. Jurisdictions often impose rules relating to shifting income among commonly controlled parties, often referred to as transfer pricing rules. Residency based systems are subject to taxpayer attempts to defer recognition of income through use of related parties. A few jurisdictions impose rules limiting such deferral ("anti-deferral" regimes). Deferral is also specifically authorized by some governments for particular social purposes or other grounds. Agreements among governments (treaties) often attempt to determine who should be entitled to tax what. Most tax treaties provide for at least a skeleton mechanism for resolution of disputes between the parties.

Introduction
Systems of taxation vary among governments, making generalization difficult. Specifics are intended as examples, and relate to particular governments and not broadly recognized multinational rules. Taxes may be levied on varying measures of income, including but not limited to net income under

local accounting concepts, gross receipts, gross margins (sales less costs of sale), or specific categories of receipts less specific categories of reductions. Unless otherwise specified, the term "income" should be read broadly. Jurisdictions often impose different income based levies on enterprises than on individuals. Entities are often taxed in a unified manner on all types of income while individuals are taxed in differing manners depending on the nature or source of the income. Many jurisdictions impose tax at both an entity level and at the owner level on one or more types of enterprises. These jurisdictions often rely on the company law of that jurisdiction or other jurisdictions in determining whether an entity's owners are to be taxed directly on the entity income. However, there are notable exceptions, including U.S. rules characterizing entities independently of legal form. In order to simplify administration or for other agendas, some governments have imposed "deemed" income regimes. These regimes tax some class of taxpayers according to tax system applicable to other taxpayers but based on a deemed level of income, as if earned by the taxpayer. Disputes can arise regarding what levy is proper. Procedures for dispute resolution vary widely and enforcement issues are far more complicated in the international arena. The ultimate dispute resolution for a taxpayer is to leave the jurisdiction, taking all property that could be seized. For governments, the ultimate resolution may be confiscation of property, dissolution of the entity, or even the death penalty. Other major conceptual differences can exist between tax systems. These include, but are not limited to, assessment vs. self-assessment means of determining and collecting tax; methods of imposing sanctions for violation; sanctions unique to international aspects of the system; mechanisms for enforcement and collection of tax; and reporting mechanisms.

Taxation systems
Countries that tax income generally use one of two systems: territorial or residential. In the territorial system, only local income income from a source inside the country is taxed. In the residential system, residents of the country are taxed on their worldwide (local and foreign) income, while nonresidents are taxed only on their local income. In addition, a very small number of countries, notably the United States, also tax their nonresident citizens on worldwide income. Countries with a residential system of taxation usually allow deductions or credits for the tax that residents already pay to other countries on their foreign income. Many countries also sign tax treaties with each other to eliminate or reduce double taxation. In the case of corporate income tax, some countries allow an exclusion or deferment of specific items of foreign income from the base of taxation.

Individuals
The following table summarizes the taxation of local and foreign income of individuals, depending on their residence or citizenship in the country. It includes 244 entries: 194 sovereign countries, their 40 inhabited dependent territories (most of which have separate tax systems), and 10 countries with limited.

Residency
Residential systems face the daunting tasks of defining "resident" and characterizing the income of nonresidents. Such definitions vary by country and type of taxpayer, but usually involve the location of the person's main home and number of days the person is physically presence in the country. Examples include:

The United States taxes its citizens as residents, and provides lengthy, detailed rules for individual residency of foreigners, covering:

Periods establishing residency (including a formulary calculation involving three years); Start and end date of residency; Exceptions for transitory visits, medical conditions, etc.

The United Kingdom establishes three categories: non-resident, resident, and resident but not ordinarily resident.[ Switzerland residency may be established by having a permit to be employed in Switzerland for an individual who is so employed.

Territorial systems usually tax local income regardless of the residence of the taxpayer. The key problem argued for this type of system is the ability to avoid taxation on portable income by moving it offshore. This has led governments to enact hybrid systems to recover lost revenue.

Citizenship
Almost all countries tax foreign income only of residents, or do not tax it at all. However, as of 2012 two countries tax the worldwide income of nonresidents who are citizens of the country:

Eritrea taxes its nonresident citizens on their foreign income at a reduced flat rate of 2% (income tax rates for residents are progressive from 2 to 30%). It has been reported that Eritrea enforces this tax on its citizens abroad through denial of passports, denial of entry or exit from the country, confiscation of assets in Eritrea, and even harassment of relatives living in Eritrea, until the tax is paid. The United Nations Security Council has passed a resolution condemning the Eritrean diaspora

tax, the Parliament of Sweden plans to prohibit the practice there, and the Canadian government is also against it.

The United States taxes its citizens and resident foreigners on their worldwide income, and nonresident foreigners on their local income. US citizens residing in other countries may exclude some of their foreign income from US taxation, and take credit for income tax paid to other countries, but they must file a US tax return to claim the exclusion or credit even if they result in no tax liability. US citizens abroad, like US residents, are also subject to various reporting requirements regarding foreign finances, such as FBAR, FATCA, and IRS forms 3520, 5471, 8621, 8891 and 8938. The penalties for failure to file these forms on time are often much higher than the penalties for not paying the tax itself.

Two other countries currently tax based on citizenship in limited situations, due to a treaty or temporarily:

France taxes its citizens who reside in Monaco as residents of France, according to a treaty signed between the two countries in 1963. In 2009, a French court ruled that only French citizens who have previously resided in France are subject to this treaty, so French citizens by descent who were born and have always lived in Monaco, with no French income, would not have to pay income tax to France. However, the French government decided to apply the court ruling only to those with dual citizenship of a third country. The matter remains in litigation, and has been debated at the French Senate. Other than this case, France does not tax the foreign income of its nonresident citizens.

Spain continues taxing its citizens who move from Spain to a tax haven as residents of Spain, for the first five years after moving there. After this period, they are no longer considered residents of Spain for tax purposes. Other than this case, Spain does not tax the foreign income of its nonresident citizens.

A few other countries used to tax the foreign income of nonresident citizens, but have abolished this practice:

Mexico used to tax its citizens in the same manner as residents, on worldwide income. A new income tax law, passed in 1980 and effective 1981, determined only residence as a basis for taxation of worldwide income.

The Soviet Union used to tax its citizens on worldwide income regardless of where they resided. After the country was dissolved in 1991, none of its successor states kept taxation based on

citizenship, using instead residence as a basis for taxation of worldwide income, or taxing only local income.

The Philippines used to tax the foreign income of nonresident citizens at reduced rates of 1 to 3% (income tax rates for residents were 1 to 35% at the time). It abolished this practice in a new revenue code in 1997, effective 1998.

Vietnam used to tax its citizens in the same manner as residents, on worldwide income. The country passed a personal income tax law in 2007, effective 2009, removing citizenship as a criterion to determine residence.

Myanmar used to tax the foreign income of its nonresident citizens at a flat rate of 10% (income tax rates for residents range from 3 to 40%). As part of a series of reforms, the country abolished this practice in 2011, effective 2012.

Corporations
Countries do not necessarily use the same system of taxation for individuals and corporations. For example, France uses a residential system for individuals but a territorial system for corporations, while Singapore does the opposite, and Brunei taxes corporate but not personal income.

Exclusion
Many systems provide for specific exclusions from taxable (chargeable) income. For example, several countries, notably Cyprus, Luxembourg, Netherlands and Spain, have enacted holding company regimes that exclude from income dividends from certain foreign subsidiaries of corporations. These systems generally impose tax on other sorts of income, such as interest or royalties, from the same subsidiaries. They also typically have requirements for portion and time of ownership in order to qualify for exclusion. The Netherlands offers a "participation exemption" for dividends from subsidiaries of Netherlands companies. Dividends from all Dutch subsidiaries automatically qualify. For other dividends to qualify, the Dutch shareholder or affiliates must own at least 5% and the subsidiary must be subject to a certain level of income tax locally. Some countries, such as the United States and Singapore, allow deferment of tax on foreign income of resident corporations until it is remitted to the country.

Individuals vs. enterprises

Many tax systems tax individuals in one manner and entities that are not considered fiscally transparent in another. The differences may be as simple as differences in tax rates, and are often motivated by concerns unique to either individuals or corporations. For example, many systems allow taxable income of an individual to be reduced by a fixed amount allowance for other persons supported by the individual (dependents). Such a concept is not relevant for enterprises. Many systems allow for fiscal transparency of certain forms of enterprise. For example, most countries tax partners of a partnership, rather than the partnership itself, on income of the partnership. A common feature of income taxation is imposition of a levy on certain enterprises in certain forms followed by an additional levy on owners of the enterprise upon distribution of such income. Thus, many countries tax corporations under company tax rules and tax individual shareholders upon corporate distributions. Various countries have tried (and some still maintain) attempts at partial or full "integration" of the enterprise and owner taxation. Where a two level system is present but allows for fiscal transparency of some entities, definitional issues become very important.

Source of income
Determining the source of income is of critical importance in a territorial system, as source often determines whether or not the income is taxed. For example, Hong Kong does not tax residents on dividend income received from a non-Hong Kong corporation. Source of income is also important in residency systems that grant credits for taxes of other jurisdictions. Such credit is often limited either by jurisdiction or to the local tax on overall income from other jurisdictions. Source of income is where the income is considered to arise under the relevant tax system. The manner of determining the source of income is generally dependent on the nature of income. Income from the performance of services (e.g., wages) is generally treated as arising where the services are performed. Financing income (e.g., interest, dividends) is generally treated as arising where the user of the financing resides. Income related to use of tangible property (e.g., rents) is generally treated as arising where the property is situated. Income related to use of intangible property (e.g., royalties) is generally treated as arising where the property is used. Gains on sale of realty are generally treated as arising where the property is situated. Gains from sale of tangible personal property are sourced differently in different jurisdictions. The U.S. treats such gains in three distinct manners: a) gain from sale of purchased inventory is sourced based on where title to the goods passes; b) gain from sale of inventory produced by the person (or certain related persons) is sourced 50% based on title passage and 50% based on location of production and certain assets; c) other gains are sourced based on the residence of the seller.

Where differing characterizations of an item of income can result in differing tax results, it is necessary to determine the characterization. Some systems have rules for resolving characterization issues, but in many cases resolution requires judicial intervention. Note that some systems which allow a credit for foreign taxes source income by reference to foreign law.

Definitions of income
Some jurisdictions tax net income as determined under financial accounting concepts of that jurisdiction, with few, if any, modifications. Other jurisdictions determine taxable income without regard to income reported in financial statements. Some jurisdictions compute taxable income by reference to financial statement income with specific categories of adjustments, which can be significant. A jurisdiction relying on financial statement income tends to place reliance on the judgment of local accountants for determinations of income under locally accepted accounting principles. Often such jurisdictions have a requirement that financial statements be audited by registered accountants who must opine thereon. Some jurisdictions extend the audit requirements to include opining on such tax issues as transfer pricing. Jurisdictions not relying on financial statement income must attempt to define principles of income and expense recognition, asset cost recovery, matching, and other concepts within the tax law. These definitional issues can become very complex. Some jurisdictions following this approach also require business taxpayers to provide a reconciliation of financial statement and taxable incomes.[140]

Deductions
Systems that allow a tax deduction of expenses in computing taxable income must provide for rules for allocating such expenses between classes of income. Such classes may be taxable versus non-taxable, or may relate to computations of credits for taxes of other systems (foreign taxes). A system which does not provide such rules is subject to manipulation by potential taxpayers. The manner of allocation of expenses varies. U.S. rules provide for allocation of an expense to a class of income if the expense directly relates to such class, and apportionment of an expense related to multiple classes. Specific rules are provided for certain categories of more fungible expenses, such as interest. By their nature, rules for allocation and apportionment of expenses may become complex. They may incorporate cost accounting or branch accounting principles, or may define new principles.

Thin capitalization

Most jurisdictions provide that taxable income may be reduced by amounts expended as interest on loans. By contrast, most do not provide tax relief for distributions to owners. Thus, an enterprise is motivated to finance its subsidiary enterprises through loans rather than capital. Many jurisdictions have adopted "thin capitalization" rules to limit such charges. Various approaches include limiting deductibility of interest expense to a portion of cash flow, disallowing interest expense on debt in excess of a certain ratio, and other mechanisms.

Enterprise restructures
The organization or reorganization of portions of a multinational enterprise often gives rise to events that, absent rules to the contrary, may be taxable in a particular system. Most systems contain rules preventing recognition of income or loss from certain types of such events. In the simplest form, contribution of business assets to a subsidiary enterprise may, in certain circumstances, be treated as a nontaxable event. Rules on structuring and restructuring tend to be highly complex.

Credits for taxes of other jurisdictions

Systems that tax income earned outside the system's jurisdiction tend to provide for a unilateral credit or offset for taxes paid to other jurisdictions. Such other jurisdiction taxes are generally referred to within the system as "foreign" taxes. Tax treaties often require this credit. A credit for foreign taxes is subject to manipulation by planners if there are no limits, or weak limits, on such credit. Generally, the credit is at least limited to the tax within the system that the taxpayer would pay on income earned outside the jurisdiction. The credit may be limited by category of income, by other jurisdiction or country, based on an effective tax rate, or otherwise. Where the foreign tax credit is limited, such limitation may involve computation of taxable income from other jurisdictions. Such computations tend to rely heavily on the source of income and allocation of expense rules of the system.

Withholding tax
Many jurisdictions require persons paying amounts to nonresidents to collect tax due from a nonresident with respect to certain income by withholding such tax from such payments and remitting the tax to the government.] Such levies are generally referred to as withholding taxes. These requirements are induced because of potential difficulties in collection of the tax from nonresidents. Withholding taxes are often imposed at rates differing from the prevailing income tax rates. Further, the rate of withholding may vary by type of income or type of recipient. Generally, withholding taxes are reduced or eliminated under

income tax treaties (see below). Generally, withholding taxes are imposed on the gross amount of income, unreduced by expenses. Such taxation provides for great simplicity of administration but can also reduce the taxpayer's awareness of the amount of tax being collected.

Treaties
Tax treaties exist between many countries on a bilateral basis to prevent double (taxes levied twice on the same income, profit, gain, inheritance or other item). In some countries they are also known as double taxation agreements, double tax treaties, or tax information exchange agreements (TIEA). Most developed countries have a large number of tax treaties, while developing countries are less well represented in the worldwide tax treaty network. The United Kingdom has treaties with more than 110 countries and territories. The United States has treaties with 56 countries (as of February 2007). Tax treaties tend not to exist, or to be of limited application, when either party regards the other as a tax haven. There are a number of model tax treaties published by various national and international bodies, such as the United Nations and the OECD. Treaties tend to provide reduced rates of taxation on dividends, interest, and royalties. They tend to impose limits on each treaty country in taxing business profits, permitting taxation only in the presence of a permanent establishment in the country. Treaties tend to impose limits on taxation of salaries and other income for performance of services. They also tend to have "tie breaker" clauses for resolving conflicts between residency rules. Nearly all treaties have at least skeletal mechanisms for resolving disputes, generally negotiated between the "competent authority" sections of each country's taxing authority.

Anti-deferral measures
Residency systems may provide that residents are not subject to tax on income outside the jurisdiction until that income is remitted to the jurisdiction. Taxpayers in such systems have significant incentives to shift income offshore. Depending on the rules of the system, the shifting may occur by changing the location of activities generating income or by shifting income to separate enterprises owned by the taxpayer. Most residency systems have avoided rules which permit deferring offshore income without shifting it to a subsidiary enterprise due to the potential for manipulation of such rules. Where owners of an enterprise are taxed separately from the enterprise, portable income may be shifted from a taxpayer to a subsidiary enterprise to accomplish deferral or elimination of tax. Such systems tend to have rules to limit such deferral through controlled foreign corporations. Several different approaches have been used by countries for their anti-deferral rules.

In the United States, rules provide that U.S. shareholders of a Controlled Foreign Corporation (CFC) must include their shares of income or investment of E&P by the CFC in U.S. property. U.S. shareholders are U.S. persons owning 10% or more (after the application of complex attribution of ownership rules) of a foreign corporation. Such persons may include individuals, corporations, partnerships, trusts, estates, and other juridical persons. A CFC is a foreign corporation more than 50% owned by U.S. shareholders. This income includes several categories of portable income, including most investment income, certain resale income, and certain services income. Certain exceptions apply, including the exclusion from Subpart F income of CFC income subject to an effective foreign tax rate of 90% or more of the top U.S. tax rate. The United Kingdom provides that a UK company is taxed currently on the income of its controlled subsidiary companies managed and controlled outside the UK which are subject to "low" foreign taxes. Low tax is determined as actual tax of less than three-fourths of the corresponding UK tax that would be due on the income determined under UK principles. Complexities arise in computing the corresponding UK tax. Further, there are certain exceptions which may permit deferral, including a "white list" of permitted countries and a 90% earnings distribution policy of the controlled company. Further, antideferral does not apply where there is no tax avoidance motive. Rules in Germany provide that a German individual or company shareholder of a foreign corporation may be subject to current German tax on certain passive income earned by the foreign corporation. This provision applies if the foreign corporation is taxed at less than 25% of the passive income, as defined. Japan and some other countries have followed a "black list" approach, where income of subsidiaries in countries identified as tax havens is subject to current tax to the shareholder. Sweden has adopted a "white list" of countries in which subsidiaries may be organized so that the shareholder is not subject to current tax.

Transfer pricing
The setting of the amount of related party charges is commonly referred to as transfer pricing. Many jurisdictions have become sensitive to the potential for shifting profits with transfer pricing, and have adopted rules regulating setting or testing of prices or allowance of deductions or inclusion of income for related party transactions. Many jurisdictions have adopted broadly similar transfer pricing rules. The OECD has adopted (subject to specific country reservations) fairly comprehensive guidelines. These guidelines have been adopted with little modification by many countries. Notably, the U.S. and Canada have adopted rules which depart in some material respects from OECD guidelines, generally by providing more detailed rules.

Arm's length principle: a key concept of most transfer pricing rules is that prices charged between related enterprises should be those which would be charged between unrelated parties dealing at arm's length. Most sets of rules prescribe methods for testing whether prices charged should be considered to meet this standard. Such rules generally involve comparison of related party transactions to similar transactions of unrelated parties (comparable prices or transactions). Various surrogates for such transactions may be allowed. Most guidelines allow the following methods for testing prices: Comparable uncontrolled transaction prices, resale prices based on comparable markups, cost plus a markup, and an enterprise profitability method.

The Importance of International Tax Planning

International tax planning strategies can be a legitimate way to minimize international tax liabilities. International tax planning is especially important to consider when you are devising a strategy for an offshore company formation. International taxation can be a complex field and thorough research should be undertaken before considering your business expansion. Engaging the services of a professional corporate services firm can help to provide reassurance that the necessary research and due diligence has been carried out. It is important to have comprehensive knowledge of the requirements of the country in which you are setting up the business as well as your country of residence. Offshore tax strategy is not necessarily as daunting as it may seem. An experienced corporate tax-planning advisor will guide you through all the required steps. It is important to consider different options and such as advisor should assist you do this and develop a suitable strategy. Your strategy should be formed with full awareness of the advantages or benefits, as well as disadvantages, and risks, of each the different options available to you. Some of the benefits of effective international, or offshore, tax planning can include:

Legally minimizing international tax liabilities Protecting business, and personal, assets Taking advantage of double taxation treaties between your resident country and other offshore countries Maximize working capital Improved financial efficiency

An effective, well-structured international tax planning strategy can legally benefit an international business in a number of areas. It can be a complex process, especially when multiple jurisdictions are involved. There are a number of fundamental issues to consider before deciding on an optimum strategy and this is the reason why using an experienced professional can be valuable. They will assist with both developing the most suitable strategy and avoiding potential issues from arising.

Healy Consultants is a leading corporate services firm that assists entrepreneurs and investors with their company incorporation requirements. The firm provides a range of services including Singapore Company Formation, tax planning and offshore investing.

INTERNATIONAL TAX-LAW CONFLICTS

The most common conflicts of the international tax 1. 2. 3. 4. 5. 6. Conflict of double taxation (for example: an income is taxed in two states at once) Tax avoidance, evasions conflict Conflicts concerning tax heavens, off-shore firms Conflict because discrimination between foreign and domestic taxpayers Harmful tax competition Conflicts arising out of breach of international tax law principles

Conflict of double taxation (For example: an income is taxed in two states at once): - The same tax is levied by two or more states - To the same taxpayer, - In connection with the same tax subject, and - For the same period. For example in the international taxation there are principles and conjunct.

SOURCES OF INTERNATIONAL TAX LAW

During the International transactions tax rules can have basically different sources: a.) the domestic tax law of the country that is involved in the international transaction b.) the other (the third country) - also is involved- countries law c.) and the relevant potential tax preferences between the states, d.) and the European tax law sources. The domestic tax rules define the main base of the applicable law (meaning that in both domestic and international transactions should be applied). The international rules define, if there is a taxation difference between international or domestic transaction. These rules can only be applied in international transactions, and involve such rules like tax credits for foreigners or the rules of tax withholding and the source of income. Treaties excluding double taxation are changing the national tax rules on the basis of income taxes. They often provide source rules to avoid double taxation, or they allow special tax withholding. If there is a conflict between tax convention on income and the national tax law, the main rule is, that on the taxpayer applies the best (with the lowest cost) rule. In fact the main problem is that there is no higher 4

supranational- international tax law, which would be valid for all nations. In the tax-law of the big international organizations, principles can be discovered (for example EU), or the various agreements between sovereign states (GATT, OECD) contain such provisions, that generally applies to international transactions. Similarly significant are the guidelines of the European Union, primary and secondary legal sources that in some cases - if they contain favorable rules for the taxpayer - heading the national tax-law provision.8 The German court made an example for that9, when it placed the legislation of the European Union in advantage against the domestic tax-law. Indeed, in a case according to German tax-law, sales-tax exemption would have prevailed based on principles adopted by the EU member countries. The German entrepreneurs did not pay tax referring to the EU principle, however the tax office referring to the German tax-law identified tax deficit. The German financial court ruled in the favour of the tax payers, so basically it repealed its own specific domestic taxlaw rules. This was forced by the competitive neutrality within the regulations of EU member states. So the European Union's laws take precedence over domestic law also in the field of tax law.

THE CLASSIFICATIONS OF TAX SYSTEMS - IN TERMS OF INTERNATIONAL TAX-LAW

The sovereignty of nations in connection with the international transactions involves the right to defy the applicable law. There are two main considerations in determining the field of taxation: - The residence (residence, location, place of residence). This is the personal principle. - And the principle of source.10 this is the principle of territory. These connecting rules (that connects the tax system with the tax payer) can be divided on two aspects: - Personal and - Economical. The principle of personal connection is followed by the principle of residence, while the economic connection is followed by the principle of source. The personal principle can be determined by: - Citizenship, - Residence or - Place of residence of the individuals, the place of business or location for the firms. Those tax systems that limit their tax powers by personal connection, fallow the Principle of residence, which is also called universal, total principle and that, is a worldwide principle of establishing absolute, complete and general tax liability. By the principle of residence the tax payer is determining in accordance with the jurisdiction. The connecting rule of economical principle can be found by those tax systems, in which the tax payer is subject to taxation, where the governing rule is the property, location of property, location or source of income. When the tax system applies the source principle that can also be called principle of territory, than the tax system is limiting the tax powers, tax sovereignty.

THE MOST IMPORTANT INTERNATIONAL TAX LAW

PRINCIPLES

OF

EQUITY AND NEUTRALITY The most important principles of tax-law are the following: -the principle of burden sharing -contribution to local public services -prohibition of discrimination: the principle of equity and neutrality -prohibition of tax avoidance -prohibition of harmful tax competition principles. When a state determines its own tax system, two very important objective requirements should be calculated: The first: the principle of equity, meaning, that all taxpayers should be treated in the same economic situation; one cannot be put at a disadvantage. The concept of equality is often referred to as horizontal equality, which means that the taxpayer in the same position, after the same taxable income, has to pay the same level of tax, regardless of origin, place or type of the income, it is all the same that the respective is being domestic or foreigner or that the income is produced or invested. The equity based tax system requires a taxation system that is fair even in a moral point of view and all taxpayer share the contribution of public expenditure. Of course this principle encourages the taxpayers of law abiding and the observance to the tax rules simultaneously.

The International Dimension of Taxation

In the development of a countrys tax laws, the international dimension plays an increasingly important role that significantly restricts the rules that might be adopted if regard were had only to domestic considerations. The increasing role of international factors is mainly attributable to the globalization of the world economy.

Importance of International Taxation

International trade has existed since the birth of nations, but there has been an accelerating growth not only in trade but also in finance and investment since the end of World War II. This growth has far outstripped the general growth in the world economy. One important cause has been the gradual removal of barriers to international trade through the various negotiating rounds of the General Agreement on Tariffs and Trade (the GATT, which as of 1995 is administered by the World Trade Organization or WTO). For finance, the removal of exchange controls in most industrial countries, commencing from the floating of exchange rates in the early 1970s, has been a notable factor leading to the globalization of world capital and financial markets. The international organizations most involved here have been the IMF and the Bank for International Settlements. In relation to investment, the main multilateral push is yet to come. In recent years, the foreign direct investment laws of investee countries and the investment rules for various institutional investors in investor countries have been liberalized and bilateral investment treaties have grown. The Multilateral Agreement on Investment is currently under negotiation in the OECD. When this treaty is concluded in the near future, it is proposed to extend its regime worldwide through the cooperative efforts of the OECD and the WTO, which will see further global relaxation of investment controls. In addition, the end of the cold war has

freed up the international transfer of technology, and labor is also becoming more mobile, especially for high-cost services (such as professional, management, and consulting services) and within trade blocs. Overlaying all these developments and substantially contributing to many of them are the great advances in international communications and computer technology. It is a corollary of this growth in international transactions that international tax laws (along with international trade, finance, and commercial laws) have become more significant to each countrys legal system. Moreover, as restrictions in other areas are reduced or removed, taxation is brought increasingly into focus, but there is a significant difference in the tax case. Whereas it may be possible to liberalize or abolish rules in other areas affecting international transactions, taxation needs to be retained in some form for the financing of governments. The international challenge for taxation is the development of a system that does not act as an undue impediment to international transactions while protecting the revenue of each state.

The Challenge for International Taxation

There are two main categories of case that international tax rules have to deal with. First, there is the taxation of persons from outside a country who work, enter into transactions, or have property or income in the country. Second, there is taxation of persons who belong to a country and work, enter into transactions, or have property or income abroad. The usual term used in international taxation to denote the concept of a persons belonging to a country is residence (resident and nonresident being used to indicate whether a particular person belongs to a country or not); similarly the usual term for income arising in a particular place is source (domestic and foreign being used to indicate whether particular income is sourced inside or outside a country). The two categories arise in virtually all areas and types of taxation. For the income tax, the issues are the taxation of domestic income of nonresidents and the taxation of foreign income of residents. In both categories of case, the main problem is the potential for double taxation or double no taxation of the income. That is, more than one country may seek to tax without reference to tax levied in another country, or no country may tax (usually on the assumption that another country is taxing, although often it will be the result of the increased opportunities for tax planning or tax cheating on the part of taxpayers that international transactions offer). Double taxation is likely to act as a barrier to international transactions, and the nations of the world are generally agreed on the desirability of removing such barriers as a means of increasing global welfare. By similar reasoning, double no taxation of international transactions will create a bias in favor of international over domestic transactions, leading to a loss of global (and national) welfare, not to mention tax revenue. While, however, there is general agreement among taxpayers and governments on the undesirability of double taxation, double no taxation is obviously desired by taxpayers and to some extent tolerated or even encouraged by governments. Developing countries often express the view that any increase in global welfare arising from the removal of international barriers accrues mainly to industrial

countries. International agreements sometimes contain special regimes to deal with these concerns of developing countries, such as the generalized system of preferences in the GATT, which allows industrial countries to confer tariff privileges on developing countries without being obliged to extend them to all GATT members. In the income tax field, this developing country view finds expression in the desire to offer tax incentives to international investors in order to attract capital and to ensure that the tax systems of industrial countries do not negate the effect of the incentives by collecting the tax that the developing countries have given up. The desired result of developing countries is generally achieved by tax sparing provisions in bilateral tax treaties, which effectively sanction double no taxation and hence create a bias in favor of international investment in developing countries. This particular policy in favor of double no taxation is dealt with elsewhere in this volume. In this chapter, the general premise is that the basic goal of the international income tax system is to avoid double taxation and double no taxation.

Consensus on International Tax Rule

As s the importance of the international dimension of income taxation has grown, an international consensus has emerged about the structure of the international income tax regime. The income tax is typically levied by a country on (1) the domestic and foreign income of its residents and (2) the domestic income of nonresidents. These basic rules are referred to respectively as the residence and source principles of taxation. The tax legislation of a country should in succinct terms state in some suitably conspicuous place (either the general provision levying the income tax, or the beginning of the group of provisions dealing with international issues, or both) whether and to what extent it has adopted these rules. If a resident of one country earns income from a source in another country, double taxation is likely to result because one country will tax that income on a source basis and the other country on a residence basis. In this case, the internationally accepted regime is that the source country has the prior right to tax (although this right may be limited by treaty), and the residence country is responsible for relieving any double taxation that results. Such relief is generally achieved through one of two systems, the exemption system whereby the foreign income is exempted from tax in the residence country, and the foreign tax credit system whereby the tax of the residence country on the foreign income is reduced by the amount of source country tax on the income. Most countries employ some combination of the two systems.

Purpose of Tax Treaties

The purpose of bilateral tax treaties is typically expressed in their preamble to be the avoidance of double taxation and the prevention of fiscal evasion. As most countries contain within their domestic law provisions to prevent double taxation of their residents in the most common case (where another country taxes the same income on a source basis), the main operation of tax treaties in this respect is for other types of double taxation that can

arise as elaborated below. The prevention of fiscal evasion primarily refers to cases where taxpayers fraudulently conceal income in an international setting and rely on the inability of tax administrations to obtain information from abroad. The exchange of information article in tax treaties is the major provision dealing with this problem. Because of the capital flight experienced by many developing and transition countries, exchange of information is important, but in practice there are some considerable hurdles to successful exchange for reasons developed below. From the perspective of developing and transition countries, there are a number of other purposes of tax treaties that are usually unstated but in many cases are more important. First, there is the division of tax revenues to be derived from income involving the two countries that are parties to the treaty. Where flows of income from business and investment are balanced between two countries, or even among a group of countries, it often does not make a large difference if each country agrees to significantly curtail its source jurisdiction to tax, as its residence taxation of income sourced in the other country is correspondingly increased. Where the flows are substantially unbalanced, the conclusion of a treaty under which each country gives up some of its source jurisdiction to tax generally has the effect of transferring revenue from one country to the other. Typically, developing and transition countries (and many smaller industrial countries) will be in the position vis--vis industrial countries of substantial net capital importers and hence will want to preserve source country tax rights. Second, developing and transition countries nowadays generally desire to encourage capital inflows from capital-exporting countries. Tax treaties may facilitate this process in a number of ways. In a very general sense, entering into tax treaties acts as a signal that a country is willing to adopt the international norms. This symbolic function is reinforced by the nondiscrimination article of tax treaties, by which the country undertakes not to discriminate under its tax laws against residents of treaty partners. Many potential investors attach great importance to the nondiscrimination article, in light of the historical antipathy that many developing and transition countries have in the past exhibited to inward investment. It is no coincidence that many tax treaties with transition countries are negotiated alongside investment protection treaties.

Relationship of Tax Treaties and Domestic Law

It is not necessary to incorporate into domestic law the contents of treaties that operate only between states and do not directly affect private persons. A tax treaty, however, is intended to confer enforceable rights on taxpayers against the countries that are parties to the treaty. How this occurs is a matter for the constitutional law of each state, but in many cases it is necessary for each country to carry out some formal law-making process, such as approval of the tax treaty by parliament. Further, the provisions of tax treaties are intended to have precedence over any inconsistent provisions of domestic tax law. Again, how this is affected is a matter for the constitutional law of the countries concerned. A common practice is to insert such a provision either into the law giving effect to the treaty or into the domestic tax law itself. The usual result of such a provision under the law of most countries is that, apart from the administrative treaty provisions on the mutual agreement procedure and the exchange of

information, a treaty sets limits on the operation of domestic law but does not expand its operation. Thus, if a country taxes business profits arising from sales to residents of the country by a resident of another country without reference to a permanent establishment concept, the business profits article of a tax treaty will usually prohibit such taxation, unless those profits are attributable to a permanent establishment in the country. The outcome is the same if the domestic law uses a permanent establishment concept, but the concept is wider than that used in a relevant treaty. Similarly, if the tax applied under domestic law to dividends and interest paid to a resident of the other treaty country exceeds the maximum rates permitted in the treaty, the source state is obliged to reduce its taxation accordingly. If, however, a country levies no tax on dividends or interest paid to nonresidents, then the fact that a treaty allows such taxation up to a specified limit does not mean that such dividends and interest are taxable. It is possible, however, for domestic law to provide that if a treaty permits taxation that does not otherwise occur under domestic law, then the treaty rule will become the domestic rule for this case. This is the position in France18 (and many Francophone African countries under their tax legislation) and in Australia with respect to source rules contained in treaties under legislation giving force to tax treaties. Such a result is fairly uncommon, however. By contrast, the administrative provisions of tax treaties (which may include articles on mutual agreement, exchange of information, and assistance in collection) by their very terms expand domestic law in the sense of giving powers that generally do not exist under domestic law. Thus, the mutual agreement procedure as contained in article 25 of the OECD Model gives an avenue of recourse to challenge assessment to tax in certain cases that does not exist under domestic law and overrides domestic limitation periods. Article 26 gives power to exchange information that does not usually exist under domestic law and modifies the secrecy provisions of domestic law accordingly. The consequence of this relationship between tax treaties and domestic law suggests an important guideline for drafting the domestic tax rules themselves. If the domestic rules by and large follow the rules typically found in tax treaties, this will simplify the question of the relationship between tax treaties and domestic law and provide transparency to foreign investors as well as indicating (even in the absence of an extensive tax treaty network) the intention of the country to adopt internationally accepted standards.20 This approach also gives instant access to a substantial body of commentary that is accepted by international consensus as elaborating and explaining the wording in question. The consequences of followingor not followingthis guideline will be explored below. Because an international consensus exists on the structure and content of tax treaties, no one country, except perhaps the United States, is able to depart substantially from international norms. Accordingly, having a country tax treaty model that departs radically from the existing international models and following that model in domestic law generally is not a viable option for developing or transition countries.21 Moreover, no country can sensibly adopt a policy of residence taxation only (i.e., excluding the source principle). Neither would it make sense for developing and transition countries to adopt a policy of source-only taxation

International Tax Priorities for Developing and Transition Countries

It will be evident from this chapter that the construction of the international elements of the income tax system in domestic law and tax treaties is a complex topic. Among developing and transition countries (as among industrial countries), there will be wide differences in the capability of the tax administration to deal with international tax issues. While priorities will vary from one country to another, this concluding part of the chapter indicates a line of development that should suit many developing and transition countries. The priority of any tax system will always be to tax the domestic income of resident taxpayers. With the increasing internationalization of economic relations, however, even this goal means that attention must be given to international income tax issues. For better or worse, the globalization of the world economy impinges on developing and transition countries and it is not possible for a country to isolate itself or its tax system. The interdependence of market economies is a new phenomenon, and transition countries in particular retain a residual belief in the ability of regulation to deal with problems. In some developing countries also, the capacity of economic regulation in the current economic environment is overrated. Developing and transition countries face similar problems of international taxation as industrial countries, which mean that, whatever may have been the case in the past, it is not possible to adopt the attitude that international issues can wait. The incentives for capital flight are strong in developing and transition countries even apart from the tax system. If a country operates the source principle only, then it is necessary to have robust rules for the source of income to ensure that the source-based tax is not avoided. Even with such rules, there will be a strong incentive for residents to move income offshore in order to avoid taxation, which will be a relatively simple matter for passive portfolio income (by investment choice). The residence principle should be adopted to prevent this form of tax avoidance. Once the residence principle is adopted, then measures for the relief of double taxation by way of exemption or a simple foreign tax credit are also necessary. At this point of development, the country has satisfied the basic norms for international tax rules on which tax treaties depend. The ability of residents, again by simple investment choice, to derive foreign-source passive income through nonresident taxpayers (such as offshore mutual funds) indicates that further measures are necessary even for the simple goal of protecting the domestic tax base in the case of residents not engaged in active businesses. A simple provision indicating an intention to levy tax in these cases, together with enforcement efforts directed at tax evasion using foreign bank accounts, is the best that can be achieved to deal with the various kinds of capital flight. Residents involved in purely domestic business activities can also use the international tax system to avoid taxes. In this case, investments will be looped offshore and back into the country, creating the potential for such techniques as transfer pricing, thin capitalization, and profit stripping to move profits out of the country, usually to tax havens. The simplest approach for dealing with such problems is a brief provision levying tax on the resident owners of the offshore entities. Such provisions are necessary today simply to ensure collection of tax on the

domestic income of residents. With provisions in place to secure the domestic tax base, probably the next priority should be tax treaties. These marginally increase the capacity to enforce taxation of the domestic income of residents through exchange of information (although the use of tax havens for much of the offshore activity limits the effectiveness of tax treaties). Most important, they signal to foreign investors the countrys intention to play by the generally accepted rules of international taxation and not to discriminate against foreign investors while leaving room (if negotiated in an appropriate form) to extend domestic taxes to foreign investors. Except in the increasingly unusual case of a country deciding not to pursue the negotiation of tax treaties, the contents of tax treaties overshadow the way in which a country should frame its tax laws for the taxation of foreign investors. It has been suggested throughout this chapter that the rules of tax treaties should generally be followed in domestic law for greater transparency and simplicity in the application of the tax law where a tax treaty is operative. Taxation of foreign investors in developing and transition countries is a politically divisive issue. On the one hand, there is a natural resentment against the economic resources of a country being owned and exploited by foreigners. In the past, this attitude contributed in many developing countries to restrictions on foreign-owned operations. On the other hand, the need for foreign capital, technology, and management skills is increasingly felt as more and more countries compete for what is available, especially since the transition countries have entered the picture. The result is policy and administrative ambivalence to taxation of foreign investment. Many countries offer tax incentives for foreign direct investors. While the efficacy of these incentives in attracting increased foreign investment may be doubted, any attempt to tax foreign direct investors effectively involves formidable problems of drafting the law and administering it. The basic provisions for taxing nonresidents consist generally of withholding taxes on passive and employment income and collection by assessment on business income. The investment choices for portfolio foreign investors and the tax avoidance techniques available to the foreign direct investor mean that such provisions are not adequate and that rules in domestic law on transfer pricing, thin capitalization, and tax havens are required. These will by no means cover the tax avoidance strategies available. A general ant avoidance provision or doctrine will assist the tax administration to cope with international tax avoidance, but requires considerable effort to implement. In short, any serious attempt to collect tax from foreign direct investors is fraught with drafting and administrative difficulties, while taxation of portfolio investors may simply induce them to move their investment out of the country. For these reasons, the taxation of foreign investors is probably the last international taxation issue that a developing or transition country should seriously tackle. The number and significance of the international tax problems that confront the income tax is one reason why developing and transition countries do well to rely on alternative tax bases in addition to the income tax as a major source of tax revenue. The valueadded tax, excises, social security, and property taxes generally present fewer international difficulties of drafting and enforcement than the income tax.

Tax Systems and Their Impact

An analysis of alternative welfare benchmarks for taxing foreign income is usefully framed within an analysis of how existing rules influence firm behavior. This section reviews the rules facing American firms and then considers the evidence on the effect of these rules on investment and tax avoidance activities.

International tax practice

The taxation of international transactions differs from the taxation of domestic economic activity primarily due to the complications that stem from the taxation of the same income by multiple governments. In the absence of double tax relief, the implications of multiple taxation are potentially quite severe, since national tax rates are high enough to eliminate, or at least greatly discourage, most international business activity if applied two or more times to the same income.

The foreign tax credit

Almost all countries tax income generated by economic activity that takes place within their borders. In addition, many countries - including the United States - tax the foreign incomes of their residents. In order to prevent double taxation of the foreign income of Americans, U.S. law permits taxpayers to claim foreign tax credits for income taxes (and related taxes) paid to foreign governments. These foreign tax credits are used to offset U.S. tax liabilities that would otherwise be due on foreign-source income. The U.S. corporate tax rate is currently 35 percent, so an American corporation that earns $100 in a foreign country with a 10 percent tax rate pays taxes of $10 to the foreign government and $25 to the U.S. government, since its U.S. corporate tax liability of $35 (35 percent of $100) is reduced to $25 by the foreign tax credit of $10.

Tax deferral

Americans are permitted to defer any U.S. tax liabilities on certain unrepatriated foreign profits until they receive such profits in the form of dividends. This deferral is available only on the active business profits of American-owned foreign affiliates that are separately incorporated as subsidiaries in foreign countries.

The profits of unincorporated foreign businesses, such as those of American-owned branch banks in other countries, are taxed immediately by the United States. To illustrate deferral, consider the case of a subsidiary of an American company that earns $500 in a foreign country with a 20 percent tax rate. This subsidiary pays taxes of $100 to the foreign country (20 percent of $500), and might remit $100 in dividends to its parent U.S. company, using the remaining $300 ($500 - $100 of taxes - $100 of dividends) to reinvest in its own, foreign, operations. The American parent firm must then pay U.S. taxes on the $100 of dividends it receives (and is eligible to claim a foreign tax credit for the foreign income taxes its subsidiary paid on the $100). But the American firm is not required to pay U.S. taxes on any part of the $300 that the subsidiary earns abroad and does not remit to its parent company. If, however, the subsidiary were to pay a dividend of $300 the following year, the firm would then be required to pay U.S. tax (after proper allowance for foreign tax credits) on that amount.

U.S. tax law contains provisions designed to prevent American firms from delaying the repatriation of lightly-taxed foreign earnings. These tax provisions apply to controlled foreign corporations, which are foreign corporations owned at least 50 percent by American individuals or corporations who hold stakes of at least 10 percent each. Under the Subpart F provisions of U.S. law, some foreign income of controlled foreign corporations is deemed distributed, and therefore immediately taxable by the United States, even if not repatriated as dividend payments to American parent firms.

Excess foreign tax credits

Since the foreign tax credit is intended to alleviate international double taxation, and not to reduce U.S. tax liabilities on profits earned within the United States, the foreign tax credit is limited to U.S. tax liability on foreign-source income. For example, an American firm with $200 of foreign income that faces a U.S. tax rate of 35 percent has a foreign tax credit limit of

$70 (35 percent of $200). If the firm pays foreign income taxes of less than $70, then the firm would be entitled to claim foreign tax credits for all of its foreign taxes paid. If, however, the firm pays $90 of foreign taxes, then it would be permitted to claim no more than $70 of foreign tax credits. Taxpayers whose foreign tax payments exceed the foreign tax credit limit are said to have excess foreign tax credits; the excess foreign tax credits represent the portion of their foreign tax payments that exceed the U.S. tax liabilities generated by their foreign incomes. Taxpayers whose foreign tax payments are smaller than their foreign tax credit limits are said to have deficit foreign tax credits. American law permits taxpayers to use excess foreign tax credits in one year to reduce their U.S. tax obligations on foreign source income in either of the two previous years or in any of the following five years.

In practice, the calculation of the foreign tax credit limit entails certain additional complications, notable among which is that total worldwide foreign income is used to calculate the foreign tax credit limit. This method of calculating the foreign tax credit limit is known as worldwide averaging. A taxpayer has excess foreign tax credits if the sum of worldwide foreign income tax payments exceeds this limit.

Taxation and FDI

Tax policies are obviously capable of affecting the volume and location of FDI, since; all other considerations equal, higher tax rates reduce after-tax returns, thereby reducing incentives to commit investment funds. Of course, all other considerations are seldom equal. Countries differ not only in their tax policies, but also in their commercial and regulatory policies, the characteristics of their labor markets, the nature of competition in product markets, the cost and local availability of intermediate supplies, proximity to final markets, and a host of other attributes that influence the desirability of an investment location. Furthermore, the various tax and regulatory policies that are relevant to foreign investors may be correlated with non-tax

features of economies that independently affect FDI levels. Consequently, it is necessary to interpret evidence of the effect of taxation with considerable caution.

The empirical literature on the effect of taxes on FDI considers almost exclusively U.S. data, either the distribution of U.S. direct investment abroad, or the FDI patterns of foreigners who invest in the United States. The simple explanation for this focus is not only that the United States is the worlds largest economy, but also that the United States collects and distributes much more, and higher-quality, data on FDI activities than does any other country. The available evidence of the effect of taxation on FDI comes in two forms. The first is time-series estimation of the responsiveness of FDI to annual variation in after-tax rates of return. Implicit in this estimation is a q-style investment model in which contemporaneous average aftertax rates of return serve as proxies for returns to marginal FDI. Studies of this type consistently report a positive correlation between levels of FDI and after-tax rates of return at industry and country levels. The implied elasticity of FDI with respect to after-tax returns is generally close to unity, which translates into a tax elasticity of investment of roughly -0.6. The estimated elasticity is similar whether the investment in question is American direct investment abroad or FDI by foreigners in the United States. The primary limitation of aggregate time-series studies is that they are identified by yearly variation in taxes or profitability that may be correlated with important omitted variables. As a result, it becomes very difficult to distinguish the effects of taxation from the effects of other variables that are correlated with tax rates. Two of the time-series studies exploit crosssectional differences that offer the potential for greater explanatory power. Slemrod (1990) distinguishes FDI in the United States by the tax regime in the country of origin, comparing the behavior of investors from with tax systems similar to that used by the United States to the behavior of investors whose home countries exempt foreign profits from taxation. He finds no clear empirical pattern indicating that investors from countries that exempt U.S. profits from home-country taxation are more sensitive to U.S. tax changes than are investors from countries granting foreign tax credits. Swenson (1994) reports that industries in which the (U.S.) aftertax cost of capital rose the most after passage of the U.S. Tax Reform Act of 1986 were those in which foreign investors concentrated their FDI in the post-1986 period, which is consistent

with the tax incentives of foreign investors from countries granting foreign tax credits.

Other studies of investment location are exclusively cross-sectional in nature, exploiting the very large differences in corporate tax rates around the world to identify the effects of taxes on FDI. Grubert and Mutti (1991) and Hines and Rice (1994) estimate the effect of national tax rates on the cross-sectional distribution of aggregate American-owned property, plant and equipment (PPE) in 1982. Grubert and Mutti analyze the distribution of PPE in manufacturing affiliates in 33 countries, reporting a -0.1 elasticity with respect to local tax rates. That is, controlling for other observable determinants of FDI, ten percent differences in local tax rates are associated with one percent differences in amounts of local PPE ownership in 1982. Hines and Rice consider the distribution of PPE in all affiliates in 73 countries, reporting a much larger -1 elasticity of PPE ownership with respect to tax rates. Altshuler, Grubert and Newlon (2001) compare the tax sensitivity of aggregate PPE ownership in 58 countries in 1984 to that in 1992, reporting estimated tax elasticitys that rise (in absolute value) from -1.5 in 1984 to -2.8 in 1992. Desai, Foley and Hines (2002b) use affiliate-level data to identify the impact of differences in income tax rates and other taxes on the allocation of FDI within companies. The results indicate that one percent lower income tax rates are associated with 0.4 percent larger affiliate assets, which translates into an estimated elasticity of asset allocation with respect to income taxes of 0.125.

Taxation and tax avoidance

One of the important issues in considering the impact of taxation on international investment patterns is the ability of multinational firms to adjust the reported location of their taxable profits. To the extent that FDI can facilitate the advantageous relocation of profits, then firms will have incentives to tailor their international investment strategies with such relocation in mind. Hence any complete analysis of the impact of taxation on

the operations of multinational firms must necessarily consider the ability and evident willingness of multinational firms to undertake activities to avoid international tax obligations. The financing of foreign affiliates presents straightforward opportunities for international tax avoidance. If an American parent company finances its investment in a foreign subsidiary with equity funds, then its foreign profits are taxable in the host country and no taxes are owed the U.S. government until the profits are repatriated to the United States. The alternative of financing the foreign subsidiary with debt from the parent company generates interest deductions for the subsidiary that reduce its taxable income, and generates taxable interest receipts for the parent company. Simple tax considerations therefore often make it attractive to use debt to finance foreign affiliates in high-tax countries and to use equity to finance affiliates in low-tax countries. The evidence is broadly consistent with these incentives. Hines and Hubbard (1990) find that the average foreign tax rate paid by subsidiaries remitting nonzero interest to their American parent firms in 1984 exceeds the average foreign tax rate paid by subsidiaries with no interest payments, while the reverse pattern holds for dividend payments. Grubert (1998) estimates separate equations for dividend, interest, and royalty payments by 3467 foreign subsidiaries to their parent American companies (and other members of controlled groups) in 1990, finding that high corporate tax rates in countries in which American subsidiaries are located are correlated with higher interest payments and lower dividend payout rates. The evidence provided in Desai, Foley and Hines (2003a) indicates that 10 percent higher local tax rates are associated with 2.8 percent higher debt/asset ratios of American-owned affiliates, and that borrowing from related parties is particularly sensitive to tax rates. Contractual arrangements between related parties located in countries with different tax rates offer numerous possibilities for sophisticated tax avoidance. It is widely suspected that firms adjust transfer prices used in within-firm transactions with the goal of reducing their total tax

obligations. Multinational firms typically can benefit by reducing prices charged by affiliates in high-tax countries for items and services provided to affiliates in low-tax countries. OECD governments require firms to use transfer prices that would be paid by unrelated parties, but enforcement is difficult, particularly when pricing issues concern unique items such as patent rights. Given the looseness of the resulting legal restrictions, it is entirely possible for firms to adjust transfer prices in a tax-sensitive fashion without even violating any laws.

The evidence of tax-motivated transfer pricing comes in several forms. Grubert and Mutti (1991) and Hines and Rice (1994) analyze the aggregate reported profitabilitys of U.S affiliates in different foreign locations in 1982. Grubert and Mutti examine profit/equity and profit/sales ratios of U.S.-owned manufacturing affiliates in 29 countries, while Hines and Rice regress the profitability of all U.S.-owned affiliates in 59 countries against capital and labor inputs and local productivities. Grubert and Mutti report that high taxes reduce the reported after-tax profitability of local operations; Hines and Rice find considerably larger effects (one percent tax rate differences are associated with 2.3 percent differences in before-tax profitability) in their data. While it is possible that high tax rates are correlated with other locational attributes that depress the profitability of foreign investment, competitive conditions typically imply that aftertax rates of return should be equal in the absence of tax-motivated income-shifting. The fact that before-tax profitability is negatively correlated with local tax rates is strongly suggestive of active tax avoidance. Using affiliate-level data, Desai, Foley and Hines (2002b) show that 10 percent higher tax rates are associated with 0.6 percent lower profit rates, which corresponds to an elasticity of reported profits with respect to the tax rate of 0.33. Harris, Morck, Slemrod and Yeung (1993) report that the U.S. tax liabilities of American firms with tax haven affiliates are significantly lower than those of otherwise-similar American firms over the 1984-1988 period,

which may be indirect evidence of aggressive transfer-pricing by firms with tax haven affiliates. Collins, Kemsley and Lang (1998) analyze a pooled sample of U.S. multinationals over 19841992, finding a similar pattern of greater reported foreign profitability (normalized by foreign sales) among firms facing foreign tax rates below the U.S. rate. And Klassen, Lang and Wolfson (1993) find that American multinationals report returns on equity in the United States that rose by 10 percent relative to reported equity returns in their foreign operations following the U.S. tax rate reduction in 1986. Patterns of reported profitability are consistent with other indicators of aggressive tax-avoidance behavior, such as the use of royalties to remit profits from abroad and to generate tax deductions in host countries. Hines (1995) finds that royalty payments from foreign affiliates of American companies in 1989 exhibit 0.4 elasticity with respect to the tax cost of paying royalties, and Grubert (1998) also reports significant effects of tax rates on royalty payments by American affiliates in 1990. Clause (2001) finds that reported trade patterns between American parent companies and their foreign affiliates, and those between foreign affiliates located in different countries, are consistent with transfer-pricing incentives. Controlling for various affiliate characteristics, including their trade balances with unaffiliated foreigners, Clausing finds that ten percent higher local tax rates are associated with 4.4 percent higher parent company trade surpluses with their local affiliates, which is suggestive of pricing practices that move taxable profits out of high-tax jurisdictions. In subsequent work, clause (2003) reports that prices used for transactions between U.S. parent companies and their foreign affiliates differ from prices for comparable goods used by companies transacting with unrelated parties in ways that tend to relocate taxable profits out of high-tax jurisdictions and into low-tax jurisdictions. Swenson (2001) finds a similar pattern in the reported prices of goods imported

into the United States, in which high unit tariff rates appear to be associated with unusually low prices. Dividend repatriations from foreign subsidiaries to domestic parent companies trigger tax obligations, so firms have incentives to adjust the timing and magnitude of dividend payments in order to avoid home country taxes. Hines and Hubbard (1990) analyze a crosssection of U.S. multinationals using tax return data from 1984 in an effort determine the sensitivity of multinational dividends to tax costs. In their sample, Hines and Hubbard note that large aggregate payouts are the result of selective and infrequent dividend payments by affiliates. Using this cross-section of data, they conclude that a one percent decrease in the repatriation tax is associated with a four percent increase in dividend payout rates.The evidence provided in Hines and Hubbard suggests that tax considerations are very important determinants of the timing of dividend repatriations. The cross-section used by Hines and Hubbard makes it impossible to distinguish the effects of transitory and permanent changes in repatriation taxes. Altshuler, Newlon and Randolph (1995) attempt to identify permanent and transitory tax costs by creating an unbalanced panel of subsidiaries using tax returns from 1980, 1982, 1984 and 1986. Permanent repatriation tax costs for subsidiaries are constructed from a first-stage regression that uses as explanatory variables statutory withholding tax rates and average tax rates of other subsidiaries in the same country. Altshuler, Newlon and Randolph find, as predicted by Hartman (1985), that transitory tax costs influence dividend payments while permanent tax costs do not. The effort to disentangle the permanent and temporary tax costs of dividends is limited, however, by the very small number of annual observations for each firm. Grubert (1998) and Grubert and Mutti (2001) report that dividends are sensitive to tax costs in their analyses of cross-sections of tax returns for 1990 and 1992, respectively. Desai, Foley and Hines (2001, 2002a) consider the responsiveness of dividend repatriations to

tax rate differences, finding that a variety of non-tax factors affect repatriation decisions, but that one percent lower repatriation tax rates are associated with one percent higher dividends implying that repatriation taxes reduce aggregate dividend payouts by 12.8 percent.