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April 2, 2015
News Analysis: The Power of a Name: Stateless Income and Its Failings
by Mindy Herzfeld

Full Text Published by Tax Analysts®

This article first appeared in the March 23, 2015 edition of Tax Notes International.

The concept of stateless income has significantly affected international tax policy since 2011, when University of Southern California Gould School of Law professor Edward Kleinbard coined the term. The phrase has provided a rationale for various international tax reform efforts now underway. More broadly, Kleinbard's articles on stateless income can be seen as providing the blueprint for the OECD's 15-point base erosion and profit-shifting action plan. (Prior coverage: here and here.)

Kleinbard's profound influence on the past year of international tax policymaking deserves to be recognized. By the same token, however, the extent of that influence also warrants a critique of the premises that have driven the policy efforts growing out of concerns about stateless income. Kleinbard's far-reaching influence, and the near-universal acceptance of his analysis of the problems in the international tax system, deflect attention from the fact that his analysis glosses over the political and historical realities that gave rise to the systemic problems he describes. Understanding those realities helps explain why the BEPS project may be floundering.

Kleinbard's arguments as laid out in his articles essentially ignore that governments often have a vested interest in allowing opportunities for multinational corporate tax planning. This self-interest has allowed the system to develop and to perpetuate itself. It is easier for countries to encourage direct investment by providing multinationals with opportunities for cross-border tax planning than to try to sell corporate tax breaks to a suspicious public. Developing policy proposals while ignoring these political realities bodes poorly for the success of the solutions. Moreover, talking about stateless income without acknowledging the benefits the system provides to particular jurisdictions ignores much of the picture, including the interests individual countries have in protecting their sovereignty and important elements of the current system of international taxation.

Stateless Income and Its Consequences

In a 2011 article, Kleinbard defined stateless income as:

    income derived by a multinational group from business activities in a country other than the domicile (however defined) of the group's ultimate parent company, but which is subject to tax only in a jurisdiction that is not the location of the customers or the factors of production through which the income was derived, and is not the domicile of the group's parent company.

    [Kleinbard, "Stateless Income" (11 Florida Tax Review 699, 702 (2011)).]

As an example of stateless income, Kleinbard describes Google's double Irish structure. In that structure, Google's subsidiaries in Europe, the Middle East, and Africa pay royalties to an Irish limited company, which in turn makes offsetting deductible royalty payments to a Dutch BV. The Dutch BV makes a deductible royalty payment to a dual-resident Irish/Bermuda company, which was subject to tax only in Bermuda, which imposes no corporate income tax. Profits earned by Google in royalty-paying jurisdictions are therefore presumably shielded from corporate income tax.

Despite Kleinbard's careful delineation of the term "stateless income," the phrase has taken on a meaning of its own. Policymakers around the world have co-opted it to serve their own goals of enacting international tax reform focused on BEPS. The extent to which the concept of stateless income has taken root and served as the underpinning of so many recent international tax reform proposals can be seen in the extent to which the term has surfaced in the proposals and in rhetoric that government officials have used to describe tax abuses that must be curtailed. For example:

  • The U.S. Treasury green book (issued with the Obama administration's fiscal 2016 proposed budget) argued that proposed changes to restrict the use of hybrid instruments were needed to restrict arrangements that "create stateless income."
  • In congressional testimony, Robert Stack, Treasury deputy assistant secretary (international tax affairs), described the principal target of the BEPS project as "so-called stateless income."
  • Pascal Saint-Amans, director of the OECD Centre for Tax Policy and Administration, and Raffaele Russo, head of the BEPS project, have described solving the problem of stateless income as a primary goal of the BEPS project. These statements coincide with BEPS discussion drafts that identify "restoring taxation on stateless income" as one of the key goals of the project. (See Saint-Amans and Russo, "Combating BEPS and making sure we have fair tax systems: An OECD/G20 Venture," Sept. 29, 2014, available at

In defining the status quo as resulting in stateless income, Kleinbard's articles allowed governments to envision a world in which there was a pot of global profits simply waiting for someone to tax them. Because nobody wanted to be left out of that party, governments rushed to be the first to lay claim to the income.

Stateless Income and Its Solutions

Kleinbard identified the "mechanics of stateless income tax planning" to include the following:
  • earnings stripping, particularly that aided by check-the-box;
  • transfer pricing, with an emphasis on abuses inherent in cost-sharing arrangements;
  • aggressive contractual terms in transfer pricing; and
  • legal system arbitrage that, for example, allows debt in one jurisdiction to be treated as equity in another.

Kleinbard also pointed out other features of the system leading to the stateless income problem:
  • the recognition of "the separate tax personas of different juridical persons," even when they are commonly owned;
  • the general practice of treating interest on indebtedness as deductible to the payer;
  • a multinational enterprise's freedom under transfer pricing rules to deal with a subsidiary as if it were an independent actor;
  • the meaninglessness of risk shifting among related-party members, or treating the capital of a subsidiary separate from that of the parent; and
  • the norms of freedom of contract within the group.

Much of what's in the BEPS action plan, and the solutions proposed in the discussion drafts on individual action items, can be traced to these features in the system. For example, the proposed revisions to the transfer pricing drafts focus on the problems of risk shifting and moral hazard resulting from the actions of related parties.While most of the characteristics of the international tax system described by Kleinbard were widely known, in identifying and analyzing the issues in the manner he did, Kleinbard set out a convenient blueprint for the OECD to draft the BEPS action plan.

The Flaws of Stateless Income as a Concept

In painting a picture of a broken system, Kleinbard fails to acknowledge the following political and historical realities as significant contributors to that system.

Reality 1: Income Isn't Stateless

Kleinbard's description of stateless income makes clear that in coining the term he was simply devising a catchy phrase to describe a situation in which income is separated from the economic factors of production. But as is also clear from parsing the definition, stateless income is not really stateless. It mostly resides in jurisdictions that obtain significant benefits from serving as a haven for the cash or income of multinational companies, even if that income isn't taxed at rates as high as those in other countries, or at all. Those jurisdictions have a vested interest in preserving the status quo, because it provides high-value employment to their citizens.

Further, to label such income as "stateless" delegitimizes the sovereignty of countries that receive income shifted from high-tax jurisdictions. Even though the OECD has repeatedly given credence to each country's ability to set its own tax rates, and said the BEPS project is not an attempt to diminish countries' sovereignty, the repeated characterization of income that ends up in zero- or low-tax jurisdictions as "stateless" does exactly that.

One could argue that shaming those jurisdictions serves an important purpose of trying to improve the overall integrity of the international tax system. But the fact that many of these jurisdictions have lower than average per capita income, and that many are former colonies of developed Western nations, suggests that a more balanced approach is needed to an exercise that in effect would primarily benefit 21st-century industrialized economies. As the IMF and the OECD have recognized, base stripping is also a significant problem for developing countries, particularly in Africa. But those countries are not the drivers of the BEPS project, and any benefits they might receive from it can be seen as secondary to the goals of the developed nations leading the project.

Reality 2: Political Benefits of Stateless Income

Because they begin from the premise that the current rules allow for significant tax planning opportunities for multinationals that lead to inefficient economic results, Kleinbard's articles ignore the large role played by political systems that have considerable self-interest in perpetuating those rules. In many cases, the governments that have attacked BEPS the hardest have also facilitated those practices historically. Because Kleinbard's article, "Stateless Income," begins by describing a problem that needs to be solved, and ignores the political drivers and historical realities that gave rise to that problem, it risks dooming to political failure any proposed solution. The BEPS project, mandated by the G-20, has identified a problem but neglected to acknowledge its historical causes. Because of that, it has been able to proceed from a moral high ground without considering the role of many government actors in enabling the status quo.

Here is some historical and political context in which to view the current systemic issues in the international tax system.

    U.K. Territories, Dependencies, and Former Colonies
Ten jurisdictions impose no corporate income tax. Three -- Bermuda, the Cayman Islands, and the British Virgin Islands -- are British overseas territories. Gibraltar, with a 10 percent corporate income tax, is also a British overseas territory. A British overseas territory has its own constitution and its own government, and its own local laws. Powers devolve to the elected governments of the territories to the extent possible consistent with the United Kingdom retaining those powers necessary to discharge its sovereign responsibilities.

Jersey, Guernsey, and the Isle of Man (also jurisdictions with low tax rates) are crown dependencies; as such, they are internally self-governing and have their own directly elected legislative assemblies; administrative, fiscal, and legal systems; and courts of law.

In a 2012 white paper, the U.K. government defined its relationship with the territories and set out its commitment to work with them to address their challenges. One of the priorities identified was working with the territories to strengthen good-governance arrangements, public financial management, and economic planning.

The United Kingdom has stated that it wants its territories to flourish. To that end, it has declared that its "fundamental responsibility is to ensure the security and good governance of the Territories and their peoples. This requires us, amongst other things, to promote the political, economic, social and educational advancement of the people of the Territories, to ensure their just treatment and their protection against abuses, and to develop self-government and free political institutions."

At the same time, the United Kingdom is a leader of the BEPS project and has taken a strong role in emphasizing the importance of preventing tax avoidance through BEPS. In a 2014 paper, "Tackling Aggressive Tax Planning in the Global Economy: UK Priorities for the G20-OECD Project for Countering Base Erosion and Profit Shifting," the government outlined its strategies for dealing with a system of international tax rules that has "allowed some companies to manipulate internal transactions to ensure a high proportion of their profits accrue in low tax jurisdictions."

There is an inherent tension between the U.K.'s role as a strong proponent of the BEPS project and the fact that much of the stateless income ends up in jurisdictions over which the United Kingdom has oversight and a vested interest in ensuring sustainable local economies.

    The European Union
While the BEPS project represents the most coordinated global attack on BEPS, the European Commission has also taken a page from Kleinbard's playbook. In its recent state aid cases against Luxembourg, Ireland, and the Netherlands, it has questioned those countries' granting transfer pricing rulings to several multinationals. (Prior analysis: Tax Notes Int'l, Dec. 8, 2014.) Under the guise of the EU's state aid rules, which prohibit the provision by a national public authority of an advantage conferred selectively to specific undertakings, the commission has questioned the transfer pricing practices and tax planning structures of (primarily U.S.) multinational companies.

It is especially worthwhile to consider, then, the importance of the role that European institutions, in particular the Court of Justice of the European Union, play in enabling the types of base erosion structures that Kleinbard described. In several decisions over the past decade, the CJEU has enforced the mandates on freedom of establishment and free movement of capital enshrined in the Treaty on the Functioning of the European Union. (See, for example, National Grid Indus BV (C-371/10).) These decisions have forced EU member countries to modify their laws to permit more tax-free movement of assets and, accordingly, shift income among EU member countries. (Prior analysis: Tax Notes Int'l, Jan. 13, 2014.) Also, changes to EU corporate law, such as the passage of the EU merger directive, have increased the ease of tax-free cross-border transfer of assets. At the same time, the EU has declined to enforce greater tax harmonization among EU member countries generally.

The EU legal changes and the CJEU decisions have greatly aided BEPS among EU member countries. The commission may simply be trying to stop corporate tax planning with its state aid actions. But the EU's role of integrating the tax systems of its member countries, while constrained in several important respects, cannot be ignored when attempting to propose solutions to the base erosion problem. It is a root cause of the problem and one that cannot be expected to disappear anytime soon.

    U.S. Check-the-Box
The U.S. check-the-box system is most often described -- including by Kleinbard -- as inappropriately perpetuating the use of foreign base eroding techniques and avoidance of subpart F inclusions by U.S. multinationals. Yet that description ignores the political reality that the check-the-box system permits the U.S. Congress to subsidize U.S. multinationals at little political cost. U.S. legislators have a vested interest in preserving a system that allows for base eroding by U.S. multinationals, which in turn allows them to keep their foreign tax rates low, to the ultimate benefit of the U.S. Treasury. And it is far easier politically to continue to allow U.S. multinationals to keep their effective tax rates lower by not overturning loose subpart F rules, rather than attempting a corporate tax rate cut.

The strong interest that congressional lawmakers, at the insistence of their corporate constituents, have in the check-the-box system was made clear to the administration when it proposed to limit those rules in the 2009 budget. The proposal died as a result of pressure from Congress, which threatened to overturn it through legislative action. As that makes clear, it is not just corporate multinational taxpayers that benefit from the system, but governments as well. The U.S. government has every reason to continue supporting the check-the-box system, which is a large part of the stateless income story, because it benefits its multinational enterprises and ultimately its fisc.

Reality 3: It's a Zero-Sum Game

While Western countries are participating in the BEPS project for their own purposes, the BRICS countries of Brazil, Russia, India, China, and South Africa, which have been included in the project, have their own self-interests to uphold.

As Kleinbard points out, "Stateless income also flourishes because of nations' collective failure to agree on other critical international tax norms that would determine the 'source' of income -- that is, the mechanical rules by which income is attributed to one jurisdiction or another." He describes the phenomenon as leading to "the dissolution of any coherence to the concept of geographic source."

The description of the stateless income problem as one integrally tied to the failure to tie taxable income to its source has led to countries aggressively asserting their rights to taxation at source. This is particularly evident in the eagerness with which India and China have joined in the BEPS efforts. One could characterize their adoption of the project as a means of asserting their jurisdiction over more income that could be sourced to their countries.

The Future of Stateless Income

A project to eliminate stateless income provides cover for countries wanting to change the international tax system to acquire greater taxing rights over profits that now have only a tenuous connection to their jurisdiction.

It cannot be assumed that if the flaws in the system are fixed, this stateless income will simply return to its home. Countries that bought into the project on that assumption will continue to be disappointed. A project to reallocate stateless income necessarily involves winners and losers, and as is becoming increasingly evident, the winners will likely be those countries able to assert more source-based taxation rights.

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