Arthur J. Cockfield is a professor at Queen's University Faculty of Law in Kingston, Ontario.
This article is a revised version of "Chapter 1: Introduction," in: Arthur J. Cockfield, ed., Globalization and Its Tax Discontents: Tax Policy and International Investments (Toronto: University of Toronto Press, 2010). The book collects essays in honor of the late tax professor Alex Easson.
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The topic of globalization and tax is an ancient one. Writings on the subject date back at least 2,500 years to the work of Herodotus, the ancient Greek scholar who coined the term "history."1 In The Histories, Herodotus tells us of an era when ancient peoples came increasingly in contact with one another through cross-border trade and investment as well as warfare. He was writing during the so-called Greek Enlightenment, a time of relative peace and prosperity for the Greeks who, a generation before, had successfully defended their lands against invasion by the Persians. Intensely interested in foreign developments, the Greeks reviewed the tax systems within the great Persian and Egyptian empires to see what lessons they could learn. For instance, Herodotus tells us that in 594 B.C., Solon the Athenian copied the Ancient Egyptian practice of forcing citizens to declare how much wealth they had for tax purposes.2
In an era of enhanced global economic interdependence, modern governments, like those of the ancients, increasingly study the tax policies in place elsewhere. In contemporary terms, they are seeking to ensure that their tax rules governing the treatment of cross-border investments are competitive with those of foreign tax regimes, a much friendlier battle than the real ones of earlier eras. Recently, governments in Canada, the United States, the United Kingdom, Japan, Germany, Italy, Australia, New Zealand, Sweden, and elsewhere have discussed reforming their tax systems so that they encourage (or at least do not inhibit) international investments.3 Provoked in large part by tax competition concerns, the United Kingdom and Japan have moved to territorial tax systems that generally exempt from taxation foreign active business income, leaving the United States as the last major player with a full-blown residence-based taxation system.4
This article discusses the tax policy challenges presented by an environment that generally permits governments to develop international tax rules as they see fit. It begins by identifying three policy worries of high-tax governments in which:
- multinational firms locate assets in relatively low-tax jurisdictions;
- multinational firms shift paper profits to relatively lower tax jurisdictions; and
- the governments increasingly cannot discern the appropriate taxing jurisdiction for taxing value-added economic activities in an economically integrated world.
To highlight the relevant policy issues, this article discusses the challenges of taxing the Hollywood blockbuster movie 300, which was loosely based on Herodotus's account of the Battle of Thermopylae in The Histories. A final section touches on the ways that international tax policy analysis struggles to identify optimal laws and policies given the reality of a noncooperative government setting.
In recent decades, the increase in international trade and investment -- for example, direct investment into and out of Canada increased by roughly 500 percent between 1986 and 2007 -- likely has been encouraged by the falling of tariff and non-tariff barriers promoted by binding global agreements including the WTO agreements.5 However, countries have refused to negotiate binding multilateral tax agreements, so that tax remains one of the last barriers to the integration of global capital markets. As a result, investment decision-making is becoming increasingly sensitive to national tax differences. This environment promotes several international tax policy challenges.
First, the current international tax regime permits countries to maintain different tax rules, which encourages multinational firms to shift the location of their investments and operations to countries that impose relatively lower (or nil) tax burdens. While there is an ongoing debate on the impact of tax on foreign direct investment location decisions, empirical studies increasingly suggest that these investment decisions are influenced by tax.6 The outcome is a loss of employment and tax revenues to relatively high-tax countries. The different national tax regimes also distort cross-border investment decision-making in a manner that is not considered economically efficient -- assets are deployed in countries for tax reasons and not out of real economic rationales. At least in theory, this process reduces national and global welfare because assets are not being used in their most productive fashion.
Second, multinational firms shift more paper profits through sophisticated tax-planning strategies to investments in countries that impose relatively lower (or nil) tax burdens, which often reduces taxes collected in relatively high-tax countries. Studies increasingly show that the substitution of intragroup equity and debt financing, as well as the location of external debt, occurs in situations of near-perfect substitutability.7 As mentioned, in recent years some governments have reformed their tax systems to exempt from tax all foreign-source active business income. This development has led to the paying of increased academic and policy attention to tax rules that permit interest deductions to fund foreign investments and operations that are exempt from residence-country tax.8 These interest deductions for exempt foreign-source income, in fact, are responsible for one of the biggest holes in the global fiscal web, since they reduce taxable profits and revenues in countries that maintain relatively high taxes. Yet the residence-based taxation of foreign-source active business income is similarly subject to taxpayer manipulation: The phenomenon of achieving zero or negative tax on foreign-source income has been labeled "self-help territoriality" in that U.S. residents have managed to structure their activities in order to transform the ostensible U.S. worldwide tax system into an exemption (or territorial) tax system.9
Third, it is becoming progressively more difficult to determine which country should assess the appropriate tax liability (along with enjoying the resulting tax revenues) on globally integrated products and services derived through cross-border investments. In particular, the appropriate taxing jurisdiction for highly mobile intangibles is difficult to ascertain.10 A related concern is the fair sharing of tax revenues among governments from taxing these globally integrated products and services. Because of the difficulty in identifying the country where taxable value-adding activities are taking place, resistance to solutions involving collective action can also harm economically vulnerable countries that do not have the resources to audit and tax complex cross-border transactions involving highly mobile factors of production.
An Example: Taxing 300
For a sense of the policy challenges, consider the tax issues surrounding one such globally integrated product: the 2007 international blockbuster film 300. As mentioned, the film was loosely based on Herodotus's account in The Histories of the Battle of Thermopylae (circa 480 B.C.), in which King Leonidas led his 300 Spartan warriors, as well as other Greek troops, against a Persian army of overwhelming numbers. The movie enjoys an interesting pop culture pedigree. In 1962, a Hollywood movie called The 300 Spartans was seen by a young Frank Miller, who eventually went on to reproduce aspects of the film in his graphic novel 300.11 The recent film was based on this book, with Miller acting as a consultant and executive producer.
The film highlights the complexities of taxing modern, globally integrated products, given the reality of a noncooperative environment. It was produced by a major U.S. film studio but almost entirely filmed on digital video in a green-screened warehouse outside Montreal. A Montreal special effects company later added digital effects, so that the movie appears to have been filmed in an exterior setting. To date, the movie has earned worldwide revenues of more than US $500 million.
Regarding the first tax concern, about the impact of tax on investment location, 300 was filmed and edited in Montreal in large part because of film and video production tax credits offered by the Canadian and Quebec governments.12 Does it matter that Canada attracted this international investment in part as a result of tax incentives? Do such tax incentives distort cross-border investment decision-making in an unproductive manner, as some argue?13 The Canadian government justifies these incentives in part as a way to encourage film works that protect and enhance Canadian culture (in this case, presumably the culture of Canadians with Greek ancestry). As long as there is no global tax institution to bind participating countries to international tax rules, governments can deploy tax incentives (for example, the Canadian film and production tax credits) as they see fit, which could distort cross-border investment decision-making in a manner that is economically inefficient, leading to overall reductions in global wealth (and corresponding reduced standards of living).14
In terms of the second international tax concern, about the use of tax planning to shift income to reduce global tax liabilities, it is difficult to assess whether planning played a role in the financing or operations of 300. A typical movie industry tax-planning strategy involves shifting studio overhead costs to profitable movies (such as 300), because they can be deducted against gross revenues to reduce taxable profits. In this way, studios protect their investments against the many movies that lose money -- the box office winners subsidize the losers. The problem is that, although Canadian and U.S. tax laws (as well their tax treaty) generally do not permit tax losses in a corporation in one country to be offset against profits in the other, they allow two related corporations in the same country to undertake this loss offsetting.15
These rules encourage multinational firms to engage in sophisticated tax planning to ensure their investments remain viable. They can achieve additional tax savings by shifting their profits to a jurisdiction (such as a tax haven) with low or nil taxes. In the case of 300, because the U.S. studio sold the film rights to distributors around the world, it might have been possible to shift some of the profits from these sales, as well as any resulting tax revenues, away from countries with relatively high taxes, including Canada and the United States.
Regarding the third tax concern, about ensuring that governments collect an appropriate share of tax revenues from the profits of multinational firms, assuming that 300 generated taxable profits, which country should enjoy a greater share of the tax revenues? The matter is complicated because 300 is a unique, intangible asset that will continue to enjoy streams of cross-border royalty income from the sales of rights to use the asset. Most of the film's initial creative input occurred in the United States: It was adapted from the work of a U.S. writer, and the director and several screenwriters were also American. Should this fact entitle the U.S. government to tax a greater share of the global profits from sales to movie distributors, as well as subsequent royalties? Because most of the actual filming and editing of the movie took place in Canada, does that warrant greater taxation by the Canadian government? Did Canada, through its film and video production tax credit, voluntarily give up its right to tax the film's profits in exchange for other benefits, for example fostering and maintaining a skilled workforce in Canada?
The tax policy issues that arise from this scenario are vexing indeed. And this is just one of seemingly countless examples -- automobiles, cellphones, software, toys, and call centers, to name a few -- of globally integrated products and services to which these conundrums apply.
Given the reality of a noncooperative government regime, how should international tax reform efforts address the challenges of globalization? On the one hand, globalization encourages flows of cross-border investments; on the other, it constrains policy options as countries find they can no longer "go it alone" and develop international tax policy positions as they see fit. Because tax is interwoven with the fabric of society, as Solon the Athenian realized long ago, these policy decisions are of critical importance in determining each country's vision of a just society. Governments have already ceded policy control over many other areas, such as international trade; now they are struggling to determine the appropriate policy responses that will let them maintain democratic control over their tax systems while recognizing that globalization makes this control increasingly illusory.
International tax reform is thus one of the last policy battlegrounds of globalization. Indeed, like some unruly beast, international tax policy refuses to be tamed by traditional international law principles.16 Developments considered passé in other areas of public international law seem almost radical when considered for implementation within the international tax regime. For instance, governments have only recently begun to seriously contemplate cross-border tax law mechanisms such as binding arbitration for some international tax disputes, the reciprocal enforcement of cross-border tax debts, or even the distant possibility of a multilateral tax treaty -- tax law "innovations" that have been in place in some shape or form for more than a half-century in international trade.
And so it goes for the taxation of international investments in spite of the pressures of globalization: The tax law and treaty rules that govern the taxation of these investments remain much the same today as the ones advocated by League of Nations experts almost 100 years ago.17 Because of the politically charged nature and glacial pace of international tax reform, some longtime tax observers, such as Alex Easson, maintain that international tax policy analysis should try to integrate current thinking about economic theory with an understanding of the broader political, social, historical, and other realities that dictate whether tax reform measures will succeed.18 To these observers, the main policy challenge is to develop effective international tax rules and processes within what is essentially a noncooperative government setting.
For the foreseeable future, governments will deploy their tax systems to promote perceived national welfare interests, including tax-friendly reforms to attract international investments as well as to promote the competitiveness of their multinational firms. As countries become more tied together, the cost of maintaining the status quo attitude appears to be escalating.
1 Robert B. Strassler (ed.), The Landmark Herodotus, The Histories, trans. by Andrea L. Purvis (New York: Pantheon Books, 2007).
2 Under this early form of self-assessment, citizens could be punished by death if they failed to accurately assess their wealth (or if they revealed that "his livelihood was not a just and honest one"). In a sentiment that presumably would be shared only by the most cold-hearted modern tax authority, Herodotus declared that this was "an admirable law, and may it always remain in force." Id. at 201, 250.
3 See United Kingdom, HM Treasury Introduction and HM Revenue & Customs, "Taxation of the Foreign Profits of Companies: A Discussion Document" (London: HM Treasury, 2007); U.S. Treasury Dept., Office of Tax Policy, "Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century" (Washington: 2007); and Canada, Advisory Panel on Canada's System of International Taxation, "Final Report" (Ottawa: Department of Finance, Dec. 2008), at 19. For discussion of different national reform efforts along with benchmarking analysis of national tax regimes, see Arthur J. Cockfield, Examining Policy Options for the Taxation of Outbound Direct Investment (Ottawa: Advisory Panel on Canada's System of International Taxation, Sept. 2008).
4 The 2011 OECD International Tax Conference, held in June 2011 in Washington, focused in part on international tax competitiveness concerns regarding the U.S. tax system. For a critique of U.S. efforts to develop a territorial system, see Lawrence Lokken, "Territorial Taxation: Why Some U.S. Multinationals May be Less than Enthusiastic about the Idea (and Some Ideas They Really Dislike)," 59 SMU Law Rev. 751 (2006). Critics maintain that "tax competitiveness" should not be used as a criterion to evaluate optimal international tax policy because the concept is not grounded in any substantive tax policy content. See Paul R. McDaniel, "Territorial v. Worldwide International Tax Systems: Which is Better for the U.S.?" 8 Fla. Tax Rev. 283, 301 (2007).
5 See Statistics Canada, The Daily (May 6, 2008).
6 For a review of relevant literature, see U.S. Department of Treasury, Office of Tax Policy, "The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study" (Washington: 2000), at 177-199.
7 See, e.g., Mihir A. Desai, C. Fritz Foley, and James R. Hines Jr., "A Multinational Perspective on Capital Structure Choice and Internal Capital Markets," 59 J. Fin. 2451 (2005).
8 See, e.g., Tim Edgar, Jonathan Farrar, and Amin Mawani, "Foreign Direct Investment, Thin Capitalization, and the Interest Expense Deduction: A Policy Analysis," 56 Can. Tax J. 803 (2008).
9 See Treasury, supra note 3, at 55, 57.
10 See, e.g., OECD Committee of Fiscal Affairs, Transfer Pricing and Intangibles: Scope of the OECD Project (Jan. 25, 2011).
11 See Frank Miller and Lynn Varley, 300 (Milwaukie, Oregon: Dark Horse Books, 1998).
12 "'We went to Montreal especially for the fantastic tax incentive that is offered by Quebec to filmmakers -- that's not only a production incentive, it's also a visual effects incentive,' said 300 producer Jeffrey Silver. 'Compared with other Canadian provinces, Quebec offers an extra 20 per cent labour-based visual effects tax credit for foreign producers'" (quoted in Melora Koepke, "Montreal proves a worthy opponent: While T.O.'s film industry ails, Quebec's advantages have a special effect," Toronto Star, Mar. 7, 2007). Note that these Canadian and provincial tax credits are available to domestic as well as foreign film producers.
13 Restrictions on incentives have been imposed in limited areas, such as the OECD's Harmful Tax Competition project, which prohibits the use of tax incentives for international investments in financial and other services, and the European Union's nonbinding Business Code of Conduct.
14 See Vito Tanzi, Taxation in an Integrating World (Washington: Brookings Institution, 1995), at 140 (indicating it may be time to develop a world tax institution); Richard M. Bird, "Shaping a New International Tax Order," Bull. for Int'l Fiscal Documentation (1988), at 292, 293 (calling for heightened cooperative reforms efforts).
15 In Canada, tax laws generally prohibit one corporation's losses to be offset against a related corporation's profits. The Canadian tax authorities, however, have allowed some tax-planning strategies that enable loss offsetting to take place; see Canada Revenue Agency, Income Tax Technical News 30 (May 21, 2004). In 2010 and 2011, the Canadian Department of Finance is engaging in public consultations about a more formalized system of loss transfers within corporate groups. Under U.S. tax law, corporate loss offsetting is generally permissible (when ownership equals or exceeds 80 percent of common shares). For a discussion of aspects of the U.S. and Canadian international tax systems, see Arthur J. Cockfield and David S. Kerzner, The Manager's Guide to International Tax (Toronto: Thomson Reuters Carswell, 1999).
16 Traditional international law mechanisms arguably apply to international tax matters in limited circumstances; see Reuven S. Avi-Yonah, International Tax as International Law (New York: Cambridge University Press, 2007), at 2 (discussing the relationship between international tax law and customary international law).
17 See Prof. M. Bruins et al., Report on Double Taxation Submitted to the Financial Committee (Geneva: League of Nations, 1923) (discussing different alternatives to the taxation of cross-border business profits and recommending exclusive residence-based taxation); and Technical Experts to the Financial Committee of the League of Nations, Double Taxation and Tax Evasion: Report and Resolutions (Geneva: League of Nations, 1925) (advocating the residence-based taxation of business profits along with foreign tax credits for taxes paid to source countries). The League of Nations ultimately endorsed a regime of bilateral tax treaties that had been in place since the 19th century.
18 See, e.g., A.J. Easson, Tax Law and Policy in the EEC (London: Sweet & Maxwell, 1980), at 264-266 (describing the political hurdles that must be overcome to promote the economic interests of Europe); Alex Easson, Tax Incentives for Foreign Direct Investment (The Hague: Kluwer Law International, 2004) (meshing underlying economic theories with practical tax administration concerns).
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