Corporate income tax coordination as a response to international tax competition and international tax arbitrage

International tax competition and international tax arbitrage have received considerable attention recently in the academic literature as well as from tax policy makers. Although corporate income tax coordination ■ 1081 it is recognized that harmonization of national income tax bases addresses both concerns, the conventional analytical approach views each of these phenomena as giving rise to distinct policy issues. This article, in contrast, emphasizes the shared conceptual and consequential attributes of international tax competition and international tax arbitrage. In terms of competition for mobile capital, which is the focus of the article, international tax competition involves revenue and possible efficiency losses associated with the substitution of the location of investment. International tax arbitrage involves the same consequences associated with the substitution of transactional forms. The author argues that the common policy problem presented by international tax competition and international tax arbitrage can be defined in terms of instances of perfect or nearly perfect substitutability of lower-taxed transactions for higher-taxed transactions. Substitution in these circumstances results in revenue loss, with little in the way of direct efficiency losses, since there is often little or no sacrifice of desired non-tax attributes. When viewed in this manner, international tax competition and international tax arbitrage can be seen to present a policy problem that is neither recognized nor addressed by most of the arguments found in the existing literature. In principle, comprehensive harmonization of national corporate income tax bases could address the revenue loss associated with instances of perfect or nearly perfect substitutability; but, at least in the case of international tax competition, this response is arguably poorly targeted and, in any event, is impractical. Drawing on some standard lessons from fiscal federalism, the author concludes that tax policy makers should focus on limited international coordination efforts in an attempt to target mobile capital and the inconsistent characterization of transactional forms that is the basis for international tax arbitrage. Although the limited responses described in the article could be implemented unilaterally, their adoption on a coordinated basis by a broad range of countries would ensure consistent treatment across a broad range of investment locations and transactional forms. In effect, by narrowing the range of divergent tax treatment, the adoption of the suggested responses on a coordinated basis would maximize their effectiveness. With respect to international tax competition for mobile capital, the recommended response is a conventional one that involves the extension of the application of residence-based taxation through controlled foreign corporation (CFC) regimes. It is argued that these regimes should apply to a range of business income from foreign direct investment that exhibits the same mobility features as those commonly associated with foreign portfolio investment. As a response to international tax competition, CFC regimes should be based on a “tainted income” approach. A “designated jurisdiction” approach is an overinclusive response that engages the thorny debate over the desirability of capital-export versus capital-import neutrality. With respect to international tax arbitrage, the recommended response is a more radical one that involves the extension of source-based income taxation in the context of foreign direct investment. This result would be realized by adopting, in this particular context, either of two approaches. One approach would apply a uniform withholding tax to otherwise deductible payments of dividends, interest, and royalties made to foreign direct investors. The withholding tax rate would approximate the general corporate income tax rate in the source country. The other approach would apply a rule of non-deductibility to dividend, interest, and royalty payments made to foreign direct investors. Either of these approaches would be supported by a rule of deemed 1082 ■ canadian tax journal / revue fiscale canadienne (2003) vol. 51, no 3 corporate status in the source country for all resident entities that are used to structure foreign direct investment in the country. Ideally, source taxation should also be protected through comprehensive formulary allocation of interest expense, research and development (R & D) expenses, and overhead expenses, which can otherwise be sourced in a manner that approaches the instances of perfect or nearly perfect substitutability associated with international tax arbitrage in the context of foreign

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