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2000 , and Harmful Tax : Reflections on the FSC Controversy Reuven S. Avi-Yonah University of Michigan Law School, [email protected]

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Recommended Citation Avi-Yonah, Reuven S. "Tax, Trade and Harmful Tax Competition: Reflections on the FSC Controversy (Foreign Sales Corporations)." Tax Notes Int'l 21, no. 25 (2000): 2841-5.

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tion procedures in the case of any "subsidy ... which operates directly or indirectly to increase Tax, Trade, and Harmful of any product from, or to reduce imports of any product into, Tax Competition: [a contracting party's] territory."5 In addition, the article expressly Reflections on the FSC prohibits the use of any subsidy "on the of any product ... Controversy which subsidy results in the sale of such product for export at a price by Reuven S. Avi-Yonah lower than the comparable price charged for the like product to Reuven S. Avi-Yonah is a professor of law at the buyers in the domestic market."6 A Michigan Law School. note clarifies that the exemption of an exported product from borne by the like product when destined for domestic consumption (such as zero rating exports for he current controversy over II concludes that most production VAT) "shall not be deemed to be a 7 T foreign sales corporations tax havens, and some traditional subsidy." (FSCs) provides a good opportu­ and headquarters tax havens, Article XVI was significantly nity to address the broader ques­ constitute export subsidies under expanded by the Subsidies Code tion of the proper relationship the GATT. Finally,· Part III asks included in the 1994 version of the between the international income whether harmful tax competition GATT. 8 The Subsidies Code defines tax regime and the WTO. In par­ is better addressed by the WTO or "subsidy'' as including cases where ticular, can one identifY aspects of by organizations with less binding " that is that are adjudicatory power, such as the otherwise due is foregone or not subject to the jurisdiction of the OECD. It concludes that, while in collected."9 To be actionable under WTO, as reflected in the General the short term the OECD has the the GATT, a subsidy must be Agreement on Tariffs and Trade advantage, the WTO may provide "specific to an enterprise or (GATT)? This article will argue a better forum in the longer term. that there are certain aspects of current international I. The GATT and Taxes practice that are subject to the There are two articles of the 1 jurisdiction of the WTO. In partic­ General Agreement on Tariffs and See generally Reuven S. Avi-Yonah, ", Tax Competition, and the ular, many of the regimes identi­ Trade that bear directly on fied by the OECD as constituting Fiscal Crisis of the ," 113 taxation.2 Article III of the GATT Harv. L. Rev. 1573 (2000). harmful tax competition should provides that "internal taxes ... 2The 1994 version of the GATT is part also be considered export subsidies should not be applied to imported of the Marrakesh Agreement Establishing under article XVI of the GATT, or domestic products so as to afford the World Trade Organization, reached at and, therefore, as being subject to protection to domestic production."3 the conclusion of the Uruguay Round of challenge under WTO procedures, Because of the reference to trade negotiations (April1994). GATT just as the FSCs were challenged Secretariat, The Results of the Uruguay products, this provision has Round ofMultilateral Trade Negotiations bytheEU. generally been understood as - The Legal Texts (Geneva, 1994) (hence­ forward GATT), i. The article is divided into three referring only to indirect taxes (i.e., taxes or consumption taxes 3GATT, 490. parts. Part I is a general descrip­ 4 tion of those parts of the GATT such as the VAT). However, even if See , and Protectionist Taxation, NBER Research that relate to taxation. Part II the article is interpreted as referring to direct taxes as well, it Working Paper 4902 (1994) (while theoret­ addresses the application of GATT ically it is possible to design tax rules that rules to three types of tax havens, seems unlikely that the income have the same effect as tariffs, in practice which I have elsewhere named tax, in particular, can be used as this is difficult to achieve). "traditional tax havens," "produc­ an instrument for protecting 5GATT, 508. tion tax havens," and ''headquar­ domestic production because of the 6GATT, 509. The FSC regime was ters tax havens."1 The first type difficulty of designing income tax struck down under this provision. are the offshore tax havens, while provisions that will apply only to 7GATT, 549. foreign production. 4 the other two are what the OECD 8Agreement on Subsidies and Counter­ calls "preferential tax regimes" in Article XVI of the GATT vailing Measures, GATT 264. otherwise high-tax countries. Part provides, in general, for notifica- 9GATT, 264.

Tax Notes International 18 December 2000 • 2841 Special Reports industry or group of enterprises or the promise of no taxation and It would seem that such pro­ industries."10 In addition, a specific bank secrecy; and (c) "headquar­ duction tax havens constitute subsidy is prohibited only if it is ters tax havens," i.e., regimes prohibited export subsidies under "contingent, in law or in fact ... designed to attract multinational the GATT. They generally involve upon export performance" or ''upon enterprises to locate their head­ foregone revenue (i.e., are tax the use of domestic over imported quarters in a jurisdiction by expenditures), are specific to goods."11 Annex I to the Subsidies promising no taxation (or no certain taxpayers (in fact they are Code includes an "illustrative list current taxation) of income derived frequently negotiated deals), and of export subsidies" which includes from foreign subsidiaries.16 are "in fact" contingent on export "[t]he full or partial exemption How do the GATT rules previ­ performance, because the products remission, or deferral specifically ously described apply to these or services they involve cannot be related to exports of direct three types of ? The targeted at the domestic market. taxes ... paid or payable by indus­ 12 clearest application is in the case The case of traditional tax trial or commercial enterprises." of production tax havens. These havens is harder. Since there is no However, a footnote clarifies that regimes are generally "ring income tax, they do not involve this language "is not intended to "foregone revenue" or a tax expen­ limit a Member from taking diture in the traditional sense. measures to avoid the double However, traditional tax havens taxation of foreign source income 13 frequently grant exemptions to the earned by its enterprises." offshore sector from those taxes The other agreement included that they do collect (e.g., VAT). in the 1994 version of the GATT Moreover, they frequently involve that bears on taxation is the not just pure investments (which General Agreement on Trade in are presumably not covered by the Services (GATS). Because services current GATT) but, in particular, frequently involve FDI, in this case the provision of financial services, the line between trade and invest­ such as brokerage or insurance, ment is particularly blurred. targeted entirely at foreigners (and Therefore, the United States frequently ring fenced as well). inserted provisions in the GATS Thus, arguably, traditional tax that prevent it from overriding havens, or at least that part of domestic tax legislation and their activities that is more than income tax treaties applicable to FDI. In particular, the provision of national treatment for service providers can be avoided if "the difference in treatment is aimed at 10GATT, 265. ensuring the equitable and 11GATT, 266. effective imposition or collection of 12 14 GATT, 305. The list also includes a direct taxes." In addition, most provision for exemption or remission of favored nation (MFN) treatment fenced," i.e., they are designed to indirect taxes in excess of those levied on can be avoided if the difference in foster exports and, therefore, are products for domestic consumption, and treatment follows from a tax separated from the domestic defines direct and indirect taxes to include treaty.15 income tax and VAT, respectively. GATT, economy (and sometimes also not 305 n. 58. Deferral is allowed if accompa­ available to domestic investors). nied by an interest charge. Ibid. II. Application of GATT The regimes are ring fenced 13GATT, 305 n. 59. Rules to Tax Havens precisely because they are set up 14GATT, 339-340. In previous work, I have identi­ by countries with a real domestic 15 tax base that do not wish to see GATT, 340; see also GATT, 346 (no fied three types of tax havens: (a) arbitration in the case of existing tax trea­ "production tax havens," in which that base eroded by the tax conces­ ties). sions granted within the preferen­ there is a specific or 16For further elaboration, see Avi­ other type of tax benefit designed tial regimes. The EU and OECD y onah, Globalization, supra. reports on harmful tax competition to attract foreign investors to set 17See "OECD Releases Tax Haven up production facilities in a host cite dozens of such regimes, even Blacklist," Tax Notes Int'l, July 3, 2000, p. country; (b) "traditional tax though they limit themselves only 7, or 2000 WTD 124-10, or Doc 2000-17611 havens," i.e., jurisdictions with to regimes of member countries (3 original pages); "Primarolo Group's and (in the case of the OECD) Report Identifies 66 Harmful Tax little or no income tax that seek to Regimes," Tax Notes Int'l, Mar. 20, 2000, attract foreign investors and exclude "real" investments (i.e., p. 1283, or 2000 WTD 50-1, or Doc financial service providers through manufacturing) .17 2000-7548 (8 original pages).

2842 18 December 2000 Tax Notes International Special Reports pure passive investment, fall regimes, query whether an because of the progress it has within the prohibition on export exemption regime that does not already made on the issue. subsidies as well. Moreover, since take into account whether the However, in the long run, relying they are generally not party to tax income was subject to tax at source on the OECD to restrict harmful treaties, the exclusion of treaty qualifies as a "measure to avoid tax competition suffers from three matters from GATS does not cover ." Fundamentally, a significant drawbacks. First, the them. general exemption regime distin­ OECD only has 29 members, and The toughest cases are head­ guishes between domestic and it is not clear that it can effectively foreign source activities in a way enforce its anti-tax competition quarters tax havens. This covers 21 specific regimes designed to attract that frequently subsidizes exports, rules on non-member countries. foreign multinational enterprises not just investments, and, For example, solutions that rely on (MNEs), which are akin to produc­ where the parents of MNEs are tion tax havens. Those are presum­ located assume that no significant ably export subsidies for the growth in MNEs will take place reasons stated above. However, outside the OECD, and solutions they also cover things like the U.S. that rely on the OECD as the deferral regime and the European market assume no significant exemption for foreign source markets outside the OECD. Either assumption may become wrong, income of domestic MNEs. Are In the short run, the these export subsidies under the and when that happens solutions GATT? If the only activity involved OECD is clearly the that rely on OECD enforcement is pure investment (e.g., the acqui­ superior forum to will lose their effectiveness unless sition of a foreign target), then the those emerging markets were to regime is not covered. But usually address the problem of join the OECD. While several there is also the provision of harmful tax competition developing countries have joined services and/or transfer of intangi­ because of the progress the OECD recently (e.g., South bles, and frequently also the sale of Korea and Mexico), it is hard to goods to the foreign subsidiaries. it has already made on imagine China or India doing so in In these cases there is trade, and this issue. the near future. the provision could be an export Second, relying on the OECD to subsidy. implement solutions to the The ultimate question in this harmful tax competition problem, regard is whether deferral or even if those solutions are tailored exemption is a tax expenditure, to benefit developing countries, because foregone revenue is a may not be acceptable to those precondition to finding a subsidy countries. Even though the OECD under the GATT. In a worldwide has made a huge effort to include non-OECD members in the tax regime such as the United States, therefore, can be construed as an the answer is clearly yes (and export subsidy if the income is not deferral is in the tax expenditure taxed at source. 19 budget). What about an exemption regime?18 The Europeans have III. Should Harmful Tax argued that the exemption of Competition Be Addressed 18That is why the new U.S. exclusion foreign source income in Europe is Through the WTO? for "qualifYing foreign trade income" (new part of the normative baseline. But code section 114) seems unlikely to pass defining the baseline for the I have argued elsewhere that WTO muster, since it operates in the European regimes is hard, since the problem of harmful tax compe­ context of a worldwide tax regime. they contain many worldwide tition cannot be adequately 19Note, however, that the FSC report features (such as CFC regimes). addressed by the current interna­ does seem to approve of "territorial tax systems." But this is dicta; if the case ever Thus, I think that it is possible to tional tax regime based on 20 came before the WTO, the U.S. seems to argue that there is "foregone bilateral treaties. A multilateral have a stronger argument for complaining revenue" here as well, even if it is effort clearly is needed, and the about the European exemption systems not reflected in the tax expendi­ question is whether the proper than most tax experts assume. ture budget. forum for it is the WTO or an orga­ 20See Avi-Yonah, Globalization, supra. nization such as the OECD, with a 21 But what about the footnote The EU effort is even more limited in more restricted membership and that specifically excludes regimes scope, and has run into significant prob­ fewer adjudicatory powers. lems because of this, as the recent develop­ designed to avoid double taxation? ments on taxation of savings make clear While the intent of this footnote The OECD is clearly the (the U.K. and Luxembourg will cooperate was to exclude the European superior forum in the short run only if Switzerland and the U.S. do).

Tax Notes International 18 December 2000 • 2843 Special Reports competition project, it is still iden­ and insures that players have an ments are characterized as prison­ tified as the rich countries' club. incentive to cooperate.24 In an ers' dilemma or assurance games, Thus, it is hard to believe that assurance (stag hunt) game, both they seem to present precisely the developing countries will be able to players cooperate if they can be kind of problem that only a multi­ shed their suspicions that the assured of the other player's coop­ lateral organization with OECD will not act in their eration.25 In the first case, an orga­ rule-making power can effectively interests even if it actually does so. nizational setting is needed to resolve.26 manage retaliatory strategies Third, the OECD effort is However, Green also raises while, in the second, it is needed to limited so far to geographically another objection to giving the provide the information required mobile financial services, and wro authority over taxes which, for the assurance to exist. excludes real investments, in practice, is likely to be far more although these constitute a signifi­ However, in the context of tax potent: the problem of sovereignty. cant part of the problem. In competition, it would seem that Countries are wary of giving up addition, even for the areas it does both retaliation and lack of infor- their sovereignty over tax matters, cover, the OECD has only the which lies at the heart of their power to persuade, not to adjudi­ ability to exercise national power. cate. This concern is particularly acute in the U.S. and almost led to the From these perspectives, the failure of the entire Uruguay wro is a more attractive Round as the U.S. insisted, at the candidate for "world tax organiza­ last minute, on excluding direct tion." It has a much broader taxes from the purview of the membership than the OECD, and GATS. 27 Green argues that if the developing countries are much wro dispute resolution better represented (and have real mechanism were given authority clout, as shown by the recent over tax issues, this may lead to struggle over choosing the Director widespread noncompliance, espe- General of the wro, as well as by events at Seattle). Moreover, as indicated above, the wro rules already cover and prohibit most forms of harmful tax competition identified by the OECD. But there are several serious 22See Robert E. Hudec, ''Reforming objections to including tax matters GATT Adjudication Procedures: The Lessons of the DISC Case," 72 Minn. L. in the jurisdiction of the wro. Rev. 1443 (1988); William M. Considine, First, it has been argued that the 'The DISC Legislation: An Evaluation," 7 wro lacks sufficient tax N.Y.U. J. Int'l. L. & Pol. 217 (1974). 22 expertise. However, that problem 23See Robert M. Green, "Antilegalistic can be remedied by hiring a suffi­ mation are serious problems. For Approaches to Resolving Disputes cient number of tax experts to sit example, in the case of portfolio Between Governments: A Comparison of on the WfO's panels. In fact, as investment the U.S. began a race the International Tax and Trade Regimes," 23 Yale lnt'l L. J. 79 (1998). the wro has expanded its juris­ to the bottom by abolishing its 24 diction to non- matters, its See id.; see also Robert Axelrod, The withholding tax, and other Evolution of Cooperation (1984). staff already includes tax experts countries responded (i.e., retali­ 25 who also understand trade issues. The assurance game has a payoff ated) by abolishing their own structure in which the best outcome is if Robert Green has advanced a taxes. In the current situation, no both countries cooperate, while in the pris­ more serious objection, arguing country dare re-impose its tax oner's dilemma, the best outcome is if you without adequate assurance that defect and the other side cooperates. See that the costs of imposing the "Antilegalistic Approaches," supra. WfO's legalistic dispute-resolution other countries will follow. 26 Similarly, for direct investment, The in internation­ mechanism outweigh any al taxation in the 1980s resembled a pris­ benefits. 23 Green argues that the countries have adopted tax incen­ oners' dilemma, in which one country (the need for the wro to resolve trade tives or have adopted deferral and U.S.) preferred to defect while others coop­ disputes legalistically is based on exemption rules for their resident erate in order to draw investment to it. MNEs in response to the actions of But the current situation is more like an two features that are typically assurance game, in which the U.S. and lacking in the tax context: retalia­ other countries and fear of other OECD members would prefer coop­ tion and lack of transparency. changing such policies without eration above all other outcomes. Retaliation is a feature of repeated assurance that others will follow 27 See "Antilegalistic Approaches," prisoners' dilemma-type games suit. Thus, whether these develop- supra.

2844 • 18 December 2000 Tax Notes International Special Reports cially given the perception that the to those cases in which the adverse of repeating the FSC struggle over WTO is non-transparent and that result is truly perceived as a severe and over again on a worldwide it lacks democratic legitimacy.2s limit on its sovereignty. In other basis may indeed be a powerful Green may be wrong about this cases, the stigma of disapproval is impetus for inducing both member estimate, especially since the sufficient to ensure cooperation. and non-member countries to analysis above has shown that the cooperate with the less coercive WTO already has jurisdiction on IV. Conclusion and less costly OECD effort. But most forms of harmful tax competi­ The OECD's effort to combat should the OECD effort fail, then tion, so that further extension of its harmful tax competition has so far serious consideration should be powers would be unnecessary. But been a remarkable success, given to pursuing the goal of even if Green is right and sover­ achieving much more progress in a limiting harmful tax competition eignty poses a real problem, there short time frame than most through the WTO, in the ways 9 may be a solution to this as well. observers would have predicted outlined above.2 + Under the GA'IT regime, all when it started in 1998. However, decisions had to be reached by the hard part is yet to be tackled: consensus, i.e., with the agreement will countries actually give up of the party whose regime is at their preferential tax regimes stake. Under the WTO rules, on the under the timetable devised by the other hand, all dispute settlement OECD? In addition, the OECD has rulings are binding unless there is not yet addressed the problem of a consensus not to implement them, preferential regimes for real 28See id.; see also Joel P. Trachtman, i.e., when even the complaining investments, and it is unclear "The Domain ofWTO Dispute Resolution," whether it can achieve progress on 40 Harv. Int'l L. J. 333 (1999) (describing party agrees to refrain from action. factors to be weighed in choosing between Perhaps the former rule is more preferential regimes in rules and standards in the WTO context). appropriate for tax matters than non-member countries. But it should be noted that the WTO the latter, because it gives the loser From this perspective, I believe already has exercised jurisdiction over a veto if it feels that its sovereignty matters such as food safety, intellectual that it is helpful and not harmful property, and similar issues that also is truly at stake. Similar rules exist to the OECD effort (which I whole­ involve sensitive sovereignty issues. for tax matters in both the EU and 29 heartedly support) to point out 0f course, this assumes that some the OECD. But, as the DISC case in that most of the preferential tax forms of tax competition should be limited. the GA'IT and the adoption of the regimes identified by the OECD For the normative argument as to why tax competition report by the may also be export subsidies, and they should, as well as an attempt to OECD show, a country will distinguish, on a principled basis, harmful therefore subject to attack under from beneficial tax competition, see typically reserve its veto power only current WTO rules. The prospect Avi-Yonah, supra.

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Tax Notes International 18 December 2000 • 2845