International Taxation: Study Countries That Exempt Foreign-Source Income Face Compliance Risks and Burdens Similar to Those in the United States
Released: 2009-10-16T00:00:00

Letter

Background

Multinational Corporations and Foreign-Source Income

Corporate income tax is levied on business entities that organize and operate as corporations, as defined by each individual country’s tax rules and laws. Generally, corporations are individual business entities that issue shares and can make distributions to shareholders, such as dividend payments.

Corporations can be shareholders in other corporations, both domestic and foreign. The amount of control the corporate shareholder has over the other corporation can vary depending on the percentage of shares owned and other factors. At the low range of corporate ownership, portfolio shareholding allows a corporate shareholder to invest in a business but does not involve maintaining a controlling stake in the firm. At greater levels of ownership, corporations can own a sufficient percentage of shares to gain partial or total control of major business decisions, such as the level and timing of dividend distributions and investment and pricing strategies. For this report, we will call the controlling firm a parent corporation and the controlled firm a subsidiary. Parent-subsidiary relationships can be complicated, involving a corporation owning multiple subsidiaries, subsidiaries being controlled by multiple parents, or tiered arrangements with subsidiaries owning subsidiaries of their own. When these relationships involve entities in more than one country, these corporations are referred to as multinational corporations (MNC).

MNCs are groups of separate legal entities, which can include corporations, partnerships, trusts, and other legal entities, that operate and generate income in multiple countries, and different parts of an MNC may have different domestic jurisdictions. MNCs may also have branches—domestic, foreign, or both—as part of a corporation’s internal organizational structure. In general, each corporate entity that is part of the MNC is taxed as an individual taxable entity by the relevant governments, unless the corporation is allowed to and chooses to file a consolidated return.

Different Types of Foreign- Source Income

Corporations can earn a variety of different types of income from foreign sources. This income can be generated from transactions with either unrelated parties, such as retail customers located abroad, or related parties, such as foreign subsidiaries or other parts of the same MNC. Corporations can earn foreign-source income from active and passive activities with foreign parties. While countries vary somewhat in their definitions of active and passive income, generally speaking, active income is considered to be the income generated through the primary business activities of the corporation. Passive income, in contrast, is income that is not earned through primary business activities. Interest earned, rental income, and royalty payments from foreign sources are generally considered passive income. However, for some companies, such as financial services companies, these types of income may constitute the primary business and be considered active income under the tax laws of some countries. Additionally, corporations can purchase shares of foreign companies and receive dividend distributions based on the earnings of those companies. Table 1 below lists some general examples of different types of income that can be generated from foreign-sources.

Most Countries Take a Hybrid Approach to Taxing Foreign-Source Income

In practice, countries combine elements of worldwide and territorial approaches to taxing foreign-source income. One approach, generally referred to as deferral, deviates from the worldwide model and taxes the domestic corporation on all of its income, including income and dividends received from foreign subsidiaries, but defers taxation until the income is repatriated. Another approach, generally referred to as dividend exemption, is closer to the territorial model and permits the tax-exempt repatriation of the dividends distributed by foreign subsidiaries, but may limit the extent to which some income is exempt. In either system, foreign- source income is taxed first in the source country; under a deferral system, a residual tax is then imposed only when the income is repatriated. Figure 1 shows a continuum of tax treatments for foreign-source corporate income with hybrid systems ranging between the pure worldwide and territorial models.

The current tax system in the United States is an example of a worldwide system with deferral, which taxes domestic corporations on their worldwide income, regardless of where the income is earned and gives credits for foreign income taxes paid. Income unrelated to a U.S. trade or business earned by foreign corporations is not taxed domestically until it is distributed to a domestic shareholder, such as a domestic parent corporation, which allows deferral of taxation on income of foreign subsidiaries. Special rules may exist that tax certain shareholders, such as a parent corporation, currently on the income of certain subsidiaries in order to protect the domestic tax base. To reduce the double taxation of income, corporate taxpayers can offset, in whole or in part, the domestic tax owed on the foreign-source income through a FTC. In certain circumstances, a parent corporation may claim FTCs for foreign taxes paid by a subsidiary. Figure 2 shows how a dividend payment is generally taxed under a worldwide tax approach that permits deferral.

Many OECD countries exempt some types of foreign-source corporate income from domestic tax. Exemptions are commonly granted in these countries for dividends paid by a foreign subsidiary. As shown in figure 3, which is a simplified example of an exemption system, the domestic corporation does not incur a tax liability by receiving the dividend income from its foreign subsidiary. However, similar to the worldwide systems with deferral that were described earlier, exemption systems may disallow the tax advantages of foreign-source income under certain circumstances to protect the domestic tax base.

Study Countries Vary in the Types of Foreign-Source Income Exempted from Domestic Tax and in the Rules Governing Those Exemptions

Our study countries—Australia, Canada, France, Germany, and the Netherlands—have hybrid tax systems that exempt some types of foreign- source income and tax others. All of the study countries tax domestic corporations on income earned through rental payments and royalties. Such payments may be made by unrelated parties or by subsidiaries and are generally expenses of the payee in the foreign country but are received as income by the domestic corporation. Subject to an extensive list of exceptions, the study countries generally exempt, but to varying extents, income of domestic corporations received as foreign-source dividends from foreign subsidiaries, sales by foreign branches, and the gains from the sale of shares in foreign subsidiaries. For example, all of the study countries permit domestic corporations to receive dividends that meet certain qualifications as tax-exempt income, but differ in the rules they use in determining which dividends are qualified. In addition, Canada does not allow domestic corporations to earn tax-exempt, foreign-source income through foreign branches and taxes up to half of the capital gains on the sale of foreign subsidiary shares while the other study countries generally exempt income from these sources.

In addition to the rules above covering income payments received by domestic corporations, all study countries also have rules that tax domestic corporations on some income at the time it is earned by foreign subsidiaries, regardless of when or if the foreign subsidiary distributes a dividend. These rules, generally referred to as anti-avoidance rules, attribute certain earnings of related foreign entities to domestic corporations in order to limit the tax benefits of holding certain types of income offshore.

Table 2 presents a brief overview of the tax treatment for different types of foreign-source income in our study countries. All rows except the last show the tax treatment of income payments received by a domestic corporation. The last row shows the tax treatment of income at the time it is earned by a foreign subsidiary that is subject to certain anti-avoidance rules regardless of whether the income was distributed as a dividend.

While data was not available for most of our study countries, in Canada, at least 76 percent of foreign-source dividends received by Canadian taxpayers from foreign affiliates from 2000 to 2005 were qualified foreign- source dividends and, therefore, were tax exempt.

Study Countries Use Different Criteria to Qualify Foreign-Source Dividends for Domestic Tax Exemption

Our study countries all have certain criteria that, when met, allow domestic corporations to receive tax-exempt income in the form of dividend payments, called qualified foreign-source dividends in table 2. In each of the countries, all of the criteria must be met for the domestic corporation to receive the foreign-source dividend tax-exempt. If any of the conditions are not met, then the dividend does not qualify for the tax exemption and is, therefore, taxable. Our study countries applied up to three criteria when determining which income is tax-exempt: domestic ownership type and level of foreign subsidiaries; the type of income (active versus passive) distributed as a dividend; and the presence of a tax treaty or similar agreement between the domestic and foreign government where the subsidiary is located and income is earned.

All of our study countries except Germany require the domestic corporation to have a minimum ownership stake in a foreign subsidiary in order to qualify for the benefits of exemption. In general, these minimum ownership level stakes mean that income from portfolio or portfolio-like investment is not exempt. Each country takes a different approach in determining the type of shares that qualify dividend income for exemption with distinctions made on the type of shares and the length of time the shares are held. For example, while Canada requires domestic corporations to own 10 percent or more of any class of shares in the foreign subsidiary, France requires its corporations to own at least 5 percent of a foreign subsidiary’s shares. The requirements for each country are summarized in table 3.

In addition to the criteria above, Canada also makes a distinction between dividends distributed from active and passive income, while the other study countries do not, as shown in table 4.

Of all our study countries, currently only Canada requires that the foreign subsidiary be located and earn active income in a designated treaty country in order to qualify for the dividend tax exemption that was shown in table 2. For Canada, a designated treaty country is a country with which Canada either has a tax treaty or a tax information exchange agreement (TIEA). As was noted earlier, at least 76 percent of dividends received by Canadian taxpayers from foreign affiliates between 2000 and 2005 were tax exempt.

Study Countries Limit Tax Advantages of Earning Foreign-Source Income under Certain Conditions

As was shown in the last row of table 2, all study countries have anti- avoidance rules that limit the tax advantages of earning certain types of income abroad. In general, these rules are intended to protect the domestic tax base by preventing taxpayers from avoiding domestic tax on passive or other specific types of income by moving to or holding these types of income in a foreign country. When triggered, these rules require a domestic shareholder to be taxed currently on its pro rata share of certain types of income earned by certain foreign subsidiaries, regardless of when or if that income is distributed to the shareholder. Anti-avoidance rules exist in both worldwide and territorial tax systems, and are in effect in each of our study countries and the United States (commonly known as Subpart F in the United States).

A prominent anti-avoidance rule used by all study countries except the Netherlands applies to controlled foreign corporations (CFC). Each country’s CFC rules vary, but they generally tax domestic shareholders, including shareholding corporations, currently on certain types of income earned by foreign corporations that qualify as controlled by domestic shareholders. This is illustrated in figure 4. This means that the domestic corporation may be taxed on income that it has not received from the foreign corporation (called a deemed dividend in figure 4). This income is taxable when earned by the subsidiary, although CFC rules generally permit the domestic taxpayer to offset some or all of their domestic tax liability through credits on the foreign taxes paid on the income.

Generally, study countries establish criteria in three areas that, when met, define a domestic shareholder’s tax liability for certain types of income earned by a foreign corporation under the CFC rules. First, countries define when a foreign corporation is controlled by domestic shareholders. For example, Australia defines a controlled foreign corporation as any foreign corporation that meets either of the following definitions: (1) where five or fewer Australian residents effectively control the foreign corporation or own more than 50 percent of the foreign corporation; or (2) where one Australian entity has an individual ownership of 40 percent or more of the foreign corporation not controlled by another corporation.

Second, countries generally set a minimum level of ownership in the foreign corporation that domestic shareholders must meet before being taxed on the foreign corporation’s earnings. For example, under Canada’s CFC rules, a Canadian shareholder must own at least 10 percent of the foreign corporation to be taxed on certain types of income earned by the foreign corporation. Third, the controlled foreign corporation generally must earn certain types of income that are specified in each country’s CFC rules. For example, Germany requires that a CFC earn passive income that is taxed at an effective rate of 25 percent or less by the foreign country before a domestic corporation is required to pay tax on the CFC’s earnings.

Once the criteria above are met, domestic shareholders are taxed currently on certain types of attributed income earned by the CFC. Some countries, like Canada, generally limit the taxable foreign earnings to the domestic corporation’s pro rata share of passive income. Other countries, like France, tax domestic corporations on their pro rata sh all earnings by the foreign corporation. Table 5 presents a simplified overview of the CFC rules used by our study countries. Additional details on other types of anti-avoidance rules can be found in appendix IV.

Study Countries Face Areas of Compliance Risk and Burden Known to Exist in the United States

Differences in tax rates across countries and differences in the taxation of different types of income may create incentives to avoid tax by shifting income from a high tax jurisdiction to a lower taxed jurisdiction or by converting income from a taxable type to tax-exempt type. Such efforts to reduce taxes may sometimes be legal tax avoidance, but may also be illegal noncompliance.

Tax experts identified four areas as sources of compliance risk or taxpayer compliance burden in our study countries. None of our study countries were able to provide quantitative estimates of the extent of noncompliance with their tax laws governing foreign-source income or the amount of compliance burden placed on taxpayers. Furthermore, an exhaustive list of all sources of compliance risk and burden does not exist. However, four areas that tax experts, including tax agency officials, tax practitioners, and academics identified were: transfer pricing, anti-avoidance rules, foreign tax credits, and domestic expense deductions.

These areas are also viewed by the Internal Revenue Service (IRS) or other tax experts as sources of compliance risk or compliance burden in the United States.

While countries establish rules in these four areas to serve a variety of policy goals, including maintaining economic competitiveness and avoiding double taxation, one important consideration is protecting the domestic tax base. One unique tax administration challenge that MNCs present is that they can shift income and assets among related entities in different countries to convert taxable income, either foreign or domestic, to tax-exempt or lower-taxed foreign-source income. The laws and regulations in these four areas are intended, in part, to protect the domestic tax base by preventing MNCs from mispricing transactions, relocating domestic passive income, misusing foreign tax credits, or reallocating expenses in ways that inappropriately reduce domestic taxes. These laws also create compliance burden, often requiring taxpayers to maintain detailed records and conduct complex analyses of international transactions.

Transfer Pricing, Particularly for Intangible Property, Is a Major Compliance Risk and Source of Compliance Burden in all of the Study Countries

Many tax agency officials we met with stated that transfer pricing was the most significant compliance risk they face in the area of international taxation. Similarly, many business representatives said complying with transfer pricing rules was often the most burdensome aspect of international taxation. Transfer prices are the prices of goods and services transferred among related entities within an MNC. These prices create compliance risks because MNCs can sometimes deliberately manipulate them to shift income from one related entity to another in order to reduce tax liability. For example, a parent corporation that charges a foreign subsidiary a below-market price for a good or service lowers the parent corporation’s taxable income and raises the subsidiary’s taxable income. Depending on tax rates and rules governing exemption and deferral, shifting income in this way may reduce an MNC’s overall tax liability. An above-market price would shift taxable profits from the subsidiary to the parent.

Because transfer prices can shift taxable income from one country to another, all of our study countries have focused attention on transfer pricing with emphasis on stringent documentation requirements and audits. Generally, the study countries require taxpayers to provide evidence that transfer prices meet an arms-length standard, which means pricing transactions as if they occurred between unrelated parties. Establishing an arms-length price can be difficult when there is no comparable market price, such as for a unique good, service, or intangible property.

Although comprehensive data were not available, several experts, including the OECD, have noted that a significant amount of trade occurs between related parties. Trade in services in the United States, while not a measure of overall U.S. trade, provides an example. According to the U.S. Bureau of Economic Analysis, trade in services between CFCs and related parties increased (in nominal dollars) from approximately $38.4 billion in 1999 to approximately $178.7 billion in 2006.

The changing nature of international trade, particularly the growing trade in intangibles, is making international transactions more susceptible to transfer pricing abuse. Tax experts repeatedly identified intangible property as a particular challenge when attempting to establish a transfer price that meets the arm’s length standard. The unique nature of many intangible assets, such as patents, trademarks, copyrights, and brand recognition, means that it is difficult or impossible to identify comparable transactions for transfer pricing purposes. The revenue risk posed by mispricing intangibles can be significant because it can result in a company converting taxable income into tax-exempt or lower taxed income. For example, a parent corporation can license a patented computer technology to a foreign subsidiary and charge a below-market royalty, which is taxed in the domestic country. The subsidiary, which is in a low-tax country, uses the technology to generate a profit. The subsidiary then pays a tax-exempt dividend to the parent corporation. The parent corporation’s country loses tax revenues because the tax-exempt dividend received is inflated and the taxable royalty is reduced. Conversely, the subsidiary’s country receives additional tax revenues because the subsidiary’s income is higher than it should be, as the smaller royalty payment is a deductible expense. In the aggregate, however, the MNC reduces its tax liability because the tax rate in the subsidiary’s country is lower than the tax rate in the parent corporation’s country.

Because identifying comparable prices for intangibles is often difficult, tax agencies and taxpayers often rely on a profit-split approach. The goal is to determine the percentage of profit attributable to buyers and sellers in different countries. Company officials consistently reported that making these determinations often requires costly special studies done by outside technical experts. In Australia, for example, to help protect against penalties, it is recommended that companies document that they followed a four-step process including selecting and justifying a transfer pricing methodology and then conducting an analysis based on that methodology to determine an arm’s-length price. Appendix II provides details on the transfer pricing documentation and filing requirements for all of our study countries. One company official further said that even after making these investments, tax authorities may disagree with the results because of differences in opinion about the assumptions that had to be made. A number complained about transfer pricing reviews turning into disputes between countries over the distribution of tax liabilities. This can occur because, in many transfer pricing disputes, there are at least three interested parties, the taxpayers and two tax agencies. When a taxpayer reaches an agreement with one government on a price it can result in a lower tax payment for the other government.

On the other hand, tax agency officials repeatedly told us that they needed detailed information on the pricing methodologies used in order to verify that companies’ prices satisfy the arm’s-length standard. Tax agency officials said documentation of the data used and analysis conducted are critical to conducting independent determinations of the appropriateness of transfer prices. As one example of the importance tax agencies place on this documentation, the Australian Tax Office (ATO) has a system for rating the documentation quality. Under this system, poorly documented transfer pricing decisions are more systematically identified, allowing better targeting of audits.

Transfer pricing abuse is also known to be a significant problem in the United States. For example, IRS lists transfer pricing abuse as a high-risk compliance area because of the large number of taxpayers and significant dollar risk.

While there is agreement that transfer pricing is a major compliance risk in both our study countries and the United States, there is no consensus among the tax experts we met with about whether the compliance risks are greater in our study countries’ exemption systems or in the United States’ deferral system. Some argued that the tax benefits for an MNC from manipulating transfer prices are potentially larger under an exemption system than a deferral system. They argue that gains from transfer pricing abuse are larger if income can be made tax-exempt rather than tax-deferred. However, other experts pointed out that transfer pricing abuse is already a significant problem in the United States. Some of these experts noted that the incentives to avoid or evade tax under a deferral system can be quite large because tax can be deferred indefinitely. One of these experts also pointed out that there is no empirical evidence supporting the claim that countries with exemption systems face greater noncompliance with transfer pricing rules.

Study Countries Have Placed Greater Emphasis on Enforcing Transfer Pricing Rules

According to tax agency officials and outside tax experts, all study countries are placing greater emphasis on transfer pricing when auditing MNCs. For example, a tax practitioner in France said that the overwhelming majority of the audit issues he faces are transfer-pricing related. Another tax practitioner made the same observation about Germany, saying that there is a general perception that the burden for complying with transfer pricing has increased in recent years. These and other company representatives we spoke with said that time spent determining and documenting transfer prices in accordance with country requirements is a primary source of burden. These findings are echoed in the research of others. For example, according to a survey of 850 MNCs, 65 percent of respondents believe that transfer pricing documentation is more important now than it was 2 years ago. Similarly, two-thirds of those respondents said they increased their resources on transfer pricing experts and studies in the last 3 years.

All Study Countries Use Advanced Pricing Agreements to Address Compliance Risks

All of the study countries have developed advanced pricing agreement (APA) programs that allow taxpayers and tax agencies to resolve transfer pricing issues before tax returns are filed and without the need for time consuming and expensive audits. Tax experts’ opinions on APA participation varied, but often these experts did not consider them an efficient use of resources for addressing transfer pricing issues. Due to the time and resources required to obtain an APA, some taxpayers only pursue them for high-value transactions. Guidance provided by the Australian Tax Office illustrates the time and extensive documentation that can be required for an APA. The document, included in appendix III, lists requirements such as numerous meetings with agency officials, details of the transfer pricing methodology, and data supporting that methodology. The amount of time needed to complete an APA can be greater when it involves multiple countries. According to statistics from some of our study countries, APAs may take a year, or multiple years, to finalize. Between 1992 and the end of 2007, Canada finalized 153 APAs.

Some tax practitioners said that the decision to use APAs can also depend on the perceived risk that a transaction is likely to be subject to audit. Some taxpayers determine that APAs are less burdensome than going through an audit.

Complying with and Enforcing Anti-avoidance Rules, both CFC and Other Rules, Presents Challenges in All of Our Study Countries

According to taxpayers and tax officials we spoke with from the study countries, rules limiting the tax advantages of earning certain types of income offshore can serve as a source of taxpayer compliance burden and can be subject to compliance risk. As shown earlier in table 5, all of our study countries with the exception of the Netherlands use CFC rules as a primary method to limit the exemption or tax-deferral of certain income held offshore. In addition, all of our study countries, including the Netherlands, have additional anti-avoidance rules that may apply and disallow tax advantages on specific types of income earned offshore. See appendix IV for details of other anti-avoidance rules in our study countries and in the United States. The study countries were not able to provide us with statistics on the number of subsidiaries subject to these anti- avoidance rules, the amount of income earned by them, or the residual tax revenue they generated. Government officials we spoke with in several countries estimated the revenue generated from these rules to be low. However, some tax experts we spoke with stated that these rules played an important role in preventing MNCs from avoiding domestic taxes by earning income through CFCs.

When CFC rules are triggered, it can result in an increase in the MNC’s tax liability. As a result, some of the tax practitioners we talked to said that structuring subsidiaries to avoid CFC rules requires careful planning and continuous monitoring. It is even possible that the actions of others could change a foreign subsidiary’s CFC status. For example, as shown in table 5, one way a subsidiary of an Australian MNC can be a CFC is if five or fewer Australian investors own more than 50 percent of its shares. Consequently, a subsidiary that is not currently a CFC could become one if other Australian investors increase their ownership share.

Some tax practitioners told us that the complexity of the requirements for determining whether CFC rules applied and the amount of information needed to support a determination created considerable burden. For example, a French tax professional said that France’s CFC rules are burdensome because they require the taxpayer to make a series of complex determinations (these were summarized in table 5)—such as whether the foreign tax liability of a subsidiary is greater or less than 50 percent of what it would be had the income been earned in France—in order to decide whether the subsidiary is a CFC. Given differences in accounting and tax rules between France and a foreign subsidiary’s home country, these calculations can become complicated. German CFC rules require similar comparisons of actual taxes paid to theoretical taxes owed in determining whether the subsidiary will be taxed as a CFC. Australia takes a different approach, providing a list of countries where CFCs can be located and have fewer types of income that may be attributed to domestic corporations. It is not clear the extent to which this reduces burden in comparison to the other study countries.

Tax experts in Canada also said that acquiring information for documentation requirements related to CFC rules is particularly burdensome. For example, a Canadian firm with a 10 percent holding in a foreign subsidiary is required to provide the Canada Revenue Agency (CRA) with detailed tax and operations information from the foreign subsidiary. With only a 10 percent ownership stake, the Canadian firm may find it challenging to obtain such information in a timely manner, or at all.

Generally, CFC rules intend to limit an MNC’s ability to shift income, especially passive income, to foreign jurisdictions to avoid or postpone domestic tax. Enforcing these rules could be difficult if the tax agency is not present in the foreign jurisdictions. For example, some officials in France and Canada said they may not be able to obtain and validate information needed to enforce these rules. One French official stated that it is difficult to see if a foreign subsidiary located in a low-tax jurisdiction thousands of miles away was an active business or being used to shelter income.

While the Netherlands does not have specific CFC rules, taxpayers and tax officials stated that the compliance burden associated with other anti- avoidance rules can be significant. According to tax professionals we spoke with, the Netherlands has low-taxed passive shareholding rules, another type of anti-avoidance rule. Overall, the tax practitioners and experts we spoke with agreed that the compliance burden related to anti- avoidance rules in the Netherlands could be significant.

Exemption of Foreign- Source Income Reduces the Need for Foreign Tax Credits, but They Can Still Serve as a Compliance Risk

The study countries all have FTC systems; however, according to both tax agency officials and tax practitioners FTCs play less of a role in these countries than in the United States because of the extent to which foreign- source income is exempt. For exempt income, taxpayers do not have to track and report foreign taxes paid. However, FTCs still exist as the study countries use them to avoid double taxation on foreign-source income that is not exempt, such as income subject to anti-avoidance rules. Most study countries were not able to supply data on the amount of FTCs that are claimed by domestic parent corporations in their countries. However, some tax experts said that the extent to which FTCs are generated varies by country, the type of industry in which the MNC conducts business, and the overall structure and location of the MNC’s subsidiaries. For example, according to one German tax practitioner we spoke with, FTCs in that country tend to be generated mainly by businesses in the financial and insurance industries or where CFCs are involved.

As shown in table 6, the study countries vary in the rules they apply to FTCs. Many of these rules address the extent to which companies are allowed to accumulate FTCs and use them to offset other types of income. For example, Australia requires that all FTCs must be used in the taxable period in which they are recognized by the taxpayer on their tax filing. Any FTCs that a company has accumulated that are in excess of the amount of domestic tax actually paid on that income are lost. Canada, on the other hand, allows companies to carry excess FTCs back into the previous 3 years or forward up to 10 years. The United States allows companies to apply accumulated FTCs across different types of foreign-source incomes, across multiple countries, and over multiple years. For example, FTCs accumulated for foreign taxes paid on royalty income can be combined with FTCs accumulated on dividend income.

Some practitioners said there was some burden in tracking FTCs, but generally these rules were much less burdensome than complying with transfer pricing and anti-avoidance rules. One tax practitioner from Germany pointed out that in instances where MNCs have numerous subsidiaries subject to anti-avoidance rules it generally results in more instances where income is subject to tax in two countries, thus creating additional burden to identify and track FTCs.

Canada’s Rules for Determining if Dividend Income Is Taxable, with FTCs Allowed, or Exempt Is a Compliance Challenge and Imposes Significant Taxpayer Burden

Tax agency officials, taxpayers, and tax experts agreed that Canada’s rules for tracking foreign-source income and determining whether the income qualifies for tax exemption are complex and challenging for taxpayers and tax officials. As discussed earlier in this report, Canada’s rules for determining whether or not dividend income received from foreign subsidiaries is exempt from domestic taxation include ownership requirements, location and business activities in a treaty country, and evaluating what type of earnings (e.g., capital gains, passive income, or active income) the subsidiary is distributing as a dividend. Canadian corporations receiving dividend income that does not qualify for exemption are taxed on that income, although FTCs may be applied to offset domestic tax. Canadian corporations are responsible for tracking all foreign earnings to ensure appropriate taxation once the income is received by the Canadian corporation. Taxpayers said these rules are burdensome, in part, because they require information only available from foreign subsidiaries, complex calculations and adjustments to income based on Canadian rules, and monitoring ownership changes for the foreign subsidiary. Tax agency officials said the rules are a compliance risk because of their complexity and difficulty of validating adherence.

The Generation of Inappropriate Foreign Tax Credits Was Identified as a Compliance Risk in Canada but the Risk Was Uncertain for the Other Study Countries

One area identified by tax officials as a source of compliance risk in Canada is the generation of abusive FTCs to offset overall tax liability. Often termed FTC generators, these activities, for example, allow taxpayers to take advantage of definitions of debt and equity in two countries by setting up a subsidiary for the purpose of holding assets and generating an income stream in such a way that the income stream is subject to foreign tax but also receives an offsetting deduction so that there is no net foreign tax. The taxpayer then tries to claim a domestic tax credit against this foreign tax paid while ignoring the offset.

Tax agency officials in Canada told us that FTC generators are considered a significant compliance risk in their country. CRA officials said they were currently auditing a number of domestic corporations to determine the extent to which Canadian companies are participating in these types of schemes. Because there is often no economic purpose to such a transaction, one company generally pays the other a fee for participating in the transaction. CRA officials said, so far, they have identified a substantial amount in avoided Canadian tax from 2001 to 2005.

Several experts we spoke to with knowledge of the other study countries said they did not think FTC generators were a significant issue in those countries. For example, a tax practitioner in Germany told us that since the majority of repatriated income to Germany is tax exempt FTCs are not produced in many instances. Similarly, Australian tax agency officials said that since Australian rules require FTCs to be used immediately in the year they are recognized, it reduces the ability to exploit the FTC generator scheme. However, some experts also pointed out that there is always a possibility that taxpayers could structure specific transactions to produce improper FTCs.

FTC generators are also known to be a significant problem in the United States. For example, IRS lists them as a high-risk compliance area because of the large number of taxpayers and significant dollar risk that these types of schemes present.

Study Countries Differ in How They Limit Domestic Deductions for Expenses in Order to Prevent Erosion of the Domestic Tax Base

Using sometimes indirect methods, all study countries limit the domestic deductibility of some expenses associated with earning foreign-source income. Tax experts said that methods resulted in fewer compliance risks and burdens as compared to more direct methods. The deductibility of expenses incurred to earn foreign-source income is an issue because of the effect on revenue. If domestic deductibility is allowed under an exemption system, then MNCs are able to deduct expenses even though the resulting income is not subject to domestic tax.

France and Germany provide an example of an indirect approach to limiting expense deductions. As shown in table 2, they require corporations to add 5 percent of their gross tax-exempt dividends to their domestic taxable income (making dividends effectively 95 percent exempt) as an offset for deductible expenses incurred to earn the dividends. In our interviews with tax officials and members of the business community, this approach was cited as being less burdensome than tracing or allocating domestic expenses to tax-exempt income. Tracing would involve matching specific expenses to actual income generated. Some tax experts that we spoke to generally agreed that tracing would be ineffective. Many of the domestic expenses incurred by domestic corporations to invest or maintain an investment in a foreign subsidiary are general to the domestic corporation. These expenses include general management expenses, interest expense on borrowed money, and other administrative expenses. Because these expenses are general to the corporation, they are difficult to trace to the income items.

One alternative to tracing, mentioned by several experts we talked to, is allocating overhead expenses to income sources according to formulas. Rather than tracing expenses to actual income items, this alternative would allocate expenses according to a rule. Although not used in our study countries, allocating overhead expenses in this way could be made less burdensome than tracing. However, some experts stated that this approach would create compliance risks and burdens that do not currently exist. Several experts pointed to the United States as an example of this. In general, the United States requires U.S. corporations to allocate their expenses to a class of gross income and then, if a statutory provision requires, apportion deductions between the statutory grouping and the residual grouping. IRS officials stated that these rules were a compliance risk because corporations sometimes do not apply them appropriately. Some tax experts said these rules were a significant compliance burden because they are complex, requiring considerable time to conduct detailed calculations.

Another approach taken by all of our study countries is to limit the amount of interest expense that domestic corporations may deduct. Without limits on interest rates and amounts, corporations could shift income offshore and artificially increase domestic interest expenses, eroding the domestic tax base. The rules vary by country and in many cases apply to all corporations, not just multinationals. For example, Germany and France require that interest rates be equivalent to arm’s-length terms; the amount of expense that exceeds those terms is generally nondeductible. Germany also has a rule disallowing interest expenses that exceed 30 percent of the corporation’s adjusted earnings. Canada has a rule that targets interest paid to a foreign related-entity with a limit based on debt- to-equity ratios. With a few exceptions, tax professionals generally stated that the general types of interest expense rules described above did not pose much of a compliance burden.

The approaches taken by the study countries do not disallow all domestic deductions for expenses incurred with respect to foreign-source dividend income. However, some experts thought that the indirect approaches for limiting the deductibility of overhead expenses were more administrable and less burdensome than more targeted alternatives.

Australia, France, and Germany exempt active foreign-source income earned through foreign branches, but generally disallow domestic deductions for direct expenses attributable to earning the tax-exempt income. Direct expenses, like the cost of inventory, can be traced more easily to the income generated than more general expenses, like interest or other overhead costs.

Study Countries and the United States Do Not Regularly Report Basic Information about the Revenues Generated by Taxing Foreign-Source Corporate Income

In addition to lacking data about compliance and compliance burden for their foreign tax rules, our study countries lack data on the amount of tax revenues generated from the foreign activities of domestic corporations. This is also the case for the United States. Several federal agencies consistently report on the business activities of U.S. MNCs, but tax revenues are not included in these reports. For example, the Bureau of Economic Analysis reports on the foreign direct investment activities of U.S. MNCs and IRS reports data on the amount of income U.S. MNCs earn through CFCs.

U.S. international tax experts, including noted academics with multiple publications who we spoke to on this topic all agreed that regularly and consistently reporting U.S. tax revenue from foreign-source corporate income would be useful. They said that this information would help inform the debate about how to tax foreign-source income and potentially improve understanding of the role international tax rules play in the U.S. tax system. For example, one of these experts pointed out that it was not widely understood how little domestic revenue is actually raised from taxing foreign-source income and that the tax regime governing foreign- source income plays a role in protecting the domestic tax base.

Treasury officials and the experts we talked to noted that producing regular revenue reports is feasible. A few academic papers and a recent release from the Secretary of the Treasury on international tax issues have reported estimates. However, the experts said that these reports from different sources are not as useful as they could be because they are irregular, incomplete, and lack transparency. The experts felt that consistent and transparent reporting by a reputable government source that clearly describes the methodology used to produce the numbers and any limitations would be superior to the current occasional reports that sometimes lack much explanation. IRS and Treasury officials said IRS already collects the necessary data through corporate income tax returns to make the necessary calculations. Therefore, the tax experts said there should not be significant additional cost to the government to provide this information.

Conclusion

The United States, like our study countries, does not report the taxes collected by the United States on foreign-source income. Such basic information about the U.S. system would not be costly to provide and could contribute to the ongoing debate about the direction of U.S. policy. Such reporting would make explicit to policy makers, and perhaps to the general public as well, how little residual revenue is received by the United States from taxing foreign-source corporate income. Doing so could help highlight the important role that international corporate tax rules play in protecting the domestic tax base.

Recommendation for Executive Action

We recommend that the Secretary of the Treasury use currently collected information to report annually on the revenue to the United States Treasury from taxing foreign-source corporate income. To enhance usefulness, such reports should describe the methodology and important limitations.

Agency Comments

We requested comments on a draft of this report from the Secretary of the Treasury. Treasury agreed with our recommendation. The Acting Assistant Secretary (Tax Policy)'s letter is reprinted in Appendix VI. Treasury and IRS staff also provided technical comments, which we have incorporated as appropriate.

As agreed with your offices, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days after its date. At that time, we will send copies to the Secretary of the Treasury, the Commissioner of Internal Revenue, and other interested parties. This report will also be available at no charge on GAO’s Web site at http://www.gao.gov.

If you or your staff has any questions, please contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in Appendix VII.

Appendix I: Objectives, Scope, and Methodology

The objectives of this report were to (1) describe, for select case study countries that take a territorial approach, what types of foreign-source income the countries exempt and the rules governing those exemptions; and (2) describe, to the extent information is available, the compliance risks and taxpayer compliance burdens that the taxation of foreign-source corporate income presents for each of these countries.

To address our objectives, we selected five countries—Australia, Canada, France, Germany, and the Netherlands—to study based on several criteria, including range of tax treatments for foreign-source corporate income, unique tax system features, and Organization for Economic Cooperation and Development (OECD) membership. To gather information related to our selection criteria, we interviewed a number of corporate income tax experts, including academics, corporate tax practitioners, corporate taxpayers, officials at the OECD, and government officials. We contacted those experts that we identified through our literature review, which is described immediately below, along with experts that were recommended by other experts. Our literature review consisted of academic articles and books, national government publications, OECD and other multinational- organization publications on worldwide and territorial tax systems, and private sector research pertaining to various international aspects of corporate income tax systems and administration.

To describe the corporate income tax systems of our study countries, we consulted with corporate taxpayers, business representatives, government tax officials, and academic experts. We performed an in-depth literature review on each country’s corporate income tax system, focusing on the rules governing international taxation. We also reviewed research-based publications produced by professional services organizations, academic experts, and international organizations. In general, we relied on information provided by tax officials from the study countries as well as published documents to summarize and characterize the corporate income tax systems for each country. We collected and analyzed data on the countries and their systems for taxing foreign-source corporate income, including tax policies, administrative mechanisms, compliance activities, and taxpayer reporting and documentation requirements. We did not conduct a formal legal review of the tax laws and rules in other countries, but relied on the information supplied by tax agency officials in those countries. We also provided the tax agency officials in our study countries a copy of our report to verify data and specific factual and legal statements about the tax laws in their country.

To address our second objective, we searched for publicly available data that quantified taxpayer compliance risk and burden for each of our study countries. In addition, we interviewed tax practitioners, taxpayers, government tax officials, business representatives, and officials from the OECD. We analyzed the information gathered through interviews as well as published documents to identify and describe the common sources of taxpayer compliance risk and compliance burden across the study countries. When available, we used publicly available data obtained from governments, private sector research, and academics to support evidence provided in the interviews. In addition, we provided tax agency officials from each of the study countries with a statement of facts that were presented in the report for their review and comment. Technical corrections were made to this report based upon country responses. This report shows general tax treatments and does not present all of the details, exceptions, or rules that govern the tax treatment of foreign-source income in our study countries and the United States.

We conducted our work from June 2008 to September 2009 in accordance with all sections of GAO’s Quality Assurance Framework that are relevant to our objectives. The framework requires that we plan and perform the engagement to obtain sufficient and appropriate evidence to meet our stated objectives and to discuss any limitations in our work. We believe that the information and data obtained, and the analysis conducted, provide a reasonable basis for any findings and conclusions in this product.

Appendix II: Transfer Pricing Documentation Requirements in the Study Countries

Documentation requirements

Step 1: Accurately characterize the international dealings between the associated enterprises in the context of the taxpayer’s business and document that characterization; Step 2: Select the most appropriate transfer pricing methods and document the choice; Step 3: Apply the most appropriate method, determine the arm’s length outcome and document the process; and Step 4: Implement support processes. Install review process to ensure adjustment for material changes and document these processes.

Contemporaneous documentation required for cross border, related party transactions. Form T-106 required to be filed annually asks for reporting of non-arms-length transactions.

Taxpayers are not required to keep any transfer pricing documentation but are expected to cooperate with the tax agency in transfer pricing audits.

No formal contemporaneous documentation requirement.

Documentation that shows the type and content of business transaction to related parties, including general information about (1) the group and ownership structure, (2) business relations to related parties, (3) analysis of functions and risks, and (4) transfer pricing analysis.

Netherlands Documentation must show the arm’s length nature of the transfer price that was applied.

Appendix III: Example from Australia of the Process for Obtaining an Advanced Pricing Agreement

Appendix III: Example from Australia of the Process for Obtaining an Advanced Pricing Agreement Step 1: Pre-lodment meetings The prpoe of pre-lodgment meeting to: ■ diuss the suitability of n APA ■ llow business to provide rod otline of the propoed trfer pricing methodology ■ diuss whether the APA will nilterl or ilter■ diuss the required docmenttion nd ly■ determine whether independent expert dvice i required ■ diuss Tx Office audit ctivity (if n APA i to flow on from audit) ■ gree on te for lodging formppliction ■ gree on the APA timetable, nd ■ diuss the process for evuating the ppliction.

Pre-lodgment meeting do not ind either prty to the APA progrm.

Step 2: Lodment of formal application If proceeding with the APA, business will e required to lodge formppliction. The APA ppliction hold inclde: ■ detil of the propoed trfer pricing methodology, supported y relevnt informtion ■ term nd condition governing the ppliction of the trfer pricing methodology ■ howing tht the trfer pricing methodology will prodce rm’ length result■ diussion nd ly of the criticassumption, nd ■ suggeted period of time for which the APA will pply.

For ilterl APA we normlly dvie the trety prtner’authority once the ppliction has een ccepted.

Step 3: Analy/evaluation We evuate the d submitted nd other relevnt informtion, nd eek dditionl informtion where necessary. We normlly hve nmerous meeting with business.

Step 4: Neotiation and areement For ilterl APA, the relevnt tdminitrtion exchnge poition ppertlining the cceptability of the propoed trfer pricing methodology. A written confirmtion of the conclded greement i provided to the business.

For nilterl APA, we provide written confirmtion of the greement we rech with the business.

Step 5: Concluded APA A conclded APA contin t least the following informtion: ■ the trsaction, greement or rrngement covered y the APA ■ the period nd tx ye covered y the APA ■ the greed trfer pricing methodology nd the criticassumption on which it i based ■ the definition of key term tht form the bas of the methodology (for exmple, sale, operting profit) ■ if pplicable, nge of rm’ length result, nd ■ the business’ligtion as result of the APA.

Table 7 provides some examples of non-controlled-foreign-corporation (CFC) anti-avoidance rules. This is not a complete list of the anti- avoidance rules in these countries. The consequences of falling under these rules are not necessarily the same as the CFC rules, but those consequences are beyond the scope of this table.

Appendix V: Description of Dividend Exemption Systems in Japan and the United Kingdom

Japan and the United Kingdom both adopted dividend exemption systems in 2009. These countries previously taxed dividends received from foreign subsidiaries but allowed for foreign tax credits (FTC) for foreign taxes paid. Like our study countries, Japan and the United Kingdom have specific rules used to determine whether a dividend qualifies for exemption. Table 8 describes these rules.

Like the study countries, both Japan and the United Kingdom have anti- avoidance rules, including controlled foreign corporation (CFC) rules, which limit the tax advantages of earning or holding certain types of income in relatively low-tax jurisdictions. Japan revised their rules at the same time the dividend exemption system was implemented. The United Kingdom plans to address reforms to their CFC rules in future years. However, the United Kingdom did introduce a worldwide debt cap rule that limits the extent to which debt expenses can be deducted by corporations in the United Kingdom. One goal of this rule is to prevent situations in which businesses in the United Kingdom borrow excessively in order to invest internationally to produce exempt dividends. This is similar to some of the interest expense limitation rules we identified in the other study countries.

Appendix VI: Comments from the Department of the Treasury

Appendix VII: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, José Oyola, Assistant Director; Brian James; Ed Nannenhorn; Danielle Novak; Chhandasi Pandya; Matthew Reilly; A.J. Stephens; and Charles Veirs IV made significant contributions to this report.

Related GAO Products

Cayman Islands: Review of Cayman Islands and U.S. Laws Applicable to U.S. Persons’ Financial Activity in the Cayman Islands, an E- supplement to GAO-08-778, GAO-08-1028SP. Washington, D.C.: July 2008.

U.S. Multinational Corporations: Effective Tax Rates Are Correlated with Where Income Is Reported. GAO-08-950. Washington, D.C.: August 12, 2008.

Tax Administration: Comparison of the Reported Tax Liabilities of Foreign- and U.S.-Controlled Corporations, 1998-2005. GAO-08-957. Washington, D.C.: July 24, 2008.

Business Tax Reform: Simplification and Increased Uniformity of Taxation Would Yield Benefits. GAO-06-1113T. Washington, D.C.: Sept. 20, 2006.

Understanding the Tax Reform Debate: Background, Criteria, and Questions. GAO-05-1009SP. Washington, D.C.: September 2005.

Tax Administration: Comparison of the Reported Tax Liabilities of Foreign- and U.S.-Controlled Corporations, 1996-2000. GAO-04-358. Washington, D.C.: Feb. 27, 2004.

Tax Administration: IRS’ Advanced Pricing Agreement Program. GAO/GGD-00-168. Washington, D.C.: Aug. 14, 2000.

Tax Administration: Foreign- and U.S.-Controlled Corporations That Did Not Pay U.S. Income Taxes, 1989-95. GAO/GGD-99-39. Washington, D.C.: Mar. 23, 1999.

International Taxation: Transfer Pricing and Information on Nonpayment of Tax. GAO/GGD-95-101. Washington, D.C.: Apr. 13, 1995.

International Taxation: IRS’ Administration of Tax-Customs Valuation Rules in Tax Code Section 1059A. GAO/GGD-94-61. Washington, D.C.: Feb. 4, 1994.

International Taxation: Taxes of Foreign- and U.S.-Controlled Corporations. GAO/GGD-93-112FS. Washington, D.C.: June 11, 1993.

International Taxation: Problems Persist in Determining Tax Effects of Intercompany Prices. GAO/GGD-92-89. Washington, D.C.: June 15, 1992.